In the recent case of Malulani Group, the Tax Court held that the taxpayer’s attempt to structure an IRC Section 1031 exchange ran afoul of the related party provisions of IRC Section 1031(f). The purpose of these rules is to prevent taxpayers from exchanging low tax basis property with a related party in return for high tax basis property that was owned by the related party. Upon receipt of the taxpayer’s low tax basis property in the exchange, the related party would be permitted to substitute the high tax basis from the property it transferred back to the taxpayer. The related party could then sell the formerly low tax basis property and not recognize any tax gain.
To prevent this, IRC Section 1031(f) provides that if related parties engage in an exchange of properties, both parties must hold the property they receive at least two years or else any gain is recognized. An exception is provided in IRC Section 1031(f)(2)(C) if the taxpayer can convince the IRS that the exchange did not have tax avoidance as one of its principal purposes. IRC Section 1031(f)(4) provides that IRC Section 1031 will not apply to transactions or a series of transactions designed to avoid the purposes of IRC Section 1031(f).
In Malulani Group, the taxpayer’s wholly-owned subsidiary, MBL, sold real property to a qualified intermediary with the intention of locating suitable replacement property and completing a Section 1031 exchange. It looked at and even tried to buy several properties owned by unrelated parties. When none of those attempts succeeded, MBL had the intermediary purchase property from a related party and transfer the property to it to complete the exchange. Although the related party recognized more tax gain on the sale of its property to the intermediary than MBL would recognize from the sale of its property, such gain was offset by a net operating loss.
The taxpayer argued that the related party prohibition should not apply because tax avoidance was not a principal motive. It pointed to the fact that it did not originally intend to acquire property from a related party and in fact did so only after extensive efforts to purchase property from unrelated parties failed.
The court did not accept the taxpayer’s analysis. It determined tax avoidance by looking at the taxes the parties actually paid and compared that to the taxes that MBL would have paid if it had simply sold its property and not done a Section 1031 exchange. Under the exchange, MBL recognized no tax gain. The related party, while recognizing more gain than MBL would have recognized from the sale of its property, nevertheless offset such gain with a net operating loss so it did not pay any tax either. Therefore, in the court’s view, the transaction as structured resulted in significant tax savings. Based on this, the court determined that the taxpayer did structure the transaction with a tax avoidance motive.
If the related party had not been able to offset its tax liability with a net operating loss, the court likely would have accepted the taxpayer’s argument that it did not have a tax avoidance motive, as the related party would have paid more tax than MBL would have paid from the sale of its property. Of course, without the net operating loss, it is not likely the transaction would have been done with the related party.