The Tax Court denied nonrecognition treatment under Sec. 1031 for a deferred exchange of real estate between a corporate taxpayer and its subsidiary. The transaction allowed the taxpayer to cash out of its investment in the property with a small tax liability, indicating a principal purpose of tax avoidance, the court held, and the use of a qualified intermediary did not shield the taxpayer from the Sec. 1031(f) prohibition of related-party exchanges.
Facts: In 2006, MBL Maryland Inc., a wholly owned subsidiary of the Malulani Group Ltd., entered into an agreement with an unrelated third party to sell real estate it owned in Maryland, reserving the right to effect an exchange of property under Sec. 1031 and requiring the buyer to cooperate with the exchange. In January 2007, MBL executed an agreement with First American Exchange Co. (FAEC) for the latter to serve as MBL's intermediary in a like-kind exchange. On Jan. 10, 2007, MBL transferred the property through FAEC to the buyer. MBL had to identify replacement property on or before Feb. 24, 2007, to meet the 45-day requirement of Sec. 1031(a)(3). MBL attempted to identify a suitable property owned by an unrelated party to purchase, but was unable to do so. On Feb. 23, 2007, MBL identified three potential replacement properties, all belonging to Malulani Investments (MIL). The Malulani Group owned 69.67% of the common shares of MIL. On July 3, 2007 (within 180 days after transfer of the relinquished property, also as required by Sec. 1031(a)(3)), FAEC purchased replacement property owned by MIL and transferred it to MBL.
Upon an examination of the Malulani Group's 2007 corporate tax return, the IRS determined that the Malulani Group did not qualify for Sec. 1031 deferral of its approximately $1.9 million of gain realized in the transaction. The IRS issued a notice of deficiency, and the Malulani Group challenged the determination in the Tax Court.
Issues: Sec. 1031 provides that no gain or loss is recognized on the exchange of like-kind property held for productive use in a trade or business or for investment. A deferred exchange, where the relinquished property is transferred before the replacement property is acquired, may qualify for nonrecognition of gain if the taxpayer adheres to the time restrictions noted above. A qualified intermediary may be used to facilitate the exchange in such cases.
To prevent abuse of the like-kind exchange rules, Congress enacted Sec. 1031(f) to limit nonrecognition treatment under Sec. 1031(a) in the case of like-kind exchanges between related parties. Sec. 1031(f)(1) denies nonrecognition of gain or loss on an exchange if, within two years after the date of the last transfer of the exchange, the taxpayer or a related person disposes of the relinquished or replacement property. In addition, Sec. 1031(f)(4) disallows nonrecognition treatment for any exchange that is part of a transaction or series of transactions "structured to avoid the purposes of" Sec. 1031(f), thereby disallowing nonrecognition treatment of deferred exchanges that indirectly involve related persons through the interposition of qualified intermediaries. Sec. 1031(f)(2)(C) provides an exception from that rule for any disposition of the relinquished or replacement property within two years of the exchange if the taxpayer establishes to the IRS's satisfaction that neither the exchange nor the disposition had as one of its principal purposes the avoidance of federal income tax.
The IRS contended that MBL's exchange was disqualified from nonrecognition treatment pursuant to Sec. 1031(f)(4) as a transaction structured to avoid the purposes of Sec. 1031(f).
The Malulani Group argued that the exchange was not structured to avoid the related-persons rules because MBL had no "prearranged plan" to conduct a deferred exchange with MIL.
Holding: The Tax Court agreed with the IRS and held that the transaction at issue did not qualify for nonrecognition of gain because the like-kind exchange was structured with a tax avoidance purpose to avoid the consequences of Sec. 1031(f)(4).
The Tax Court cited its decisions in Ocmulgee Fields, Inc., 132 T.C. 105 (2009), aff'd, 613 F.3d 1360 (11th Cir. 2010), and Teruya Bros., Ltd., 124 T.C. 45 (2005), aff'd, 580 F.3d 1038 (9th Cir. 2009), which both involved deferred exchanges where taxpayers received replacement property from related parties. In both those cases, the Tax Court concluded that the deferred exchanges violated Sec. 1031(f)(4).
The Tax Court found (quoting the Ninth Circuit's opinion in Teruya Bros.) that, as a result of structuring the transaction as a deferred exchange, the Malulani Group and its subsidiary were able to "cash out of a significant investment in real property under the guise of a non-taxable like-kind exchange," as had the taxpayers in Teruya Bros. and Ocmulgee Fields. It further found that the Malulani Group had failed to demonstrate that avoidance of federal income tax was not one of the principal purposes of the exchange. Accordingly, the court held that the exchange did not qualify for nonrecognition treatment under Sec. 1031.
—By Maria M. Pirrone, CPA, LL.M., assistant professor of accounting and taxation, St. John's University, Queens, N.Y.