July 2015

TAX DEFERRED EXCHANGES UNDER INTERNAL REVENUE CODE SECTION 1031:
RECENT DEVELOPMENTS

Earlier this year, President Obama’s 2016 budget proposal, like its 2015 proposal, included a provision which, if enacted, would impose a $1 million limitation on the amount of capital gain deferred from the exchange of real property under 26 U.S.C. Section 1031, and would further exclude exchanges of art and collectibles from eligibility for gain deferral. Last month, Congress introduced legislation that would implement these proposals. See H.R. 2848 and S. 1631. Under this legislation, the $1 million limitation will be adjusted for inflation beginning in January of 2017 and will further subject to specific aggregation rules as between related parties and pass-through entities, with specific guidelines regarding exchanges of multiple properties amongst related parties to be prescribed by Secretary of Treasury. The policy reasons underlying the proposed $1 million limitation relate to the initial purpose of Section 1031 - to defer tax on gain in exchanges of property that are difficult to value. According to the Administration’s General Explanation’s of the Administration’s Fiscal Year 2016 Revenue Proposals (Feb. 2015), parties typically value properties prior to exchanges in any event, and the growing complexity of transactions using a third party - Qualified Intermediary ("QI") - make such valuations even more standard. Moreover, that Section 1031 permits taxpayers to exchange unimproved for improved real property affords them with the unintended opportunity for "permanent deferral". The $1 million limitation is thus intended to address these problems. In other words, with the erosion of the policy rationale comes the erosion of the benefit afforded by statute.

Separately, in North Central Rental & Leasing, LLC, 779 F.3d 738 (8th Cir. 2015) ("North Central"), the Eighth Circuit Court of Appeals expanded upon existing decisional law interpreting Section 1031(f)’s limitations on related party transactions and in particular the provision in Section 1031(f)(4) that nonrecognition will not be afforded to any party to an exchange which is a part of a transaction (or series of transactions) structured to avoid the purposes of the related party rules. Previous decisions have held that Section 1031(f)(4) related party transactions will not be afforded tax-deferred treatment even if structured within the parameters of the statute if the transaction results in tax benefits to one of the related parties (other than deferred gain). See Teruya Brothers Ltd. & Subs., 124 TC 45 (2005), aff’d 580 F.3d 1038 (9th Cir. 2009) and Ocmulgee Fields, Inc., 132 TC 105 (2009), aff’d 613 F.3d 1360 (11th Cir. 2010). In North Central, the Tax Court made clear that Section 1031(f)(4) applies not only in situations that result in tax benefits to a related party in a transaction, but also to situations where a related party receives a financial benefit that it wouldn’t otherwise have received. In this case, two related parties engaged in retail ("Retail Co.") and leasing ("Leasing Co.") of constructing, mining and agricultural equipment. Leasing Co., using a QI, exchanged used equipment for new equipment. The new equipment was purchased from Retail Co., who in term purchased the equipment from its manufacturer, Caterpillar. Because Retail Co. participated in a Caterpillar financing program, Retail Co. received a significant financial benefit, as it received payment from the QI, but did not have to remit payment to Caterpillar for six months, an arrangement that amounted to an interest free six-month loan. As there was no independent reason for Leasing to use Retail (through the QI) to acquire the replacement equipment, the Court held that the transaction was indeed structured to avoid the purposes of Section 1031(f).

In short, judicial decisions continue to tighten the provisions of Section 1031, to prevent related parties from entering into transactions designed to take advantage of the provisions of Section 1031 to achieve financial benefits other than tax deferral. In addition, Congress will be considering for the second year running the Administration’s proposed $1 million limitation on deferred gain under the statute, a proposal intended to sharply curtail the use of the statute for unintended, indefinite deferral of significant gains. If enacted as introduced, amendments to Section 1031 shall apply to exchanges completed in taxable years beginning after December 31, 2015.

ADDITIONAL INFORMATION

For additional information on deferred tax exchanges, please contact either Larry Inouye or Colleen Sechrest either by telephone (310.712.0100) or email (linouye@shiotani-inouye.com; csechrest@shiotani-inouye.com).