The Tale of TwoTaxpayers in Related Party 1031 Exchanges (Part 1of 2)

" 'When I use a word', Humpty Dumpty said, in a rather scornful tone, 'it means just what I choose it to mean, neither more nor less.' 'The question is', said Alice, whether you can make words mean so many different things.' " Alice through the Looking Glass, by Lewis Carroll.

Words can mean many different things- depending on interpreations of the Code sections, Cases or administrative guidance. Section 1031 Exchanges require a great deal of insight and experience to navigate these transactions successfully. This is particularly true for Exchanges involving Related Party Exchanges. Why? Much of the law concerning Section 1031 is contained in other Code Sections, cases and administrative guidence.

What is a Related Party Exchange? The IRS definition included in Section 1031(f) provides that where a taxpayer exchanges property with a related person, and, within two years after the date of the last transfer, either party sells such property received in the exchange, then Section 1031 does not apply and the Exchange is taxable.

Let's take the cases of the two taxpayers below. The first taxpayer planned that the 1031 Exchange fit squarely within the Related Party Rules. The second taxpayer planned the 1031 Exchange to be outside the Related Party Rules. In fact, quite the opposite was the result.

• Case #1: Private Letter Ruling (2007). In a recently published private letter ruling, PLR 200706001, the IRS ruled, that despite the fact that the taxpayer entered into a 1031 exchange with a related party and within two years of the exchange the related party sold relinquished property, the taxpayer was not taxed on the subsequent sale within two years of the exchange.

The IRS held that because the tax basis of the relinquished and replacement property were equivalent that the exchange and subsequent sale was not a transaction whose principal purpose was the avoidance of tax under IRC Section 1031(f)(2)(C). Outcome: Taxpayer was NOT taxed.

• Case #2: Teruya Brothers (2005). Teruya Brothers Ltd. owned 62.5 percent of the stocks of Times Super Market Ltd. Thus, pursuant to Section 1031(f), Teruya and Times were considered Related Parties. Teruya purchased, through an Exchange Qualified Intermediary, replacement property owned by Times. The Related Party as areported the sale taxable sale to absorb current tax losses. The IRS did not dispute that all of the structural elements of a valid like-kind exchange were met. However, the Tax Court recast the transactions as the economic equivalent to direct exchanges of properties between Teruya and Times. This was followed by Times's sale of the properties to unrelated third parties. The court concluded that the principal purpose of the arrangement was the avoidance of income taxes. Outcome" Taxpayer WAS taxed.

Two sets of related parties, two different outcomes. The questions are: What do the words mean? How is the Code Section interpreted? These are difficult questions, with complex solutions. In structuring a Section 1031 Exchange, it is important to rely on the expertise of an experienced Qualified Intermediary and Advisor.

Expert advice, Protected Exchanges with Covered Tax Opinion. At Strategic Property Exchanges, LLC, we provide expert advice, as well as a Tax Opinion. This protects your firm and your client for all of the following: Civil Tax Penalties, Tax Shelter Rules, Circular 230, FASB FIN 48, Schedule M-3 and professional Errors. All Proceeds are insured by Fiduciary Insurance. All Exchange protected by Errors and Omission Insurance.

Next month's article: "Who is considered to be a "Related Party" in a Section 1031 Exchage?"

Stephen L. Robison, J.D., LL.M.





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More than just commercial property can be exchanged in a 1031 process. To learn more about the other items, read our page on What can be exchanged?