March 31, 2009

Taxpayer transferred the relinquished property in an exchange (using a QI) to an unrelated third party. The taxpayer subsequently acquired the replacement property from a related party. The court disallowed the exchange under Section 1031(f)(4) because exchange was part of a transaction or series of transactions structured to avoid the purposes of the Section 1031(f) governing exchanges between related persons, and the taxpayer failed to prove that the non-tax avoidance exception of Section 1031(f)(2) applied because the taxpayer’s principal purpose was the avoidance of Federal tax. The court declined, however, to apply the accuracy related penalty.

FACTS.  Taxpayer was corporation in Macon, Georgia, controlled by a father, George Jones, and his two sons.  The related party was an LLC owned by Mr. Jones and one of the sons.  Taxpayer entered into an agreement to sell the relinquished property (Wesleyan Station) in July, 2003.  Taxpayer indicated in the agreement that it intended to exchange Wesleyan Station. Taxpayer proceeded to look around for suitable replacement property. Wesleyan Station sold on October 9, 2003, and by that time, the taxpayer had considered and rejected at least six possible replacement properties presented by brokers.  As the Wesleyan Station closing date approached, the taxpayer considered the possibility of reacquiring property it had sold to the related party in 1996 (the “Barnes & Noble Corner”). On October 15, 2003, taxpayer and the related party entered into a purchase contract, and taxpayer acquired the Barnes & Noble Corner as the replacement property on November 4, 2003 (using the QI). 

The related party recognized gain on the sale of the Barnes & Noble Corner to taxpayer of $4,185,999 (which was taxed at the individual rate of 15% because the related party was taxed as a partnership). The taxpayer reported a deferred gain on the exchange of Wesleyan Station of $6,122,736 (which would have been taxed at a corporate rate of 34%).  The taxpayer had a May 31, 2004 taxable year end and reported the exchange on its 2004 Form 1120, U.S. Corporation Income Tax Return.  It identified the related party under the heading of part II of Form 8824, “Related Party Exchange Information”. It also reported installment sale income of $475,396, resulting from the acceleration of payments due taxpayer from the related party from the 1996 sale of the Barnes & Noble Corner to the related party.   

ANALYSIS.   The court applied a two step analysis.  First, it determined if Section 1031(f)(4) applied to the exchange. That subsection provides that Section 1031 shall not apply to any exchange that is part of a transaction (or series of transactions) structured to avoid the purposes of the related party rules.  Second, assuming 1031(f)(4) did apply, then the court examined if the exchange fell within the non-tax avoidance exception for related party exchanges of Section 1031(f)(2)(C).  That subsection provides an exception to the related party rules if it is established to the satisfaction of the Secretary of Treasury that Federal tax avoidance was not one of the principal purposes of the exchange. 

Section 1031(f)(4): Under the first step of the analysis, the court examined how the taxpayer would have fared had the exchange been structured under Section 1031(f)(1), with the taxpayer and the related party first exchanging Wesleyan Station for the Barnes & Noble Corner, and the related party then selling the Wesleyan Station to a third party.  If the related party had actually received Wesleyan Station from the taxpayer in exchange for the Barnes & Noble Corner, the related party’s adjusted basis of $2,554,901 in the Barnes & Noble Corner would have shifted to the Wesleyan Station (which, in the taxpayer’s hands, had a basis of only around $716,164). Because of that step-up in basis, the related party would have realized a gain on the sale of the Wesleyan Station of approximately $1.8 million less than the taxpayer would have realized had it just sold the Wesleyan Station in a taxable sale. (And the taxable gain was taxed at 15% rather than 34%). Thus, because of this basis shifting, the exchange fell within Section 1031(f)(4) as a series of steps structured to avoid the related party rules, and the court next examined if a non-tax avoidance purpose could save the exchange.

Section 1031(f)(2)(C): Under the second step of the analysis, the court examined if Federal tax avoidance was the principal purpose of the exchange.  The court stated it was fair to infer that transactions involving basis shifting are done with the principal purpose of Federal tax avoidance.  It did note that there may be situations in which a taxpayer can overcome the negative inference drawn from basis shifting and a “cash out” by showing other reasons for the structure.  In this regard, the taxpayer offered three counter arguments to establish that the principal purpose was not tax avoidance: negative tax impacts, business purpose, and lack of a prearranged plan.  The court rejected all the taxpayer’s counterarguments.

Penalty.  The IRS wanted to apply the accuracy-related penalty of Section 6662(a) because of the taxpayer’s negligence or intentional disregard of rules or regulations, and a substantial understatement of income tax. The court declined to apply the penalty because Mr. Jones relied on the CPA to prepare the Form 8824.  As evidence that the reliance was reasonable, the court stated that the CPA was a member of the largest accounting firm in the Macon, Georgia area, and he and his firm had more experience representing real estate developers than anyone else in Macon. Mr. Jones had relied on the CPA and his firm for tax advice for many years. The CPA was aware of all facts relevant to the exchange, and he was required to interpret section 1031(f)(4) in preparing the return. The court seemed to imply that transactions occurring after the issuance of the 2005 opinion in Teruya Brothers, Ltd., & Subs. V. Commissioner, 124 TC 45 (2005) will be subject to penalties.  Note also that the CPA checked the related party transaction box on Form 8824.

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