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A LIKE-KIND EXCHANGE DISASTER (RELATIVELY SPEAKING)

February 09, 2005

A frequent theme of the Tax Update is the danger of engaging in tax relationships with related parties.

Teruya Brothers, LTD is a Hawaii real estate developer. When the time came to sell two choice properties for around $13 million, Teruya Brothers decided to use a Section 1031 like-kind exchange to avoid the tax.

Unfortunately, they got a subsidiary involved. The result: a $4 million tax bill.

HOW THEY TRIED TO USE SECTION 1031

Section 1031 is designed to let taxpayers swap "like-kind" property without paying current tax; gain is deferred by carrying the "basis," or cost, of the property given up to the property received in the swap. This defers the gain until the property received in the swap is someday sold.

Over the years the tax law has made it easier to have what looks like a sale be treated as a section 1031 swap. The law allows taxpayers to park cash with an intermediary when a property is sold. If the seller can identify a replacement property within 45 days of a sale, and the intermediary can close on it within 180 days, the transfer of the property from the intermediary to the seller can be treated as a Section 1031 swap. (We generalize here - don't do this at home.)

THE TROUBLE WITH RELATED PARTIES

The section 1031 rules say that if you swap with a related party, and the related party sells your old property within two years, the transaction is disqualified from the benefits of section 1031 treatment.

WHERE TURUYA BROTHERS STUMBLED

When Teruya Brothers sold the Royal Towers Apartments and the Ocean Vista Condominiums in 1996, it had the proceeds deposited with a qualified intermediary. The intermediary acquired the replacement property from Times Super Market, a Hawaii grocery chain; the intermediary then transferred the replacement property to Teruya Brothers, all in compliance with the 45-day and 180-day limits.

There was only problem: Teruya Brothers owned 62.5% of Times Super Market.

What's the problem, you might ask? After all, if you swap with an unrelated intermediary, why would you care where the intermediary got the property?

Unfortunately for Teruya Brothers, the IRS has for some time taken the position this fact pattern is taxed as

1. An exchange between the Teruya Brothers and Times Super Market, followed by

2. A sale to the third party by Times Super Market.

In other words, the related party -- not the intermediary -- is considered the other party in the swap. Looked at this way, the sale is disqualified because the related party has sold the property acquired in the swap within two years - in fact, it sold it immediately.

The Tax Court today said the IRS position is correct.

LESSONS FROM THE TAX COURT

Teruya Brothers said that they should still qualify for tax-free treatment because the deal wasn't primarily for tax avoidance. If today's decision is upheld on appeal, it will pretty much ratify the IRS view that you can't sell to a third party through an intermediary and use the proceeds to acquire replacement property from a related party.

Cite: Teruya Brothers and Subsidiaries v. Commissioner, 124 T.C. No. 4.

Royal Towers Apartments, Salt Lake, HI

UPDATE: More on the basics of Section 1031 here.

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