On August 25, 1997, the Internal Revenue Service issued a Private Letter Ruling that has been hotly debated among exchange experts. PLR 9748006 involved a taxpayer who, through a qualified intermediary, transferred relinquished property to an unrelated buyer and acquired replacement property from his mother. Relying on § 1031(f)(4) of the tax code, the IRS ruled that the transaction did not qualify as a like-kind exchange. In essence, § 1031(f)(4) states that any transaction or series of transactions structured to avoid the related party rules will not be treated as a like-kind exchange under § 1031. This has been called the "catchall provision" in the related party rules.1 Although private letter rulings apply only to the taxpayers for whom they are written and cannot be used or cited as precedent, this ruling is important because it gives us the first insight we have into the Service's position in interpreting § 1031(f)(4) until case law or additional treasury regulations address the ambiguities that exist. A brief overview of the legislative history behind the related party rules, questions that have arisen among exchange professionals, the findings in PLR 9748006, and various experts' reactions to this ruling will hopefully clarify some of the issues that must be considered when structuring an exchange involving a related party.
Prior to 1989 no special restrictions existed for related parties wishing to exchange property. Many creative taxpayers and their attorneys discovered that it was quite permissible to gain a tax advantage through "basis shifting." Basis shifting usually occurred when the taxpayer wanted to sell a low-basis property for cash. To avoid paying high capital gains taxes on the disposition of the low-basis property, the taxpayer would exchange the low-basis property with a related party who owned a high-basis property. The property that he wished to dispose of for cash was now in possession of the related party, had a high basis, and could be sold without recognizing much, if any, taxable gain.
Basis shifting in and of itself was then and still is permissible under § 1031. Congress, however, viewed the immediate "cashing out" of the formerly low-basis property as abusive. In 1989 Congress enacted I.R.C. Sections 1031(f) and (g), commonly referred to as the "related party rules," which provide that neither the taxpayer nor the related person can dispose of the property it received in an exchange for two years following the last transfer of property, except in cases involving involuntary conversion, the death of either the taxpayer or the related person, or where proof is provided to the satisfaction of the IRS that the exchange or disposition was not for purposes of avoiding taxes.2 A related person is defined as any person bearing a relationship to the taxpayer described in §§ 267(b) or 707(b)(1), including family members (siblings, spouse, ancestors, and lineal descendants); an individual and a corporation, where the individual owns more than 50 percent of the stock; or two corporations that are part of the same control group.3 Section 1031(f)(4), as discussed above, prohibits the structuring of an exchange to avoid the purpose of the related party rules, and § 1031(g) suspends the tolling of the two-year holding period during any time in which the taxpayer or related party's risk of loss is diminished by the holding of a put, the holding by another person of an option to acquire the property, a short sale or any other transaction.
Sections 1031(f) and (g) seem to address only direct two-party swaps between related parties. No mention is made in the Regulations of how a three-party exchange (involving the taxpayer, an unrelated party, and a related party) or a four-party exchange (involving the taxpayer, an unrelated party, a qualified intermediary, and a related party) can be accomplished. Can a taxpayer transfer his relinquished property to a related party and acquire replacement property from an unrelated party? Would both the taxpayer and the related party then have to wait two years to sell the property each acquired? Can a taxpayer transfer his relinquished property to an unrelated party and acquire replacement property from a related party? Attorneys and qualified intermediaries, since the inception of the related party rules, have questioned how to accomplish a deferred exchange involving a related party.
In 1994, the Tax Section of the American Bar Association authored the ABA Tax Section Report On Open Issues in Like-Kind Exchanges. In its report, the ABA posed many questions regarding unclear exchange issues and proposed answers to those questions. The report was submitted to the IRS with a request that it be adopted to provide practical guidance for exchangors. In stating its purpose, the report said, "[o]ur aim is to permit tax practitioners to replace with a simple yes or no the phrase 'although there is no guidance specifically addressing this question, most people assume that this is the answer…'." The IRS has not yet responded to the report. Although not authoritative, many professionals look to the answers the ABA Tax Section devised in the absence of any true authority. Group C of the questions and answers contained in the report discusses issues created by I.R.C. Sections 1031(f) and (g).
Discussing whether a taxpayer could, via a qualified intermediary, transfer relinquished property to a related party and acquire replacement property from an unrelated party, question and answer number 20 of the ABA report viewed this transaction as permissible and non-abusive since no basis shifting or "cashing out" by the taxpayer or related party of one of their properties occurred. Instead, a new cost basis was created. Conversely, question and answer number 21 of the report questioned whether the taxpayer could relinquish property to an unrelated party and acquire replacement property from a related party. The report found that this would be an abusive transaction, stating, "[h]ere, the transaction is merely a rearrangement of the steps described in the Senate Finance Committee Report, and thus is covered by the anti-abuse language of Section 1031(f)(4)." The Senate Finance Committee adopted the House Report that gave the following example of a disallowed transaction structured to avoid the related party rules:
For example, if a taxpayer, pursuant to a prearranged plan, transfers property to an unrelated party who then exchanges the property with a party related to the taxpayer within two years of the previous transfer in a transaction otherwise qualifying under section 1031, the related party will not be entitled to nonrecognition treatment under section 1031.4
This example cautions against acquiring replacement property that has been owned in the previous two years by a related party. One writer went even further than the ABA committee, cautioning against any exchange involving a related party other than a direct swap between the related parties, saying, "Section 1031(f) precludes the use of an accommodation party in a deferred exchange."5
Some exchange practitioners, on the other hand, have viewed that if the replacement property acquired by the taxpayer from a related party is held for two years, it is a valid exchange. Richard M. Heller, Esq., in a manuscript presented for the East Coast Regional Membership Meeting of the Federation of Exchange Accommodators, Inc. on May 15, 1998, cautioned against possible abuse inherent in acquiring replacement property from a related party, but gave as an example:
The taxpayer could sell high basis property to an unrelated party and receive low basis replacement property from a related party. The replacement property would have a high basis in the hands of the taxpayer, who could then dispose of it without recognizing gain. The rules of § 1031(f) should apply here to disqualify the exchange if the taxpayer disposes of the replacement property within two years.
The IRS's position in PLR 9748006
In its analysis of the taxpayer's sale of relinquished property to an unrelated party, via a qualified intermediary, followed by the acquisition of replacement property from a related party, the IRS in PLR 9748006 made the following assertions:
Section 1031(f) is thus intended to deny nonrecognition treatment for transactions in which related parties make like-kind exchanges of high basis property for low basis property in anticipation of the sale of the low basis property. The committee determined that 'if a related party exchange is followed shortly thereafter by a disposition of the property, the RELATED PARTIES have, in effect, 'cashed out' of the investment, and the original exchange should not be accorded nonrecognition treatment.' H.R. Rep. No. 247, 101st Cong. 1st Sess. 1340 (1989)(emphasis added). The committee thus treats the related parties in these transactions as a single taxpayer, and the subsequent disposition of exchange property by one related party as a 'cashing out' by the other related party.
In this case, Taxpayer disposed of Property X through a qualified intermediary and through the same qualified intermediary acquired Property Z from Related Party. The economic result of this series of transactions is identical to what would have occurred in a direct exchange of Property X for Property Z between Taxpayer and Related Party, followed by a sale of Property X by Related Party to Unrelated Third Party.
In this particular instance, the taxpayer had entered into a contract to sell to an unrelated party and attempted to acquire his replacement property from an unrelated party but was unsuccessful. He argued that since the exchange was not originally structured as a related party exchange according to a prearranged plan, there was no tax avoidance motive in existence at the time he entered into the contract for the sale of his relinquished property to an unrelated party. IRS, nonetheless, found that the "[t]axpayer has not demonstrated that use of a qualified intermediary was not to avoid the purposes of the related party rules of section 1031(f)."
Reactions to the PLR Among Leading Exchange Advisors
In a presentation made on April 16, 1998 for the National Real Estate Development Conference, Michael Phillips, Esq. commented, "[t]his holding is not a surprise to practitioners familiar with Section 1031(f) and its legislative history. But it must have come as a surprise to the taxpayer and his advisors who have become the first reported, albeit unwitting, victims of Section 1031(f)(4)." He went on to say, "[i]n the context of related party exchanges, Section 1031(f)(4) represents the codification of substance over form."6 Mr. Phillips proceeded to give an excellent analysis of ten possible exchange scenarios involving a related party, and discussed why he thought each would or would not succeed under § 1031(f)(4). In general, he found that in any exchange where basis shifting, either directly or indirectly, occurred, and one of the related parties cashed out of the transaction within two years, § 1031(f)(4) could be applied.
Other exchange advisors have viewed PLR 9746008 as extreme on the part of the IRS. In the April 1998 newsletter of the Federation of Exchange Accommodators, Andrew Potter (agreeing with the taxpayer's argument that he used a qualified intermediary because he did not originally intend to exchange with a related party) wrote,
Obviously, the use of a Qualified Intermediary in the transaction was in conformity with normal commercial exchange practices as the Taxpayer originally sought to obtain property other than Property Z as replacement property. The views expressed by the Internal Revenue Service lead to the conclusion that the writer of this Private Letter Ruling was unfamiliar with these practices or that some other reasons exist for the overly harsh treatment of the Taxpayer.
Because no court case has yet resolved the questions created by Section 1031(f)(4) and the Regulations do not amplify its meaning, attorneys and exchangors may well heed the advice of Michael Phillips, "[i]f a related person is involved in the exchange in any capacity (e.g., a buyer, seller or prior owner of any of the properties involved in the exchange), the transaction or series of transactions must be tested under Section 1031(f)(4)."7
1 Jeremiah M. Long & Mary Foster Vrbanac, Tax-Free Exchanges Under Section 1031 § 2:48. (West Group 1997)
2 I.R.C. §§ 1031(f)(1) and (2).
3 I.R.C. § 1031(f)(3).
4 H.R. Rep. No. 101-247, 101st Cong., 1st Sess. 1341 (1989).
5 Dennis J. Carlin, Solving Related Party Issues After 1989 Tax Legislation (May 13, 1991) (unpublished manuscript, presented at the 4th Annual Conference on Section 1031 Exchanges sponsored by the National Real Estate Development Center.)
6 Michael K. Phillips and Gregory J. Rocca, Related Party Exchanges: What Works, What Fails and What Remains Uncertain (April 16, 1998) (unpublished manuscript, presented at the 11th Annual Conference on Section 1031 Exchanges sponsored by the National Real Estate Development Center).