In Malulani [11/16/16], the taxpayer was a corporation whose primary operations consisted of leasing commercial property in various states. It filed consolidated returns with a wholly owned subsidiary corporation (sub). It also owned nearly 70% of a second corporation (C2) which also held real estate property throughout the country. On January 10, 2007, the sub through an intermediary sold one of its real estate properties to a third party resulting in a realized gain of $1.89 million. It desired to defer the gain under the deferred like-kind exchange provisions. In order for the sale to qualify for like-kind exchange treatment, the sub had to identify replacement property by February 24, 2007. Between October 31, 2006, the date the buyer expressed an interest in purchasing the relinquished property, and February 23, 2007, brokers presented the sub with numerous properties owned by unrelated parties as potential replacement properties, and the sub attempted to negotiate the purchase of an office building and an apartment building for that purpose. However, the purchase did not materialize and one day before the deadline, the sub identified three properties owned by C2. On July 3, 2007, barely within the 180-day replacement requirement, the sub purchased replacement property from C2. Although C2's realized gain was $3.13 million, it had sufficient net operating losses (NOLs) to offset the gain, resulting in no regular tax liability and an alternative minimum tax of $44,774. The taxpayer filed a consolidated tax return with its sub and pursuant to Section 1031 deferred the $1.89 million gain from the sale of the sub property.

The IRS denied like-kind exchange treatment on the basis of Section 1031(f). Section 1031(f)(1) generally provides that the like-kind exchange provisions will not apply if a taxpayer and a related person exchange like-kind property and within two years either one disposes of the property received in the exchange. This provision was enacted primarily to prevent the potential abuse where related parties engage 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.

In the current case, Section 1031(f)(1) is not applicable because it does not involve direct exchanges between two related parties. That is, only one of the property transactions in this case involved related parties (the sale of the property from C2 to the sub). However, Section 1031(f)(4) provides that like-kind exchange treatment will not apply to any related party exchange which is part of a transaction or series of transactions "structured to avoid the purposes of" Section 1031(f). Because C2 paid little tax on the transaction and the sub deferred a sizable gain from the exchange, the IRS argued that they structured the exchanges for tax avoidance purposes. The taxpayer countered that Section 1031(f)(2) provides that any disposition of the relinquished or replacement property within two years of the exchange is disregarded if the taxpayer establishes that neither the exchange nor disposition had as one of its principal purposes the avoidance of tax. It argued that it had no preconceived plan to conduct an exchange with C2 and it diligently sought a replacement property held by an unrelated party and only turned to the property held by C2 when the deadline to complete a deferred exchange was imminent. The Tax Court did not buy the taxpayer’s arguments. It noted that C2 essentially cashed out its investment virtually tax-free while significant tax savings resulted from the sub’s acquisition of the replacement property from C2. The Tax Court concluded that the taxpayer failed to demonstrate that the avoidance of tax was not one of the principal purposes of the exchange with C2. Consequently, it ruled that Section 1031 did not apply. Note: We believe the decision was harsh for several reasons. First, the transactions were not consistent with the so-called abuses that Congress was concerned with – the stepping up of basis of appreciated property using the like-kind exchange rules and then selling it a short time later. Second, C2's realized gain of $3.13 million from the sale of its property to the sub was offset by large NOLs unrelated to any tax benefits derived from Section 1031. Third, the very purpose of Section 1031 is tax avoidance. So it is nearly impossible in this case to satisfy Section 1031(f)(2) – that the like-kind exchange did not have as one of its purposes the avoidance of tax. Click Here for a copy of the complete Tax Court decision.