Tax Defered Exchanges – Benefit or costly mistake?

By Tim Binder

So-called 1031 exchanges are mainstays of professional real estate investors.  Named after Internal Revenue Code Section 1031, a properly structured exchange allows an investor to exchange property held in a trade or business or for investment purposes for other like kind property. In general, the taxable gain on the transaction is deferred and no federal or state income taxes are payable on the gain. However, when the exchange is not structured properly, the result is a taxable sale. A recent Ninth Circuit Court of Appeals case illustrates the point.
The case began in 1995 when two related taxpayers engaged in a series of exchanges designed to defer taxable gain for one taxpayer, and recognize taxable gain for the related taxpayer. The related taxpayer had a net operating loss carry over that the related taxpayer intended to use to offset the taxable gain so that little or no tax would be payable.
The Internal Revenue Service determined that both exchanges failed to qualify for tax deferral under Section 1031 and issued the taxpayer a tax deficiency notice of $4.1 million. The taxpayer took his case to Tax Court and lost. The taxpayer then appealed his case to the Ninth Circuit who agreed with the Tax Court.
The fatal flaw in the taxpayer’s position was a subsection of Section 1031 that deals with exchanges between related parties. This section requires that the exchange not have as one of its principal purposes the avoidance of federal income tax. In this case, the court had no problem concluding that the exchanges were structured for unwarranted tax avoidance purpose.
The taxpayer may have been able to avoid this result if there was a credible independent business purpose for structuring the exchanges as they were structured, and the related party had held its exchange property for at least two years following the exchange. However, when the related party sold its exchange property shortly after the exchange, both exchanges were no longer qualified for 1031 non-recognition treatment.
Exchanges can be complicated. If executed correctly they can be most beneficial to the taxpayer. But as this case illustrates, the IRS is more than willing to attack an exchange that fails to meet every requirement of the code. z

Tim Binder is a San Diego-based attorney concentrating on business, real estate, employment, construction and tax law.