The Tax Court reaffirmed its 2005 holding that use of a qualified intermediary in a section 1031 exchange of like-kind property does not bypass restrictions on such exchanges between related parties. In evaluating whether tax avoidance was a principal purpose of such a transaction for purposes of the exception to those restrictions under IRC § 1031(f)(2)(C), the court held that basis shifting between the parties establishes an inference of tax avoidance.
Under IRC § 1031 no gain or loss is recognized when a taxpayer directly, or indirectly through a qualified intermediary, exchanges property used in a trade or business solely for like-kind property that is also used in a trade or business. The basis of the acquired property will equal the basis of the relinquished property when no cash is involved. If the two parties involved in the like-kind exchange are related, the disposition of property received by either party can trigger the recognition of gain or loss if the disposition occurs within two years of the date of the original exchange.
Nonetheless, nonrecognition of gain or loss is possible if the taxpayer can show that tax avoidance was not a principal reason for the exchange or the disposition. Related parties, defined at section 267(b), include individuals who are members of the same family, as well as corporations and partnerships where one entity is a majority owner of the other.
On July 17, 2003, Ocmulgee Fields Inc., owned by Charles Jones of Macon, Ga., and his two sons, Dwight and Jefferson, agreed to sell a shopping center, Wesleyan Station, to two trusts to which it was not related. The sales agreement required closing on or before Oct. 10, 2003, and included Ocmulgee Fields’ intent that the sale was to be part of an exchange qualifying for nonrecognition of gain under section 1031. After rejecting several properties in its attempt to find suitable like-kind property and with the closing date drawing near, Ocmulgee Fields assigned its rights to sell Wesleyan Station to Security Bank, a qualified intermediary, which in turn sold the property to the trusts.
Meanwhile, Ocmulgee Fields agreed to buy property called Barnes & Noble Corner from Treaty Fields, an LLC also owned by Charles and Dwight Jones and thus a related party. Ocmulgee Fields, which seven years earlier had sold Barnes & Noble Corner to Treaty Fields, then assigned the right to buy that property to Security Bank. The bank used the proceeds of the Wesleyan Station sale to purchase Barnes & Noble Corner and transferred that property to Ocmulgee Fields. Ocmulgee reported the disposition of Wesleyan Station as a like-kind exchange on its May 31, 2004, year-end tax return, deferring the entire $6,112,736 gain and carrying over the $716,164 basis of Wesleyan Station to the newly acquired Barnes & Noble Corner property. The IRS disallowed nonrecognition of the gain and increased Ocmulgee’s taxable income by that amount, arguing the taxpayer had not shown that tax avoidance was not a main objective of the exchange.
The Service cited Teruya Bros. Ltd. & Subs. v. Commissioner, 124 TC 45 (2005), in which the Tax Court ruled against the taxpayer on similar facts. Ocmulgee argued that, unlike Teruya, it had no prearranged plan and originally had hoped to acquire replacement property from an unrelated party. Only after it could not find any suitable property did it consider the Barnes & Noble Corner property and decide to reacquire it because it owned other property in the same shopping center. The court rejected this argument, stating the prearrangement aspect in Teruya had little or no effect on its holding in that case.
To determine whether Ocmulgee qualified for the exception under section 1031(f)(2)(C) from the related-party rules that the transaction did not have tax avoidance as a principal purpose, the court said the result of a hypothetical subsequent sale of Wesleyan Station by Treaty Fields should be evaluated. The result of that hypothetical transaction would be a reduction in taxable gain of $1.8 million that would be taxed at 15% instead of 34% when it passed through to the owners (related parties) of Treaty Fields.
Examining the legislative history of section 1031(f), which states a transaction that does not shift basis between properties generally does not have tax avoidance as a principal purpose, the court inferred that a transaction that does shift basis between properties generally does have tax avoidance as a principal purpose. The court did not go so far as to say that basis shifting automatically meant that tax avoidance was a principal purpose; however, it held that Ocmulgee had not presented enough evidence to show that tax avoidance was not a principal reason for the transaction in light of the obvious tax benefits of the exchange.
The court did not uphold an accuracy-elated penalty, stating that Ocmulgee had relied upon the advice of its trusted and longtime CPA, whose decisions were not unreasonable in light of “interpretive difficulties” of the statute and the fact that the return had been filed before the court ruled in Teruya.
Ocmulgee Fields Inc. v. Commissioner, 132 TC no. 6
By Charles J. Reichert, CPA, professor of accounting, University of Wisconsin–Superior.