The Tax Court held that a taxpayer was not entitled to defer gain on a disposition of property to a related party that met the Sec. 1031(a) requirements for a like-kind exchange because the taxpayer structured the transaction to avoid the purposes of the Sec. 1031(f) related-party rules.
Background
The Malulani Group Limited (Malulani Group) is a Hawaii corporation that leased commercial real estate in various states, including Hawaii and Maryland. The Malulani Group filed consolidated 2005 and 2007 corporate income tax returns with its wholly owned subsidiary, MBL Maryland Inc. (MBL). The Malulani Group owned 69.67% of the common shares of Malulani Investments Limited (MIL), which owned real estate throughout the United States.
In October 2006, MBL received a letter of intent from an unrelated third party offering to purchase commercial real estate that MBL owned in Maryland (Maryland property). MBL's representative signed the letter of intent for Malulani Group several days later, and MBL, desiring to transfer the property in a Sec. 1031 exchange, began a search for suitable replacement property. In January 2007, MBL engaged First American Exchange Co. (FAEC) to serve as the qualified intermediary in the exchange. MBL transferred the Maryland property to FAEC, and on Jan. 10, 2007, FAEC sold the Maryland property to the third party for $4,703,000 with closing costs of $71,725. MBL's basis in the Maryland property was $2,743,235 at the time of the transfer.
To meet the Sec. 1031 requirements, MBL had to identify replacement property on or before Feb. 24, 2007. Between Oct. 31, 2006, and Feb. 23, 2007, MBL attempted to identify and negotiate the purchase of a suitable property from an unrelated seller but was unsuccessful. Up to Jan. 10, 2007, the Malulani Group and MBL did not consider acquiring a property from a related party to complete the transaction. However, on Feb. 23, 2007, MBL identified three potential replacement properties, all belonging to MIL.
On July 3, 2007, FAEC purchased certain real property owned by MIL and located in Hawaii (Hawaii property) for $5,520,000 and transferred it to MBL as replacement property for the Maryland property. MIL's basis in the Hawaii property was $2,392,996 at the time of the purchase. The Malulani Group, on its consolidated return, reported a realized gain of $1,888,040 from the sale of the Maryland property but deferred recognition of the gain under Sec. 1031, as well as an unrelated $748,273 net operating loss (NOL), which it carried back to 2005. MIL recognized a gain in excess of $3 million on the exchange, but it had NOLs in excess of the gains and only paid a small amount of alternative minimum tax as a result of the exchange.
The IRS found that the gain on the sale of the Maryland property did not qualify for deferred recognition under Sec. 1031. It claimed that although MBL's exchange of the Maryland property for the Hawaii property met the requirements for a like-kind exchange under Sec. 1031(a)(1), it was disqualified from nonrecognition treatment because it was a transaction structured to avoid the purposes of the Sec. 1031(f) related-party rules. Sec. 1031(f) disallows the nonrecognition of gain on like-kind exchange transactions between related parties if within two years either of the parties disposes of the property received in the exchange. Sec. 1031(f)(4) extends this treatment to a transaction or series of transactions "structured to avoid the purposes of" Sec. 1031(f).
After offsetting a portion of the gain with its $748,273 NOL, the IRS determined that the Malulani Group had a $387,494 deficiency for 2007. In addition, because the NOL was no longer available for carryback, the IRS determined a $264,171 deficiency for 2005. The Malulani Group filed a petition for redetermination with the Tax Court.
The Tax Court's Decision
The Tax Court held that the Malulani Group was not entitled to defer the gain on the exchange of the Maryland property under Sec. 1031. The court found that it had used a Sec. 1031 transaction involving a related party to cash out of a real estate investment free of tax, in contravention of Congress's intent that Sec. 1031 treatment should only apply to transactions where a taxpayer could be viewed as continuing its investment. Therefore, the transaction was structured to avoid the purposes of the Sec. 1031(f) related-party rules, and the Malulani Group was not entitled to defer the gain realized on the exchange of the Maryland property.
The Malulani Group argued that MBL had not structured the exchange of the Maryland and Hawaii properties to avoid the purposes of Sec. 1031(f) because MBL had no "prearranged plan" to conduct a deferred exchange with MIL, citing legislative history as support for this proposition. The company contended MBL had no prearranged plan because MBL had first diligently sought a replacement property held by an unrelated party and only resorted to property held by MIL when the deadline for completing the deferred exchange was imminent. The company also claimed that the fact that MBL had hired a qualified intermediary, which was necessary for a deferred exchange, before it decided to acquire the replacement property from MIL, was further proof that there was no prearranged plan.
The Tax Court disagreed. Citing Ocmulgee Fields, 613 F.3d 1360 (11th Cir. 2010), aff'g 132 T.C. 105 (2009), and Teruya Bros., 580 F.3d 1038 (2009), aff'g 124 T.C. 45 (2005), it found that the presence or absence of a prearranged plan to use property from a related person to complete a like-kind exchange is not dispositive of whether a transaction was structured to avoid the purposes of the related-party rules of Sec. 1031(f). Instead, the inquiry should focus on the actual tax consequences of the transaction to the taxpayer and the related party, considered in the aggregate, as compared to the hypothetical tax consequences of a direct sale of the relinquished property by the taxpayer.
Where the actual liability with a like-kind exchange will be significantly less than the hypothetical lability with a direct sale, the court had inferred in both Ocmulgee Fields and Teruya Bros. that the taxpayer structured the transaction in question with a tax-avoidance purpose. Because it found that the existence of a prearranged plan was not the deciding factor, the court also concluded it was not material that MBL engaged the qualified intermediary before deciding to acquire replacement property from a related party.
Calculating the actual and hypothetical tax amounts for the Malulani Group and MBL, the court determined that the companies would have paid in excess of $650,000 more in tax for 2005 and 2007 if the transaction were treated as a direct sale of the Maryland property. Thus, the court found that substantial economic benefits accrued to the Malulani Group, MBL, and MIL from structuring the transaction as a like-kind exchange, and it inferred that MBL structured the transaction with a tax-avoidance purpose.
The companies also argued, again based on a statement in the legislative history, that the transaction, despite the tax benefits it conferred, lacked a tax-avoidance purpose because it did not involve the exchange of low-basis property for high-basis property. The Tax Court, however, found that notwithstanding a lack of basis shifting in the transaction, a transaction might still have a tax-avoidance purpose if net tax savings were achieved in the transaction through the use of NOLs of the related party. Thus, because MIL used its NOLs to eliminate the tax on the gain that it recognized in the transaction, the lack of basis shifting did not prove that there was not a tax-avoidance purpose.
Reflections
The only witness at the Tax Court trial for the Malulani Group was its former president, who, according to the Tax Court, despite all the evidence and simple common sense indicating otherwise, sought to create the impression that the Malulani Group had no knowledge of MIL's financial condition. He did so by testifying that this information was known only to a committee of three people that oversaw MIL's financial condition for purposes of deciding the amount Malulani would loan to MIL. However, he neglected to mention he was on that committee, as the stipulated exhibits in the case showed. Ultimately, he hurt rather than helped Malulani's case, as the Tax Court stated that his attempt to obscure the truth further persuaded the court that the transaction had a tax-avoidance purpose.
Malulani Group, Ltd., T.C. Memo. 2016-209
