Background. A taxpayer generally recognizes gain or loss upon the sale or exchange of property. However, neither gain nor loss is recognized under Code Sec. 1031 on an exchange of property if:

… the taxpayer exchanges property held for productive use in a trade or business or for investment for other property to be held for productive use in a trade or business or for investment;

… the relinquished property and the replacement property are of “like kind”; and

… the replacement property is identified and the exchange is completed within statutory time limits.

If a two-party like-kind exchange is impractical or undesirable, a taxpayer may still be able to get the benefits of Code Sec. 1031 by arranging a multi-party deferred exchange. In a deferred exchange, the replacement property must be (i) identified within 45 days after the taxpayer transfers the relinquished property, and (ii) received by the earlier date of 180 days after the taxpayer transfers the old property or the due date of the taxpayer’s return for the year (including extensions).

To qualify as a deferred exchange, the transaction must be an exchange of property, not a transfer of property for money. The reinvestment of the proceeds from a cash sale of one property into a second property of like-kind will not qualify as a Code Sec. 1031 exchange.

The taxpayer isn’t treated as actually or constructively receiving money or other property before he receives like-kind replacement property solely because the obligation of the transferee to transfer replacement property to the taxpayer is secured by cash or its equivalent, provided the security is held in a qualified escrow account or qualified trust.  An escrow account is “qualified” if the escrow holder is not the taxpayer (or a disqualified person) and the escrow agreement expressly limits the taxpayer’s rights to receive, pledge, borrow or otherwise obtain the cash or its equivalent held in the account.

Facts. Ralph E. Crandall, Jr. and Dene D. Dulin owned an undeveloped parcel of property in Arizona. The property was held for investment purposes and had a basis of $8,500. They wanted to own investment property closer to their California residence, so they decided to sell the Arizona property and purchase new property with the intention of executing a tax-free exchange.

On March 4, 2005, the taxpayers sold the Arizona property for $76,000. The buyers of the property paid petitioners $10,000, and the remaining $66,000 was placed in an escrow account with Capital Title Agency, Inc. (Capital Title). At the taxpayers’ direction, $61,743.25 was held in the escrow account, and $4,256.75 was released to the taxpayers.

The taxpayers made a series of payments to an escrow account with Chicago Title Co. (Chicago Title) from January–March of 2005. Neither the Capital Title nor the Chicago Title escrow agreements mentioned a like-kind exchange under Code Sec. 1031 or expressly limited the taxpayers’ right to receive, pledge, borrow, or otherwise obtain the benefits of the funds.

Parties’ arguments. IRS contended that, since the Capital Title escrow agreement didn’t restrict the taxpayers’ access to and use of the funds held in the escrow account, it wasn’t a “qualified escrow account.” Thus, the taxpayers were in constructive receipt of the proceeds from the sale of the Arizona property. The disposition of the Arizona property was a taxable sale, and recognized gain should have been reported on the taxpayers’ 2005 return.

The taxpayers claimed that the funds in the Capital Title escrow account were held solely for the purchase of the California property and that they received no proceeds from the sale of the Arizona property.

Conclusion. The Tax Court agreed with IRS that the disposition of the Arizona property was a sale, the proceeds of which were constructively received by the taxpayers upon deposit into the Capital Title escrow account. Although the taxpayers in fact used the funds in the Capital Title escrow account to purchase the California property, they failed to comply with the Code Sec. 1031 requirements for nonrecognition. The Capital Title escrow account wasn’t a “qualified escrow account” within the meaning of the Regulations due to the lack of express limitations on the taxpayers’ use of the funds.  As a result, the taxpayers had taxable gain in 2005 from the sale of the Arizona property.

For more information about this case or 1031 exchanges in general, contact Partner F. Moore McLaughlin, IV, Esq., CPA at 401-421-5115 ext. 212 or by e-mail at mmclaughlin@mclaughlinquinn.com.

Supreme Court of the United States of America

The Supreme Court has declined to review a Ninth Circuit holding that a taxpayer could not avoid the Code §1031 like-kind-exchange related-party rule by using a qualified intermediary (QI). Teruya Brothers, Ltd. & Subsidiaries , (CA 9 2/11/2009) 104 AFTR 2d ¶ 2009-5345 , cert denied 2/22/2010.

Background. If statutory identification and replacement period requirements are met, gain or loss is not recognized currently on the exchange of property held for productive use in a trade or business or for investment for property of like kind that will be held for productive use in a trade or business or for investment. (Code §1031) QIs may be used to structure like-kind exchanges. However, under Code §1031(f), gain or loss on an exchange between related persons (under Code §267(b) or Code §707(b)(1)) must generally be recognized if either the property transferred or the property received is disposed of within two years after the exchange. Nonrecognition treatment under the like-kind exchange rules does not apply to any exchange that is part of a transaction or series of transactions structured to avoid the purposes of the related party exchange rule. (Code §1031(f)(4)) However, under Code §1031(f)(2)(C), a disposition will not 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.

Facts. Teruya Brothers Ltd. (Teruya) owned 62.5% of the common shares of Times Super Market Ltd (Times), so the two entities were related.  In 1995, in one series of planned transactions, Teruya transferred Real Property 1 to TGE, a QI, which then sold it to an unrelated third party. TGE used the sale proceeds, as well as additional funds from Teruya, to buy like-kind Replacement Property 2 for Teruya from Times, and then transferred Replacement Property 2 to Teruya. In another series of planned transactions, Teruya transferred Real Property 3 to TGE, which sold it to an unrelated party. TGE used the sale proceeds from Real Property 3, plus some cash from Teruya, to buy like kind Replacement Properties 4 and 5 from Times.

Teruya realized a $1.3 million gain on Property 1 and a $10.7 million gain on Property 3. Times realized and recognized a $1.3 million gain on Property 2 and a $2.2 million gain on Property 5, but these gains were offset by a large net operating loss. Times realized a $6.4 million loss on Property 4, but did not recognize it because of the Code §267 related-party restriction on loss recognition.

Teruya treated its transactions as tax-deferred like-kind exchanges under Code §1031, but IRS said the transactions ran afoul of the Code §1031(f)(4) related-party rule and hit Teruya with a $4 million deficiency.

Tax Court. In 2005, the Tax Court held that the transactions were economically equivalent to direct exchanges of properties between Teruya and Times (with boot from Teruya to Times), followed by the sales of the properties by Times to unrelated third parties. The interposition of a QI couldn’t obscure the end result.

Observation: In 2009, the Tax Court applied its Teruya reasoning and decision to rule against another taxpayer on the QI- Code §1031(f) issue (see Ocmulgee Fields, Inc., (2009) 132 TC No. 6).

Ninth Circuit. In 2009, the Ninth Circuit concluded that the Tax Court did not err in determining that the transactions were structured to avoid the purposes of Code §1031(f)(4). It rejected Teruya’s contention that the economic consequences of the transactions to Times were irrelevant, and that Teruya’s continued investment in real property was dispositive. Code §1031(f)(1)(C)(i) disallows nonrecognition treatment if a related party disposes of exchanged property within two years, regardless of whether the taxpayer does as well. Thus, examining the taxpayer and related party’s economic position in the aggregate is often the only way to tell if Code §1031(f) applies.

The legislative history indicating Congress’s desire to bar like-kind exchange treatment where related parties have, in effect, cashed out of the investment, confirmed that a taxpayer and a related party should be treated as an economic unit to see if Code §1031(f) applies. The Ninth Circuit pointed out that the changing economic positions of Teruya and Times readily showed that the related parties used the exchanges to cash out of an investment in low-basis real property. Before the exchanges, Teruya owned Property 1 and Property 3, and Times owned Properties 2, 4, and 5. After the exchanges, Properties 1 and 3 had been sold, Teruya owned Properties 2, 4, and 5, and Times had the cash from the sale of Properties 1 and 3 (along with boot from Teruya). All in all, Teruya and Times decreased their investment in real property by approximately $13.4 million, and increased their cash position by the same amount. By allowing Teruya and Times to cash out of a significant investment in real property under the guise of a nontaxable like-kind exchange, the Ninth Circuit concluded that the transactions were undoubtedly structured to contravene Congress’s desire that nonrecognition treatment only apply to transactions where a taxpayer can be viewed as merely continuing his investment.

The Ninth Circuit said Teruya could have exchanged its properties directly with Times, followed by Times’s selling Property 1 and Property 3 to the third-party purchasers, but this would not have had a tax-free result, since direct exchanges between related parties are ineligible for nonrecognition treatment when the exchanged property is sold within two years. Instead, Teruya employed TGE; the latter’s involvement as a QI served no purpose besides rendering simple, but tax disadvantageous, transactions more complex in order to avoid Code §1031(f)’s restrictions.

The Ninth Circuit also affirmed the Tax Court’s conclusion that Code Sec. 1031(f)(4) applied because improper avoidance of federal income tax was one of the principal purposes of the transactions.

Late in 2009, Teruya appealed the Ninth Circuit’s decision to the Supreme Court. However, on February 22, 2010, the Supreme Court declined to review the decision.

For more information on 1031 exchanges, or to ask specific questions regarding the related party rule of §1031, please contact Alexandra L. Hart, CES® at All States 1031 Exchange Facilitator, LLC by e-mail at AHart@AllStates1031.com or McLaughlin & Quinn, LLC Managing Partner and Owner of All States 1031 Exchange Facilitator, LLC Moore McLaughlin, Esq., CPA, CES® by e-mail at FMM@AllStates1031.com or either of them by phone toll-free at 877-395-1031.