Related Party Section 1031 Exchanges
Chris Burti, Vice President and Senior Legal Counsel

As the current real estate market continues to gain traction, we are seeing resurgence in the number of transactions being structured to qualify for nonrecognition of taxable gain under Internal Revenue Code Section 1031. We are also being asked to assist in structuring transactions that either involve related parties or involve factual circumstances requiring a careful analysis of related party issues.

A little 1031 refresher may be helpful first. Section 1031(a)(1) provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if the property is exchanged solely for property of a like kind that is to be held either for productive use in a trade or business or for investment. Under section 1031(d), the basis of property acquired in a section 1031 exchange is treated as having the same basis as that of the property exchanged as adjusted by certain factors not relevant to this discussion. Section 1031 and the regulations thereunder allow for deferred exchanges of property. Under section 1031(a)(3) and section 1.1031(k)-1(b), of the relevant Income Tax Regulations (the Regs.), the property a taxpayer receives in the exchange (replacement property) must be (1) identified within 45 days of the transfer of the property relinquished in the exchange (relinquished property) and (2) received by the tax payer before 180 days after the transfer of the relinquished property or the due date (including extensions) of the transferor's tax return for the taxable year in which the relinquished property is transferred whichever is earlier.

Section 1.1031(k)-1(g)(4), of the Regs., permits the taxpayer to use qualified intermediaries to facilitate like-kind exchanges. A Qualified Intermediary is not considered the agent of the taxpayer for purposes of section 1031(a). In the case of a transfer of relinquished property involving a Qualified Intermediary, the taxpayer's transfer of relinquished property to a Qualified Intermediary and subsequent receipt of like-kind replacement property from the Qualified Intermediary is treated as an exchange with the Qualified Intermediary.

There are special rules for property exchanged between related persons set out in Section 1031(f) provided as follows in pertinent part:

Section 1031(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 (emphasis added) to the taxpayer with respect to such exchange

(2) Certain dispositions not taken into account.-- For purposes of paragraph (1)(C), there shall not be taken into account any disposition–-

  (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. (emphasis added)

…

(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… (emphasis added).

The reason for the issuance of these Regs applicable to related parties is the concern that the government has for the possibility of a taxpayer using Section 1031 to "cash out" of a low basis fully depreciated property and roll the proceeds into a high basis property that will, in turn, permit further depreciation. The Tax Court has observed that "Congress concluded that if a related party exchange is followed shortly thereafter by a disposition of the property, the related parties have, in effect, 'cashed out' of the investment, and the original exchange should not be accorded nonrecognition treatment." Teruya Bros., Ltd. & Subs. v. Comm., 124 T.C. 45 (2005).

One question often posed to us is how to structure the transaction in order to make it fit within the safe harbors created by the Regs. Great care must be taken to avoid taking actions in such a structuring that are done solely to qualify for favorable tax treatment and thus, avoid taxable gain without any other business or investment purpose. One such disapproved action is simply titling the property in the name of a Qualified Intermediary in order to create a separation in title from the related party.

The essential facts in Teruya Bros. reflected that the taxpayer negotiated the sale of low basis real property to an unrelated party. In anticipation of the sale, the taxpayer arranged to purchase high basis replacement property from a controlled entity. To carry out the transaction, the taxpayer arranged for a Qualified Intermediary to acquire the property the taxpayer had agreed to sell and to sell it to the unrelated party, then use the proceeds to purchase the replacement property from the related party, and finally transfer that replacement property to the taxpayer.

The Tax Court concluded that the transaction was the economic equivalent of a direct exchange of properties between the taxpayer and the related party, followed by that party's sale of the property it received to an unrelated third party. The Court held that the interposition of a Qualified Intermediary in the transactions could not change the end result. If the IRS, thus, determines that a Qualified Intermediary was interposed in the transaction in an attempt to circumvent the limitation in section 1031(f)(1) that would have applied to an exchange directly between related persons, and the taxpayer fails to show that tax avoidance was not one of the principal purposes of the transactions, the courts will conclude that the transactions were structured to avoid the purposes of section 1031(f) and, consequently, pursuant to section 1031(f)(4), the taxpayer will not be entitled to nonrecognition under section 1031(a)(1). See: Ocmulgee Fields, Inc. v. Comm., 132 T.C. No. 6 (2009).

There is a non-tax avoidance exception included in the Regs that applies in certain instances that would otherwise be considered disqualified transactions. The non-tax avoidance exception generally will apply to (1) transactions involving certain exchanges of undivided interests, (2) dispositions in nonrecognition transactions, and (3) transactions that do not involve the shifting of basis between properties. In addressing the question often posed to us as to how to structure the transaction in order to make it fit within the safe harbors created by the Regs we emphasize that Great care must be taken because structuring the transaction solely for the purpose of fitting it within this exception will not comply with the Regs or controlling case law. To avoid taking actions in such a structuring that are done solely to qualify and thus, avoid taxable gain there must be some other reasonable and rational business or investment purpose.

Because the structure of the exchange and sale in Teruya Bros. was as described in section 1031(f)(1) of the Regs, the Tax Court then looked to see whether avoidance of Federal income tax was one of the principal purposes of the purported exchange. It did so because it had determined that the non-tax-avoidance exception of section 1031(f)(2)(C) "is subsumed within the purposes of section 1031(f), [and] any inquiry into whether a transaction is structured to avoid the purposes of section 1031(f) should … take this exception into consideration." The Court rejected the taxpayer's argument that it met the requirements of the exception and restated its observation that the economic substance of the transactions remains that the relinquished properties were cashed out immediately and the related party ended up with the cash proceeds." The court also concluded that (1) the taxpayer had failed to prove that tax avoidance was not one of the principal purposes of the two transactions and (2) the taxpayer had used the Qualified Intermediary simply to avoid the tax consequences of what was determined to be the economic equivalent of a direct exchange with the related person.

It is important to note that the Regs incorporate the definitions of related persons contained in Internal Revenue Code Sections 267 and 707(b)(1). The text of Sections is set out below and they may be summarized as follows:

Individuals

1.      Members of a family,

1. brothers and sisters (whether by the whole or half blood),
2. spouse,
3. ancestors, and
4. lineal descendants;

2.      An individual and a corporation that they directly, or indirectly, own more than 50 percent of the outstanding stock.

3.      Two corporations which are members of the same controlled group.

4.      A grantor and a Trustee of any trust.

5.      Trustees of different trusts, if the same person is a grantor of both trusts.

6.      A Trustee of a trust and its beneficiary.

7.      A Trustee of a trust and a beneficiary of another trust, if the same person is a grantor of both trusts

8.      A Trustee of a trust and a corporation controlled by the Grantor.

9.      A person and a charitable organization which is controlled directly or indirectly by such person or by members of their family.

10.  A corporation and a partnership if the same persons own more than 50 percent in value of the outstanding stock of the corporation, and more than 50 percent of the capital interest, or the profits interest, in the partnership;

11.  An executor of an estate and a beneficiary of such estate, except in the case of a sale or exchange in satisfaction of a pecuniary bequest.

Controlled Corporations

The Ownership of Stock –

     (1)   Stock shall be considered as being owned proportionately by or for its shareholders, partners, or beneficiaries;

     (2)   An individual shall be considered as owning the stock owned, directly or indirectly, by or for his family;

     (3)   An individual owning (otherwise than by the application of paragraph (2)) any stock in a corporation shall be considered as owning the stock owned, directly or indirectly, by or for his partner;

     (4)   Stock constructively owned by a person by reason of the application of paragraph (1) shall, for the purpose of applying paragraph (1), (2), or (3), be treated as actually owned by such person, but stock constructively owned by an individual by reason of the application of paragraph (2) or (3) shall not be treated as owned by him for the purpose of again applying either of such paragraphs in order to make another the constructive owner of such stock.

U.S.Code Section 267.

Losses, expenses, and interest with respect to transactions between related taxpayers

    (a) In general

      (1) Deduction for losses disallowed

        No deduction shall be allowed in respect of any loss from the sale or exchange of property, directly or indirectly, between persons specified in any of the paragraphs of subsection

           (b) The preceding sentence shall not apply to any loss of the distributing corporation (or the distributee) in the case of a distribution in complete liquidation.

      (2) Matching of deduction and payee income item in the case of expenses and interest

        If -

          (A) by reason of the method of accounting of the person to whom the payment is to be made, the amount thereof is not (unless paid) includible in the gross income of such person, and

          (B) at the close of the taxable year of the taxpayer for which (but for this paragraph) the amount would be deductible under this chapter, both the taxpayer and the person to whom the payment is to be made are persons specified in any of the paragraphs of subsection (b), then any deduction allowable under this chapter in respect of such amount shall be allowable as of the day as of which such amount is includible in the gross income of the person to whom the payment is made (or, if later, as of the day on which it would be so allowable but for this paragraph). For purposes of this paragraph, in the case of a personal service corporation (within the meaning of section 441(i)(2)), such corporation and any employee-owner (within the meaning of section 269A(b)(2), as modified by section 441(i)(2)) shall be treated as persons specified in subsection (b).

      (3) Payments to foreign persons

The Secretary shall by regulations apply the matching principle of paragraph (2) in cases in which the person to whom the payment is to be made is not a United States person.

    (b) Relationships

      The persons referred to in subsection (a) are:

        (1) Members of a family, as defined in subsection (c)(4);

        (2) An individual and a corporation more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for such individual;

        (3) Two corporations which are members of the same controlled group (as defined in subsection (f));

        (4) A grantor and a fiduciary of any trust;

        (5) A fiduciary of a trust and a fiduciary of another trust, if the same person is a grantor of both trusts;

        (6) A fiduciary of a trust and a beneficiary of such trust;

        (7) A fiduciary of a trust and a beneficiary of another trust, if the same person is a grantor of both trusts;

        (8) A fiduciary of a trust and a corporation more than 50 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for the trust or by or for a person who is a grantor of the trust;

         (9) A person and an organization to which section 501 (relating to certain educational and charitable organizations which are exempt from tax) applies and which is controlled directly or indirectly by such person or (if such person is an individual) by members of the family of such individual;

        (10) A corporation and a partnership if the same persons own -

          (A) more than 50 percent in value of the outstanding stock of the corporation, and

          (B) more than 50 percent of the capital interest, or the profits interest, in the partnership;

        (11) An S corporation and another S corporation if the same persons own more than 50 percent in value of the outstanding stock of each corporation;

        (12) An S corporation and a C corporation, if the same persons own more than 50 percent in value of the outstanding stock of each corporation; or

        (13) Except in the case of a sale or exchange in satisfaction of a pecuniary bequest, an executor of an estate and a beneficiary of such estate.

(c) Constructive ownership of stock For purposes of determining, in applying subsection (b), the ownership of stock –

         (1) Stock owned, directly or indirectly, by or for a corporation, partnership, estate, or trust shall be considered as being owned proportionately by or for its shareholders, partners, or beneficiaries;

         (2) An individual shall be considered as owning the stock owned, directly or indirectly, by or for his family;

         (3) An individual owning (otherwise than by the application of paragraph (2)) any stock in a corporation shall be considered as owning the stock owned, directly or indirectly, by or for his partner;

         (4) The family of an individual shall include only his brothers and sisters (whether by the whole or half blood), spouse, ancestors, and lineal descendants; and

         (5)   Stock constructively owned by a person by reason of the application of paragraph (1) shall, for the purpose of applying paragraph (1), (2), or (3), be treated as actually owned by such person, but stock constructively owned by an individual by reason of the application of paragraph (2) or (3) shall not be treated as owned by him for the purpose of again applying either of such paragraphs in order to make another the constructive owner of such stock.

(d) Amount of gain where loss previously disallowed If –

         (1)   in the case of a sale or exchange of property to the taxpayer a loss sustained by the transferor is not allowable to the transferor as a deduction by reason of subsection (a)(1) (or by reason of section 24(b) of the Internal Revenue Code of 1939); and

         (2)   after December 31, 1953, the taxpayer sells or otherwise disposes of such property (or of other property the basis of which in his hands is determined directly or indirectly by reference to such property) at a gain, then such gain shall be recognized only to the extent that it exceeds so much of such loss as is properly allocable to the property sold or otherwise disposed of by the taxpayer. This subsection applies with respect to taxable years ending after December 31, 1953. This subsection shall not apply if the loss sustained by the transferor is not allowable to the transferor as a deduction by reason of section 1091 (relating to wash sales) or by reason of section 118 of the Internal Revenue Code of 1939.

(e) Special rules for pass-thru entities

        (1) In general In the case of any amount paid or incurred by, to, or on behalf of, a pass-thru entity, for purposes of applying subsection (a)(2) –

                  (A)  such entity,

                  (B)   in the case of - (i) a partnership, any person who owns (directly or indirectly) any capital interest or profits interest of such partnership, or (ii) an S corporation, any person who owns (directly or indirectly) any of the stock of such corporation,

                  (C)  any person who owns (directly or indirectly) any capital interest or profits interest of a partnership in which such entity owns (directly or indirectly) any capital interest or profits interest, and

                  (D)  any person related (within the meaning of subsection (b) of this section or section 707(b)(1)) to a person described in subparagraph (B) or (C), shall be treated as persons specified in a paragraph of subsection (b). Subparagraph (C) shall apply to a transaction only if such transaction is related either to the operations of the partnership described in such subparagraph or to an interest in such partnership.

      (2) Pass-thru entity For purposes of this section, the term ''pass-thru entity'' means

                  (A) a partnership, and

                  (B) an S corporation.

       (3)   Constructive ownership in the case of partnerships For purposes of determining ownership of a capital interest or profits interest of a partnership, the principles of subsection (c) shall apply, except that –

                  (A)  paragraph (3) of subsection (c) shall not apply, and

                  (B)   interests owned (directly or indirectly) by or for a C corporation shall be considered as owned by or for any shareholder only if such shareholder owns (directly or indirectly) 5 percent or more in value of the stock of such corporation.

       (4)   Subsection (a)(2) not to apply to certain guaranteed payments of partnerships In the case of any amount paid or incurred by a partnership, subsection (a)(2) shall not apply to the extent that section 707(c) applies to such amount.

       (5)   Exception for certain expenses and interest of partnerships owning low-income housing

                  (A)   In general This subsection shall not apply with respect to qualified expenses and interest paid or incurred by a partnership owning low-income housing to - (i) any qualified 5-percent or less partner of such partnership, or (ii) any person related (within the meaning of subsection (b) of this section or section 707(b)(1)) to any qualified 5-percent or less partner of such partnership.

                  (B)   Qualified 5-percent or less partner For purposes of this paragraph, the term ''qualified 5-percent or less partner'' means any partner who has (directly or indirectly) an interest of 5 percent or less in the aggregate capital and profits interests of the partnership but only if - (i) such partner owned the low-income housing at all times during the 2-year period ending on the date such housing was transferred to the partnership, or (ii) such partnership acquired the low-income housing pursuant to a purchase, assignment, or other transfer from the Department of Housing and Urban Development or any State or local housing authority. For purposes of the preceding sentence, a partner shall be treated as holding any interest in the partnership which is held (directly or indirectly) by any person related (within the meaning of subsection (b) of this section or section 707(b)(1)) to such partner.

                  (C)   Qualified expenses and interest For purpose of this paragraph, the term ''qualified expenses and interest'' means any expense or interest incurred by the partnership with respect to low-income housing held by the partnership but - (i) only if the amount of such expense or interest (as the case may be) is unconditionally required to be paid by the partnership not later than 10 years after the date such amount was incurred, and (ii) in the case of such interest, only if such interest is incurred at an annual rate not in excess of 12 percent.

                  (D)   Low-income housing For purposes of this paragraph, the term ''low-income housing'' means –

                            (i)                  any interest in property described in clause (i), (ii), (iii), or (iv) of section 1250(a)(1)(B), and

                            (ii)                any interest in a partnership owning such property.

         (6)   Cross reference For additional rules relating to partnerships, see section 707(b).

(f) Controlled group defined; special rules applicable to controlled groups

         (1)   Controlled group defined For purposes of this section, the term ''controlled group'' has the meaning given to such term by section 1563(a), except that –

                 (A)  ''more than 50 percent'' shall be substituted for ''at least 80 percent'' each place it appears in section 1563(a), and

                 (B)   the determination shall be made without regard to subsections (a)(4) and (e)(3)(C) of section 1563.

         (2)   Deferral (rather than denial) of loss from sale or exchange between members In the case of any loss from the sale or exchange of property which is between members of the same controlled group and to which subsection (a)(1) applies (determined without regard to this paragraph but with regard to paragraph (3)) - (A) subsections (a)(1) and (d) shall not apply to such loss, but (B) such loss shall be deferred until the property is transferred outside such controlled group and there would be recognition of loss under consolidated return principles or until such other time as may be prescribed in regulations.

         (3)   Loss deferral rules not to apply in certain cases

                 (A)   Transfer to DISC For purposes of applying subsection (a)(1), the term ''controlled group'' shall not include a DISC.

                 (B)   Certain sales of inventory Except to the extent provided in regulations prescribed by the Secretary, subsection (a)(1) shall not apply to the sale or exchange of property between members of the same controlled group (or persons described in subsection (b)(10)) if –

                           (i) such property in the hands of the transferor is property described in section 1221(a)(1),

                           (ii) such sale or exchange is in the ordinary course of the transferor's trade or business,

                           (iii) such property in the hands of the transferee is property described in section 1221(a)(1), and

                           (iv) the transferee or the transferor is a foreign corporation.

                           (C)   Certain foreign currency losses To the extent provided in regulations, subsection (a)(1) shall not apply to any loss sustained by a member of a controlled group on the repayment of a loan made to another member of such group if such loan is payable in a foreign currency or is denominated in such a currency and such loss is attributable to a reduction in value of such foreign currency.

           (4)   Determination of relationship resulting in disallowance of loss, for purposes of other provisions For purposes of any other section of this title which refers to a relationship which would result in a disallowance of losses under this section, deferral under paragraph (2) shall be treated as disallowance.

(g) Coordination with section 1041 Subsection (a)(1) shall not apply to any transfer described in section 1041(a) (relating to transfers of property between spouses or incident to divorce).

Section 707(b)(1).

(b) Certain sales or exchanges of property with respect to controlled partnerships

        (1)   Losses disallowed No deduction shall be allowed in respect of losses from sales or exchanges of property (other than an interest in the partnership), directly or indirectly, between –

                (A)  a partnership and a person owning, directly or indirectly, more than 50 percent of the capital interest, or the profits interest, in such partnership, or

                (B)   two partnerships in which the same persons own, directly or indirectly, more than 50 percent of the capital interests or profits interests. In the case of a subsequent sale or exchange by a transferee described in this paragraph, section 267(d) shall be applicable as if the loss were disallowed under section 267(a)(1). For purposes of section 267(a)(2), partnerships described in subparagraph (B) of this paragraph shall be treated as persons specified in section 267(b).