The Malulani Group, Limited, and Subsidiary, (CA 9 6/12/2019) 123 AFTR 2d ¶2019-776
The Court of Appeals for the Ninth Circuit has affirmed a Tax Court decision holding that related-party transactions weren’t eligible for like-kind treatment under Code Sec. 1031. The Appeals Court agreed that the series of like-kind exchange transactions, which involved a qualified intermediary and property acquired from a related party, ran afoul of the Code Sec. 1031 related-party rules even though the taxpayer did not have a prearranged plan or intent to purchase property from the related party.
Background. Taxpayers can defer recognizing gain or loss on the exchange of a property held for productive use in a trade or business, or for investment, if the property is exchanged solely for like-kind property (like-kind exchange) held for productive use in a trade or business, or for investment. (Code Sec. 1031) However, Code Sec. 1031(f) limits the deferral of gain recognition for like-kind exchanges between related persons. Generally, Code Sec. 1031(f)(1) provides that if a taxpayer and a related person exchange like-kind property, and, within two years, either one disposes of the property received in the exchange, the deferred-recognition provisions do not apply, and gain or loss must be recognized as of the disposition date.
Code Sec. 1031(f)(4) provides that deferred-recognition treatment does not apply to any exchange that is part of a transaction, or series of transactions “structured to avoid the purpose of” Code Sec. 1031(f). Therefore, the IRS may disallow deferred-recognition treatment for the gain or loss on a like-kind exchange that indirectly involves a related person because a qualified intermediary was used. (Code Sec. 1031(f)(4))
Facts. The taxpayer, MBL, was a wholly owned subsidiary of The Malulani Group, Limited. MIL was a related corporation. On Oct. 31, 2006, MBL accepted an offer to sell its Maryland real property. MBL sold the real property through a qualified intermediary, FAEC.
After closing the sale of the Maryland property, MBL began searching for suitable replacement property. On Feb. 23, 2007, three potential replacement properties, all belonging to MIL, were identified. Until Feb. 23, 2007, MBL hadn’t previously considered purchasing any MIL property. On July 3, 2007, FAEC purchased Hawaii real property owned by MIL, and transferred it to MBL as a replacement for the Maryland property. This series of transactions was the purported like-kind exchange.
MBL’s 2007 return reported a realized gain from the sale of the Maryland property but deferred recognition of the gain under Code Sec. 1031. However, the IRS determined that MBL’s gain from the sale of the Maryland property did not qualify for deferred recognition of gain under Code Sec. 1031.
Tax Court decision. The Tax Court held that MBL’s sale of the Maryland property and its acquisition of the Hawaii property did not qualify for deferred-gain recognition because MBL indirectly acquired the Hawaii property from a related person using a qualified intermediary. The sale and acquisition, the Tax Court found, were the economic equivalent of direct exchanges of property between the taxpayer and a related party, followed by the related party’s sale of the relinquished property, and retention of the cash proceeds. Thus, the investment in the relinquished property had been cashed out, contrary to the purposes of Code Sec. 1031(f).
Appeals Court affirms. The Court of Appeals for the Ninth Circuit agreed with the Tax Court that the sale of the Maryland property and acquisition of the Hawaii property through a qualified intermediary didn’t qualify as a like-kind exchange under Code Sec. 1031. The Appeals Court noted that Code Sec. 1031(f) limits deferred gain recognition for like-kind exchanges between related persons and that MBL and MIL were related. The fact that MBL did not have a prearranged plan or intent to purchase a replacement property from MIL when it sold the Maryland property was irrelevant. MBL used a qualified intermediary to purchase a replacement property from a related party, MIL, and MIL, in effect, sold the replacement property within the two year window. Thus, under Code Sec. 1031(f)(4), the deferred-recognition provisions did not apply, and MBL had to recognize gain as of the disposition date of the Maryland property.
References: For like-kind exchanges structured to avoid the related party rule, see FTC 2d/FIN ¶I-3135.1; FTC 2d/FIN ¶I-3137; United States Tax Reporter ¶10,314.07.