1031 EXCHANGE NEWS ALERT:
THE IRS APPROVES NON-RECOGNITION TREATMENT
FOR A SERIES OF RELATED PARTY EXCHANGE TRANSACTIONS
By: James T. Walther, Esq., LL.M., General Counsel,
Legal 1031 Exchange Services, LLC
Recently, the IRS published PLR 202053007 (December 31, 2020) in which they agreed that based on facts provided by the taxpayer(s), a series of 1031 exchange transactions with related parties would still achieve tax deferral – a non-recognition of capital gain for all parties transacting the exchange.
Under § 1031(f)(4), §1031 does not apply to Taxpayer’s exchange if the exchange is part of a transaction (or series of transactions) structured to avoid the purposes of § 1031(f). For instance, if a Taxpayer exchanged a high basis property for a low basis property owned by a Related Party and the Related Party sold the high basis property shortly thereafter, it would likely be considered basis shifting. Also of concern was basis shifting and accelerated loss on replacement property. [per the legislative history to 1031(f)(4)] However, §1031(f)(2)(C) provides an exception for “non-tax avoidance” to transactions that have a business purpose other than tax avoidance, where the property is dispositioned in non-recognition transactions, and where there is not the shifting of basis between taxpayers.
The taxpayer, a corporation contended/represented that the series of transactions with four related/affiliate companies met the exception provided in §1031(f)(2)(C). The IRS agreed. However, like most PLRs, the taxpayer’s scenario is stated in very general terms.
The key factors in the IRS’ decision were:
- None of the related parties received cash-out and each conducted their own exchange.
- All replacement properties received in the exchange would be held for at least two years by the related parties.
- Upon completion of the series of exchanges, all related parties owned a replacement property that was like-kind to the property they relinquished.
The IRS’ criteria for reporting a tax avoidance exception to this type of related party exchange are set forth in the instructions for Form 8824:
If you believe that you can establish to the satisfaction of the IRS that tax avoidance was not a principal purpose of both the exchange and the disposition, attach an explanation. Generally, tax avoidance won’t be seen as a principal purpose in the case of:
- A disposition of property in a nonrecognition transaction,
- An exchange in which the related parties derive no tax advantage from the shifting of basis between the exchanged properties, or
- An exchange of undivided interests in different properties that results in each related party holding either the entire interest in a single property or a larger undivided interest in any of the properties.
While this new PLR is informative, it simply reinforces existing guidance regarding related party exchanges and the non-tax avoidance exception of §1031(f)(2)(C). However, it is still newsworthy because related party 1031 exchanges are still a somewhat unsettled subject and it has been a few years since taxpayers have seen guidance in this area. In 2019, the 9th Circuit affirmed a Tax Court holding that denied non-recognition treatment to the exchanging taxpayers. See Malulani Grp., Ltd. v. Commissioner, 771 F. App’x 800, 801 (9th Cir. 2019), T.C. Memo 2016-209.[i]
While the facts in the new PLR did not involve a cash-out scenario, it remains to be seen whether the IRS will ever answer a lingering question for many tax lawyers, accountants, and qualified intermediaries – Under what circumstances, if any, can an exchange be utilized to purchase replacement property from a related party where the related party cashes out to some extent? If anything, this latest guidance supports the premise that absent of one of the above circumstances, exchangers face a steep uphill battle when replacement property is acquired from a related party that does not conduct their own exchange. One exception could be where the related party selling replacement property in a cash out transaction recognizes more gain than the exchanging taxpayer defers. This certainly would not fall into the category of tax avoidance, but such a situation might not make sense when the sale of the replacement property to an unrelated third party could generate better tax benefits. Therefore, a taxpayer would need a compelling business reason to justify the reduced benefits from the taxable transaction with a related party.
Taxpayers who are considering a sale or an exchange to a potentially related party should consult with their tax or legal advisors regarding whether they are able to structure a valid exchange based on their specific scenario and discuss the limitations and consequences prior to commencing a sale or purchase.
[i] In Maluani Group, Ltd., the 9th Cir. Court held that the exchange was structured for “tax avoidance purposes” because taxpayer and its related entity “achieved far more advantageous tax consequences by employing [a qualified intermediary to conduct the like-kind exchanges] than it would have had taxpayer simply sold its properties to the third-party buyers itself. The entity selling replacement property had Net Operating Losses to offset recognition of its gain on the sale. One of the taxpayer’s main arguments was that the purchase of replacement property from a related entity was not a premeditated plan to avoid taxes because in the exchange, the taxpayer had originally targeted other replacement properties from unrelated third parties. However, this argument failed to persuade both the Tax Court and the 9th Cir.
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