A Like-Kind Exchange To Avoid Tax

 

Let’s talk about like-kind exchanges.

A key point is - if done correctly - it is a means to exchange real estate without immediate tax consequence.

There was a time when one could exchange either personal property or real property and still qualify under the tax-deferral umbrella of a like-kind exchange. Congress removed the personal property option several years ago, so like-kinds today refer only to real estate.

The Code section for like-kinds is 1031, but today let’s focus on Section 1031(f):

(f) Special rules for exchanges between related persons

(1) In general If—

(A) a taxpayer exchanges property with a related person,

(B) there is nonrecognition of gain or loss to the taxpayer under this section with respect to the exchange of such property (determined without regard to this subsection), and

(C) before the date 2 years after the date of the last transfer which was part of such exchange—

(i)  the related person disposes of such property, or

(ii) the taxpayer disposes of the property received in the exchange from the related person which was of like kind to the property transferred by the taxpayer,

there shall be no nonrecognition of gain or loss under this section to the taxpayer with respect to such exchange; except that any gain or loss recognized by the taxpayer by reason of this subsection shall be taken into account as of the date on which the disposition referred to in subparagraph (C) occurs.

(2) Certain dispositions not taken into accountFor purposes of paragraph (1)(C), there shall not be taken into account any disposition—

(A) after the earlier of the death of the taxpayer or the death of the related person,

(B) in a compulsory or involuntary conversion (within the meaning of section 1033) if the exchange occurred before the threat or imminence of such conversion, or

(C) with respect to which it is established to the satisfaction of the Secretary that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax.

(3) Related person

For purposes of this subsection, the term “related person” means any person bearing a relationship to the taxpayer described in section 267(b) or 707(b)(1).

(4) Treatment of certain transactions

This section shall not apply to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection.

This verbiage came into the tax Code in 1989.

What is the issue here?

Let’s use an easy example:

CTG owns a hotel building worth $1 million. Its adjusted basis is $175,00.

CTG II owns a warehouse worth $1 million and an adjusted basis of $940,000.

If CTG sells its building, the gain is $825,000 ($1 million minus 175,000).

If CTG II sells its building, the gain is $60,000 ($1 million minus 940,000).

Say that someone wants to buy CTG’s hotel. Can we beat down that $825,000 gain?

What if we have CTG and CTG II swap buildings? CTG Jr would then own the hotel but keep its $940,000 adjusted basis. CTG II would then sell the hotel at a gain of $60,000.

Yeah, no. Congress already thought of that.

You better wait at least two years before the (second) sale, otherwise you have smashed right into Section 1031(f)(1)(C). The Code then says that- unless you can sweet talk the IRS - there was never a like-kind exchange. You instead have taxable income. Thanks for playing.

Let’s look at the Teruya Brothers case.

This case requires us to determine whether two like-kind exchanges involving related parties qualify for nonrecognition treatment under 26 U.S.C. § 1031.

This appeal concerns the tax treatment of real estate transactions involving two of Teruya's properties, the Ocean Vista condominium complex (“Ocean Vista”), and the Royal Towers Apartment building (“Royal Towers”).

We will look at the Ocean Vista (OV) transaction only.

Someone wanted to buy OV.

Teruya was initially not interested. It relented – IF it could structure the deal as a Section 1031 like-kind exchange.

So far this is relatively commonplace.

Teruya wanted to buy property from Times Super Market (Times) as the replacement.

Issue: Teruya owned 62.5% of Times.

The gain (which Teruya was trying to defer) was in excess of $1.3 million.

Teruya exchanged and filed its tax return accordingly.

The IRS balked.

The IRS argued that Teruya went foul of Section 1031(f)’s “established to the satisfaction” and “structured to avoid” prohibitions.

Teruya argued that the IRS was making no sense: Times reported the gain on its tax return. It had no deferred gain from the like-kind exchange. Who would structure a transaction to avoid tax when one of the parties reported gain?

On first impression, the argument makes sense.

The Court noted that Times had a net operating loss that wiped out the gain from the sale. There was no tax.

Teruya had a problem. It sold the property within two years, meaning that the IRS had a chance to challenge. The IRS challenged, both under Section 1031(f)(2)(C) and (f)(4).

Here is the Court:

We conclude that these transactions were structured to avoid the purposes of Section 1031(f).

Teruya lost.

Teruya went into this transaction in 1995, when Section 1031(f) was relatively new. There would not have been much case law on working and planning with this Code section.

Teruya provided practitioners some of that case law. 

We now know that an advisor must expand his/her perspective beyond just the Section 1031 exchange and consider other tax attributes sitting on the tax returns of the related parties.

And sales within two years are courting death.

Dodge that and Section 1031(f)(4) might still nab you.

Our case this time was Teruya Brothers, LTD v Commissioner, 124 TC No. 4.