Sec. 1031 Related-Party Exchanges and Basis Shifting

Editor: Alan Wong, CPA

Gains & Losses

Sec. 1031 and the underlying regulations govern the tax treatment of like-kind exchanges of property. These provisions generally permit taxpayers who satisfy the requirements of Sec. 1031 to sell property, purchase like-kind replacement property, and defer the recognition of some or all of the realized gain (subject to certain exceptions). Not surprisingly, the Code provides a number of related-party exceptions designed to circumvent certain abuses. The most prevalent of those abuses is “basis shifting,” which may occur in both obvious and not so obvious circumstances. It is the “not so obvious” variety that may trip up the novice practitioner.

The fundamental construct of a Sec. 1031 basis shift can be best understood by way of an example.

Example 1: X and Y are related parties (within the meaning of Sec. 267). X owns a high-value/low-basis warehouse with a fair market value of $1,000 and an adjusted basis of $200. Y owns a high-value/high-basis apartment building with a fair market value of $1,000 and an adjusted basis of $1,000. The related group (X and Y) wants to sell the warehouse (low-basis property) for $1,000 but wants to avoid the recognition of an $800 gain ($1,000 sale price less $200 adjusted basis).

Is there a way for X and Y to trade their respective adjusted tax bases? Perhaps X and Y could simply enter into a Sec. 1031 like-kind exchange and trade properties with each other. In doing so, Y’s $1,000 pre-exchange basis in the apartment would carry over to the warehouse. This would make it possible for Y to sell the warehouse (presumably to an unrelated party) without realizing or recognizing a gain ($1,000 sale price less $1,000 carryover basis). From the perspective of the related group, and in the absence of a special rule to the contrary, the group will have effectively cashed out on the sale of the warehouse on a tax-deferred basis. However, the related-party exceptions prevent this perceived abuse under most circumstances.

There are three related-party exceptions: (1) the two-year/second disposition rule (Sec. 1031(f)(1)); (2) the rule against transactions structured to avoid the purpose of Sec. 1031(f)(1) (Sec. 1031(f)(4)); and (3) the principal purpose to avoid tax rule (Sec. 1031(f)(2)(C)). For purposes of Sec. 1031, a related person is defined as a person having a relationship to the taxpayer described in the long list of relationships in Sec. 267(b) or Sec. 707(b)(1).

Two-year/second disposition: Sec. 1031(f)(1) specifically provides that if (1) a taxpayer exchanges property with a related person, (2) there is nonrecognition of gain or loss to the taxpayer under Sec. 1031 with respect to the exchange, and (3) within two years after the date of the last transfer that was part of the exchange either the related person disposes of the taxpayer’s relinquished property or the taxpayer disposes of the replacement property received in the exchange from the related person, there will be no nonrecognition of gain or loss under Sec. 1031 to the taxpayer with respect to the exchange (referred to herein as the second disposition). Any gain or loss the taxpayer recognizes on the exchange, by reason of the Sec. 1031(f) rules disallowing related-party exchanges, is taken into account on the date on which the second disposition of either relinquished property or replacement property referred to in clause (3) occurs. Going back to Example 1, if either X or Y sells his respective property within two years of the original Sec. 1031 exchange, Sec. 1031(f)(1) mandates that no portion of the realized gain, if any, on the original exchange may be deferred under Sec. 1031.

Transaction structured to avoid the purpose of Sec. 1031(f)(1): Sec. 1031(f)(4) states that nonrecognition under Sec. 1031 does not apply to any exchange that is part of a transaction (or a series of transactions) structured to avoid the purposes of Sec. 1031(f).

Principal purpose to avoid tax: Similar to Sec. 1031(f)(4), which explores the underlying purpose of the transactional construct, Sec. 1031(f)(2)(C) provides that a disposition occurring within the statutory two-year period will not be treated as a second disposition “if it is established to the satisfaction of the Secretary that neither the exchange nor the disposition had as one of its principal purposes the avoidance of federal income tax.”

In connection with these exceptions, the lawmakers have provided some guidance on determining when an exchange (1) is not associated with a transaction structured to avoid the purposes of Sec. 1031(f)(1); or (2) does not have as its principal purpose the avoidance of tax. A Senate report explaining the Revenue Reconciliation Act of 1989 identifies at least three categories of transactions that should not be treated as second dispositions that create gain recognition under Sec. 1031(f). One of the three categories includes “transactions that do not involve the shifting of basis between properties” (S. Rep’t No. 56, 101st Cong., 1st Sess. 152 (10/12/89) (emphasis added)). Whether the IRS will exercise its discretion and apply these particular exceptions is uncertain. Because there are not yet any regulations governing related-party exchanges, the IRS has not given carte blanche approval to these transactions. Accordingly, it may be advisable to seek a letter ruling on the issue.

Example 2: The facts are the same as in Example 1, except X enters into a Sec. 1031 exchange that includes the following transactions (which occur on the same day): X transfers his warehouse (the relinquished property) to a qualified intermediary (QI), who sells it to an unrelated party for $1,000. The QI purchases Y’s apartment (replacement property) for $1,000 and transfers it to X.

Assuming that no boot was given or received in connection with the exchange, it would appear that X would not recognize any gain. To the novice, the form of this transaction is quite different from Example 1. There does not appear to be a second disposition to taint the Sec. 1031 exchange. However, in a stealthy manner, this transaction produces results identical to Example 1: The related group winds up with the apartment and cashes out on a tax-deferred basis. This transaction very likely runs afoul of the second and possibly the third related-party exceptions. (Note that the two-year period under the first exception is not a factor under the second and third related-party exceptions.)

The IRS and the Courts

Consistent with the implied and express concern over basis shifting through indirect exchanges, as reflected in the Sec. 1031(f)(4) series of transactions standard and the Sec. 1031(f)(2)(C) principal purpose standard, the IRS has addressed these issues in various rulings and pronouncements, including, among others, Technical Advice Memoranda 9748006 and 200126007, Rev. Rul. 2002-83, and Letter Ruling 200706001. The Tax Court also addressed these concerns in Teruya Brothers, Ltd., 124 T.C. 45 (2005), aff’d, 580 F.3d 1038 (9th Cir. 2009), cert. denied, Sup. Ct. Dkt. 09-716 (U.S. 2/22/10).

The conclusion that taxpayers and practitioners can take from these pronouncements, rulings, and cases is that nonrecognition treatment under Sec. 1031(a) will be disallowed if the taxpayer derives a tax benefit from using a related party to accomplish basis shifting. Accordingly, if basis shifting does not occur, it appears that nonrecognition under Sec. 1031 should be allowed. However, as noted previously, this conclusion is not entirely free from doubt.

EditorNotes

Alan Wong is a senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York, NY.

For additional information about these items, contact Mr. Wong at (212) 697-6900, ext. 986, or awong@hrrllp.com.

Unless otherwise noted, contributors are members of or associated with DFK International/USA.