Related party basis shifting case upheld

A Ninth Circuit Court of Appeals decision to affirm a previous Tax Court ruling further highlights the need for extra scrutiny in 1031 exchanges involving related parties. The 2005 Tax Court decision, involving exchanges of condominium and apartment properties (Teruya Brothers), disallowed the tax deferred swap because it occurred between related parties and the main reason for the exchanges was to reduce the overall tax bills of the buyer and seller.

In the case, the entity (Teruya Bros, Ltd) that owned the apartment building and condominium complex had a built in, large capital gain. Upon the sale, a $13 million capital gain would have resulted to this entity triggering a massive tax bill. Rather than sell, the entity transferred the real estate to an unrelated Qualified Intermediary (QI) which sold the properties and bought replacement land from a subsidiary (Times) in which the entity had a controlling interest.

The issue that causes this related party exchange to be disallowed essentially relates to the overall tax paid. The subsidiary did not exchange into additional replacement property. Rather, it chose to treat the sales as taxable events and accounted for a capital gain of roughly $3.5 M on the property sale to the related entity. However, the subsidiary that sold the property had significant net operating losses from previous operations. These NOLs were used to offset the $3.5 million gain - resulting in no taxes paid on the sales.

Effectively, what the related party exchange attempted was a "cash out". The subsidiary now had the cash from the sales. The two related entities combined had decreased their investment in real property by approximately $13.4 million while increasing their cash position by the same amount. By disallowing the related parties to cash out of a significant investment in real property under the appearance of a 1031 like kind exchange, the Appeals Court upheld the previous Tax Court decision that "these transactions were undoubtedly structured in contravention...that nonrecognition treatment only apply to transactions "where a taxpayer can be viewed as merely continuing his investment.""

It is clear that tax deferred exchanges between related parties are subject to additional scrutiny. Accounting professionals, tax and real estate attorneys and taxpayers should be familiar with, and aware of the potential pitfalls, in exchanging property between related parties. The use of a Qualified Intermediary familiar with the rules and legal precedence in dealing with this advanced topic can be of assistance in handling a related party exchange appropriately.