The U.S. Court of Appeals has affirmed a Tax Court decision that a taxpayer could not avoid the Code Sec. 1031(f) like-kind-exchange related-party rule by using a qualified intermediary (QI).  The ruling also clarified the "tax avoidance" exception to Section 1031 (f).

Background.

Most Section 1031 tax free exchanges are effected through a QI.  Under Code Sec. 1031(f), gain or loss on an exchange between related persons must generally be recognized if either the property transferred or the property received is disposed of within two years after the exchange.  However, a disposition won't trigger the related party bar if it is established to IRS's satisfaction that neither the original transaction nor the later disposition had as one of its principal purposes the avoidance of federal tax.   It has not been entirely clear how use of a QI affects this rule.

Ocmulgee Fields.

In the Ocmulgee Fields case:

(1) Ocmulgee Fields, Inc. (OFI) entered in a contract to sell appreciated property it owned (Wesleyan Station) to an unrelated party.

(2) OFI transferred Wesleyan Station to a QI. OFI had a $716,000 basis in the property.  The property was valued at approximately $7 million.

(3) The unrelated third party bought Wesleyan Station from the QI for $7.25 million.

(4) Treaty Fields, an entity related to OFI, sold appreciated property in which it had an adjusted basis of $2.55 million (the Barnes & Noble Corner) to the QI. The sale price was $6.74 million.

(5) The QI transferred the Barnes & Noble Corner to OFI to complete the exchange.

OFI claimed that when it initiated the series of transactions, it intended to swap its property for replacement property from an unrelated party but that after transferring the property to the QI, suitable replacement property couldn't be found within the statutory identification and replacement periods. The Barnes & Noble property was adjacent to property that OFI already owned.

OFI realized a gain of about $6 million but treated its part of the transaction as a like-kind tax-deferred exchange under Code Sec. 1031. Treaty Fields reported its part of the transaction as a taxable sale and reported a gain of about $4 million. Had OFI recognized the gain, it would (as a C corporation) have paid tax on it at a 34% rate. Treaty Fields was a partnership whose partners paid a 15% tax on the gain passed through to them.

IRS said OFI wasn't entitled to treat the transaction as a like-kind, tax-deferred exchange because Code Sec. 1031(f)(4) applied to the transaction, and the Tax Court agreed with IRS.

The Tax Court (the lower court) said that to determine OFI's exchange was part of a transaction or series of transactions structured to avoid the purposes of Code Sec. 1031(f), it had to disregard that exchange and consider how OFI would have fared had it instead exchanged Wesleyan Station with Treaty Fields for the Barnes & Noble Corner and had Treaty Fields then sold Wesleyan Station.  By selling Wesleyan Station, the "two year" rule is triggered, so OFI would have to rely on its deal not being a tax avoidance transaction.  The immediate tax consequences resulting from OFI's deemed exchange with Treaty Fields included an approximately $1.8 million reduction in taxable gain and Treaty Fields paying tax on its gain at a much lower rate than OFI would have paid.

The Tax Court was not convinced by OFI's argument that tax avoidance was not a principal purpose of the deemed exchange because there was a business reason for exchanging Wesleyan Station for the Barnes & Noble Corner in that the swap allowed OFI to reunite ownership of the Barnes & Noble Corner with other contiguous property that it owned, thereby yielding operating efficiencies and increasing the overall value of the reunited property.

The Tax Court concluded that the end result of the transactions was the same as if OFI had made an exchange of Wesleyan Station with Treaty Fields followed by Treaty Fields' sale of Wesleyan Station. OFI failed to show that the deemed transaction lacked as a principal purpose the avoidance of Federal income tax. As a result, the actual exchange was part of a transaction structured to avoid the purposes of section Code Sec. 1031(f) and, therefore, the nonrecognition provisions of Code Sec. 1031 did not apply to the exchange.

U.S. Court of Appeals.

A combination of several factors supported the Tax Court's finding of a tax-avoidance motive.  The Court reasoned that the related parties: (1) cashed in on their low basis property but paid taxes as if they had cashed in on their (relatively) high-basis property; (2) significantly reduced their immediate taxes by engaging in the exchange; and (3) enhanced these immediate tax savings by shifting nearly the entire burden of taxation to the party with the lowest tax rate.  The Court of Appeals therefore upheld the Tax Court's ruling.

Conclusion.