Like-kind exchanges under Internal Revenue Code Section 1031 provide a valuable tool for taxpayers to defer taxes on capital gains. The exchanges are subject to some strict rules that are intended to prevent tax avoidance scams. In a recent U.S. Tax Court case, the parties to a like-kind exchange ran into one of those restrictions — the related-party limitation — and ended up with a higher-than-expected tax bill.

Challenged transaction

MBL, a wholly owned subsidiary of The Malulani Group, filed consolidated corporate income tax returns with Malulani for the relevant year. Malulani also owned about 70% of the common shares of Malulani Investments, Limited (MIL), which owned real estate throughout the United States.

In 2007, using a qualified intermediary, MBL sold real estate (the relinquished property) to an unrelated third party. It eventually replaced it, within the requisite period of time, with real estate sold by MIL. MBL didn’t have a prearranged plan or intent to purchase a replacement property from MIL when it initially sold the relinquished property.

On its 2007 tax return, MBL reported a realized gain of about $1.9 million from the sale of its relinquished property but deferred recognition under Sec. 1031. MIL recognized a gain of about $3.1 million on its sale of the replacement property, which was almost entirely offset by net operating losses (NOLs).

The IRS determined that MBL’s gain did not qualify for deferred recognition and, consequently, the taxpayer owed $387,494 in additional taxes. The Tax Court agreed with the IRS. The taxpayer then turned to the U.S. Court of Appeals for the Ninth Circuit for relief.

Related-party limit

The Tax Court based its decision on Sec. 1031(f)(1). Congress enacted the provision in 1989 to limit nonrecognition treatment in like-kind exchanges between related persons.

According to Congress, when a related-party exchange is followed shortly thereafter by a disposition of the property, the related parties essentially have “cashed out” of the investment, so the original exchange should not receive nonrecognition treatment. Sec. 1031(f)(1) generally provides that, if a taxpayer and a related person directly exchange like-kind property, and, within two years, either party disposes of the property received in the exchange, the nonrecognition treatment does not apply.

Although the provision references only direct exchanges between related persons, Sec. 1031(f)(4) provides that nonrecognition treatment does not apply to any exchange that is part of a transaction or series of transactions structured to avoid the related-party limit. In other words, Sec. 1031(f) may disallow nonrecognition treatment of deferred exchanges that only indirectly involve related persons due to the use of qualified intermediaries.

Appellate court ruling

Like the Tax Court, the Ninth Circuit focused on the fact that, if Malulani had simply consummated the sales itself, it would have recognized a large gain. Thus, both courts found, the like-kind exchange was designed to avoid tax.

Both courts also dismissed the idea that the lack of a prearranged plan to use property from a related person to complete a like-kind exchange meant the exchange was not structured to avoid the related-party limit. Rather, a court must consider the actual tax consequences of the transaction for the taxpayer and the related party in aggregate. And then it must compare the taxpayer’s actual tax consequences with the hypothetical tax consequences of directly selling the relinquished property to the related party.

In this case, Malulani Group and MBL cashed out of the investment in the relinquished property almost tax-free. Based on this substantial economic benefit, the Tax Court and the Ninth Circuit concluded that MBL had structured the transaction to avoid taxes and did not qualify for nonrecognition treatment.

Tread carefully

Like-kind exchanges offer a permissible path to defer taxes, but only if you cross all the t’s and dot all the i’s. Your ORBA CPA can help you properly structure such transactions to withstand IRS scrutiny and reap the tax benefits.

Sidebar: Tax reform legislation limits like-kind exchanges

The tax code has long allowed taxpayers to defer taxable gains using like-kind exchanges. As Congress rushed to draft the Tax Cuts and Jobs Act (TCJA) and find ways to offset its costs in late 2017, survival of the favorable tax treatment of such exchanges was uncertain.

Although like-kind exchanges were rumored to be on the chopping block, the final legislation only limited them. Specifically, like-kind tax treatment is no longer permitted for exchanges of personal property used for business or investment purposes (such as equipment, airplanes, vehicles and intellectual property) completed after 2018. Certain exchanges of mutual ditch, reservoir or irrigation stock remain eligible, however.

Like-kind exchanges are still allowed for real estate held for business or investment purposes — that is, not primarily for sale or personal use. The personal property change, unlike many other changes under the new tax law, is permanent.

For more information, contact Tammy Partridge at [email protected], or call her at 312.670.7444. Visit ORBA.com to learn more about our Real Estate Group.