The taxpayer in the case of The Malulani Group, Limited and Subsidiary v. Commissioner, TC Memo 2016-209 was facing a problem with its attempted §1031 exchange—it was unable to locate properties to identify as replacement properties as the 45-day period for doing in its deferred exchange was running down. The taxpayer decided to identify properties held by a related entity (MBL) as properties to be acquired in order to complete the transaction.

As the Court described the matter:

In order to meet the requirements of section 1031(a)(3), MBL had to identify replacement property on or before February 24, 2007 (i.e., 45 days after the sale of the Maryland property). Between October 31, 2006, and February 23, 2007, brokers presented numerous properties owned by unrelated parties to the Malulani Group and MBL as potential replacement properties, and MBL attempted to negotiate the purchase of an office building and an apartment building for that purpose. However, as of the January 10, 2007, sale of the Maryland property, neither the Malulani Group nor MBL had considered acquiring a replacement property from MIL or any other related party. On February 23, 2007, MBL first identified three potential replacement properties, all belonging to MIL.

On July 3, 2007, FAEC purchased certain real property owned by MIL and located in Hawaii (Hawaii property) for $5,520,000 and transferred it to MBL as replacement property for the Maryland property. MIL's basis in the Hawaii property was $2,392,996 at the time of purchase.

The taxpayer faced a potential problem with this transaction, found at IRC §1031(f)(1) which generally disallows a gain deferral where a related party ends up with cash (as was true in this case). The provision provides:

(f) Special rules for exchanges between related persons

(1) In general

If—

(A) a taxpayer exchanges property with a related person,

(B) there is nonrecognition of gain or loss to the taxpayer under this section with respect to the exchange of such property (determined without regard to this subsection), and

(C) before the date 2 years after the date of the last transfer which was part of such exchange—

(i) the related person disposes of such property, or

(ii) the taxpayer disposes of the property received in the exchange from the related person which was of like kind to the property transferred by the taxpayer,

there shall be no nonrecognition of gain or loss under this section to the taxpayer with respect to such exchange; except that any gain or loss recognized by the taxpayer by reason of this subsection shall be taken into account as of the date on which the disposition referred to in subparagraph (C) occurs.

Although that provision only applies to direct exchanges, the Court notes:

…section 1031(f)(4) provides that nonrecognition treatment does not apply to any exchange which is part of a transaction or series of transactions "structured to avoid the purposes of" section 1031(f). Therefore, section 1031(f)(4) may disallow nonrecognition treatment of deferred exchanges that only indirectly involve related persons because of the interposition of qualified intermediaries. See Ocmulgee Fields, Inc. v. Commissioner, 613 F.3d at 1367; see also Teruya Bros., Ltd. & Subs. v. Commissioner, 580 F.3d 1038 (2009), aff'g 124 T.C. 45 (2005).

However, the deferral can still be obtained if the taxpayer meets the requirements of IRC §1031(f)(2)(C), which excludes from recognition a disposition “with respect to which it is established to the satisfaction of the Secretary that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax.” The taxpayer argued that it met this exception.

First, the taxpayer noted that it had attempted to find property held by unrelated parties to complete the exchange and had only turned to the related party when it was unable to find such properties. Thus, it has not entered the deferred exchange with a “prearranged plan” looking to create a tax avoidance transaction with a related entity.

The taxpayer also pointed out that its basis in the asset it disposed of was greater than that of the related taxpayer, so the gain recognized by the related taxpayer was greater than would have been recognized had the taxpayer had not entered into a §1031 exchange. Since more gain had been recognized than would have been recognized had the exchange collapsed, that also argued that there was no tax avoidance activity.

With regard to the lack of a prearranged plan at the beginning of the transaction, the Tax Court pointed out:

We considered and rejected similar arguments in Ocmulgee Fields. The taxpayer in that case had, like MBL, first made attempts to find a suitable replacement property held by an unrelated person before turning to property held by a related person. Ocmulgee Fields, Inc. v. Commissioner, 132 T.C. at 107-108. We concluded, however, that the presence or absence of a prearranged plan to use property from a related person to complete a like-kind exchange is not dispositive of a violation of section 1031(f)(4). Id. at 121-122.5

Instead, the inquiry into whether a transaction has been structured to avoid the purposes of section 1031(f) has focused on the actual tax consequences of the transaction to the taxpayer and the related party, considered in the aggregate, as compared to the hypothetical tax consequences of a direct sale of the relinquished property by the taxpayer. Those actual consequences form the basis for an inference concerning whether the transaction was structured in violation of section 1031(f)(4).

But that brings up the taxpayer’s second argument—there had been more income recognized by the two taxpayers due to this transaction than if no transaction had taken place—so would that dispose of the issue?

The Tax Court note that the analysis had to go beyond the mere question of how much gain was recognized to look at the ultimate consequences on the tax liabilities of the parties in the aggregate—and, in this case, there was less tax paid in total for the year due to the exchange being completed.

The Court continued:

It is true that MIL recognized more gain on the disposition of the Hawaii property than MBL realized on the disposition of the Maryland property. However, MIL was able to offset the gain recognized with NOLs, resulting in net tax savings to petitioner and MIL as an economic unit. Net tax savings achieved through use of the related party's NOLs may demonstrate the presence of a tax-avoidance purpose notwithstanding a lack of basis shifting. See Teruya Bros., Ltd. & Subs. v. Commissioner, 580 F.3d at 1047; see also Teurya Bros. Ltd. & Subs. v. Commissioner, 124 T.C. at 55.

In sum, by employing a deferred section 1031 exchange transaction to dispose of the Maryland property, petitioner and MIL, viewed in the aggregate, "have, in effect, 'cashed out' of the investment", H.R. Rept. No. 101-247, supra at 1340, 1989 U.S.C.C.A.N. at 2810, virtually tax free -- in stark contrast to the substantial tax liability petitioner would have incurred as a result of a direct sale.