Private Letter Ruling No. 2004-40002 (PLR 200440002)
Internal Revenue Service (I.R.S.)
Private Letter Ruling
Issue: October 1, 2004
June 14, 2004
Section 1031 — Exchange of Property Held for Productive Use or Investment
CC:ITA:B04 - PLR-101766-04
AB Partnership =
CD Partnership =
This responds to your request for a private letter ruling, dated December 4, 2003, regarding Section 1031 of the Internal Revenue Code.
AB Partnership and CD Partnership are related persons within the meaning of Section 1031(f)(3). AB Partnership owns Building 1 and CD Partnership owns Building 2. AB Partnership has agreed to transfer Building 1, including land and improvements, the tangible personal property, leases and other assets associated with Building 1, to Buyer. AB Partnership wants to defer the recognition of the gain on the transfer of Building 1. Therefore, AB Partnership will acquire Building 2, including land and improvements, as one of its identified replacement properties, in exchange for Building 1 in a transaction intended to qualify for nonrecognition treatment under Section 1031. CD Partnership will also engage in an exchange of Building 2 for other like-kind property in a transaction intended to qualify for nonrecognition treatment under Section 1031.
To facilitate their exchanges, AB Partnership and CD Partnership will enter into exchange agreements with a qualified intermediary ("QI") described in § 1.1031(k)-1(g)(4). Pursuant to AB Partnership's exchange agreement, QI will, for purposes of Section 1031 and the regulations thereunder, be treated as the seller of Building 1 to Buyer. Moreover, QI will be treated as acquiring Building 2 from CD Partnership and transferring it to AB Partnership in exchange for Building 1. Similarly, pursuant to CD Partnership's exchange agreement, QI will be treated as acquiring property to replace Building 2 ("CD's Replacement Property") and transferring it to CD Partnership in exchange for Building 2. CD's Replacement Property is, prior to its transfer to QI, owned by a party that is not related to either AB Partnership or CD Partnership.
Once all the transactions are completed, AB Partnership will own Building 2, CD Partnership will own CD's Replacement Property, and Buyer will own Building 1. AB Partnership represents that it will not dispose of Building 2 within two (2) years of its receipt as its replacement property. CD Partnership represents that it will not dispose of CD's Replacement Property received in exchange for Building 2 within two (2) years of its receipt as replacement property. For purposes of these representations, both taxpayers assert that the principles of Section 1031(f)(2) apply. AB Partnership and CD Partnership each seek a ruling regarding the application of Section 1031(f) to their respective exchanges.
Section 1031(a)(1) generally provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.
Section 1031(f) sets forth special rules for exchanges between related persons. Section 1031(f)(1) provides that if (A) a taxpayer exchanges property with a related person; (B) there is nonrecognition of gain or loss to the taxpayer in accordance with Section 1031 with respect to the exchange; and (C) within 2 years of the date of the last transfer that was part of the exchange either the taxpayer or the related person disposes of the property received in the exchange, then there is no nonrecognition of gain or loss in the exchange. In other words, the gain or loss that was deferred under Section 1031 must be recognized. Any gain or loss the taxpayer is required to recognize by reason of Section 1031(f)(1) is taken into account as of the date of the disposition of the property received in the exchange (the second disposition).
Section 1031(f)(2) provides that certain dispositions will not be taken into account for purposes of Section 1031(f)(1)(C). These include any disposition (A) after the earlier of the death of the taxpayer or the death of the related person, or (B) in a compulsory or involuntary conversion (within the meaning of § 1033) if the exchange occurred before the threat or imminence of such conversion. The excepted dispositions also include a disposition with respect to which it is established to the satisfaction of the Secretary that neither the exchange nor the second disposition had as one of its principal purposes the avoidance of federal income tax. The legislative history regarding the non-tax avoidance exception indicates that it would generally apply to (among other types of transactions) dispositions in nonrecognition transactions. See S. Print No. 56, 101st Cong., 1st Sess. 152 (1989).
Section 1031(f)(4) provides that Section 1031 shall not apply to any exchange that is part of a transaction, or series of transactions, structured to avoid the purposes of Section 1031(f). Thus, if a transaction is set up to avoid the restrictions on exchanges between related persons, Section 1031(f)(4) operates to prevent nonrecognition of the gain or loss on the exchange.
In Rev. Rul. 2002-83, 2002-2 C.B. 927, a taxpayer transfers relinquished property to a qualified intermediary in exchange for replacement property formerly owned by a related party. As part of the transaction, the related party receives cash for the replacement property. The ruling holds that because the taxpayer's use of the qualified intermediary was to avoid the application of Section 1031(f)(1), the taxpayer, under Section 1031(f)(4), was not entitled to nonrecognition treatment under Section 1031.
In the present case, Section 1031(f)(1) is not applicable to currently tax AB Partnership's disposition of Building 1 because AB Partnership is exchanging property with a qualified intermediary, who is not a related party. However, Section 1031(f)(4) provides that Section 1031 shall not apply to any exchange that is part of a transaction, or series of transactions, structured to avoid the purposes of Section 1031(f). Thus, Section 1031 will not apply if AB Partnership's exchange is structured to avoid the "purposes" of Section 1031(f).
Both the Ways and Means Committee Report and the Senate Finance Committee Print, describe the policy concern that led to enactment of this provision:
Because a like-kind exchange results in the substitution of the basis of the exchanged property for the property received, related parties have engaged in like-kind exchanges of high basis property for low basis property in anticipation of the sale of the low basis property in order to reduce or avoid the recognition of gain on the subsequent sale. Basis shifting also can be used to accelerate a loss on retained property. The committee believes 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); S. Print No. 56, at 151. The Committee Reports also included the following example of when Section 1031(f)(4) applies:
If a taxpayer, pursuant to a pre-arranged plan, transfers property to an unrelated party who then exchanges the property with a party related to the taxpayer within 2 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.
H.R. Rep. No. 247, at 1341; S. Print No. 56, at 152.
In Rev. Rul. 2002-83, the Service discussed and applied Section 1031(f)(4) to the following facts:
Individual A owns real property (Property 1) with a fair market value of $150x and an adjusted basis of $50x. Individual B owns real property (Property 2) with a fair market value of $150x and an adjusted basis of $150x. Both Property 1 and Property 2 are held for investment within the meaning of Section 1031(a). A and B are related persons within the meaning of § 267(b). C, an individual unrelated to A and B, wishes to acquire Property 1 from A. A enters into an agreement for the transfers of Property 1 and Property 2 with B, C, and a qualified intermediary (QI). QI is unrelated to A and B. Pursuant to their agreement, on January 6, 2003, A transfers Property 1 to QI and QI transfers Property 1 to C for $150x. On January 13, 2003, QI acquires Property 2 from B, pays B the $150x sale proceeds from QI's sale of Property 1, and transfers Property 2 to A.
In analyzing these facts under Section 1031(f)(4), the Service quoted the legislative history cited above for the proposition that Section 1031(f)(4) is intended to apply to situations in which related parties effectuate like-kind exchanges of high basis property for low basis property in anticipation of the sale of the low basis property. In such case, the original exchange should not be accorded nonrecognition treatment. Under the facts in the revenue ruling, A and B were attempting to sell Property 1 to an unrelated party while using the substituted basis rule of Section 1031(d) to reduce the gain on such sale from $100x to $0. This allowed the parties to "cash out" of their investment in Property 1 without the recognition of gain. The Service concluded that the transaction was structured to avoid the purposes of Section 1031(f)(1) and, therefore, A had gain of $100x on its transfer of Property 1.
The legislative history underlying Section 1031(f)(2)(C) provides that any second disposition by exchanging parties will not be taken into account for purposes of Section 1031(f)(1) if it can be established to the satisfaction of the Secretary that neither the initial exchange nor the second disposition had as one of its principal purposes the avoidance of federal income tax. In that regard, the Conference Committee Report, which adopted the Senate amendment, noted that the Senate Finance Committee Report provided that "the non-tax avoidance exception generally will apply to ... dispositions in nonrecognition transactions ...." H.R. Rep. No. 386, 101st Cong., 1st Sess. 613 (1989).
In the present case, the only subsequent disposition contemplated by the parties after AB Partnership receives Building 2 as replacement property is the use of the proceeds from the disposition of Building 2 by CD Partnership to acquire like-kind replacement property in another exchange under Section 1031, a nonrecognition transaction. Thus, because CD Partnership is structuring its disposition of Building 2 as an exchange for like-kind replacement property so that the gain on the transfer of Building 2 is eligible for nonrecognition treatment under Section 1031(a), Section 1031(f)(4) and Rev. Rul. 2002-83 are not applicable. Both AB Partnership's exchange and CD Partnership's exchange are structured as like-kind exchanges qualifying under Section 1031. There is no "cashing out" of either party's investment in real estate. Upon completion of the series of transactions, both related parties will own property that is like-kind to the property they exchanged. Moreover, neither party will have ever been in receipt of cash or other non-like kind property (other than boot received in the exchange) in return for the relinquished property.
Under the given facts and representations, Section 1031(f) will not apply to trigger recognition of any gain realized in AB Partnership's exchange of Building 1 for Building 2 or CD Partnership's exchange of Building 2 for CD's Replacement Property.
Robert A. Berkovsky
Office of Associate Chief Counsel (Income Tax & Accounting)
This document may not be used or cited as precedent.
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