The Tax Court held in Malulani Group, Limited and Subsidiary v. Commissioner of Internal Revenue, TC Memo 2016-209, that the taxpayer's transfer of relinquished property through a qualified intermediary (QI) to an unrelated person in exchange for replacement property acquired from a related person does not qualify for nonrecognition treatment under the like-kind exchange rules of Section 1031 because the transaction was structured to avoid the related party rules of Section 1031(f).

Facts

Malulani Group, Limited (MG) is a Hawaiian corporation that leases commercial real estate in several states, including Maryland and Hawaii. MBL Maryland, Inc. (MBL) is a wholly-owned subsidiary of MG, which files a consolidated federal income tax return with MBL. MG and MBL are the taxpayers for the purposes of the case. MG owns 69.7% of Malulani Investments, Ltd (MI). Prior to September 2004, MG and MI had the same president and the same Board of Directors. In September 2004, 30% of MI's shares were acquired by a hostile shareholder. MG and MI then established separate Boards and hired different separate presidents.

MG made substantial loans to MI. Loan decisions were made by MIL Note Committee, which was composed of executives and Board members of MG.

In October 2006, MBL received a letter of intent from an unrelated third party to purchase commercial real estate that MBL owned in Maryland (the relinquished property). MBL was given the right to structure the exchange under Section 1031 and the third party was obligated to cooperate in that endeavor. On October 31, 2006, the agreement was signed and the taxpayers began to search for suitable replacement property.

On January 4, 2007, MBL engaged First American Exchange Co. (FAEC) to serve as the QI. MBL transferred the relinquished property to FAEC. FAEC sold the relinquished property (sale price approximately $4.7 million, with approximately $2.7 million basis) to an unrelated third party on January 10, 2007. On February 23, 2007 (within the 45-day requirement of Section 1031(a)(3)), MBL identified three replacement properties owned by MIL. FAEC bought property owned by MIL in Hawaii (purchase price approximately $5.5 million with approximately $2.4 million basis) on July 7, 2007 and transferred it to MBL as replacement property.

The only issue before the Tax Court was whether the exchange failed to qualify for nonrecognition treatment under Section 1031(a) as a result of the special rule applicable to exchanges between related persons in Section 1031(f).

Analysis

Section 1031(a)(1) provides that "[n]o 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 [like-kind] property … held for either productive use in a trade or business or for investment."

Section 1031(f) institutes special rules for exchanges between related parties. Generally, if a taxpayer and a related person exchange like-kind property and either one disposes of the exchanged property within two years, the nonrecognition provisions of Section 1031(a) do not apply. Rather, any gain or loss must be taken into account as of the date of the second disposition.

Section 1031(f)(2)(C) further provides, in general, that a disposition of exchanged property will not be taken into account if "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."

Section 1031(f)(4) provides that Section 1031 "shall not apply to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection [(f)]."

The Court concluded that the taxpayer was not entitled to Section 1031 nonrecognition treatment because the exchange transaction was structured to avoid the related-party rules of Section 1031(f). The taxpayer failed to prove it had a principal purpose for the transaction other than income tax avoidance. To make this determination, the Court relied on the legislative history and its application in two previous cases - Ocmulgee Fields, Inc. v. Commissioner, 613 F.3d 1360 (11th Cir. 2010), aff'g 132 T.C. 105; Teruya Bros., Ltd. & Subs. v. Commissioner, 580 F.3d 1038 (9th Cir. 2009), aff'g 124 T.C. 45 (2005). See also Tax Alerts 2005-115 and 2009-518 for EY analysis. A third previous case, not cited in the Malulani decision, is North Central Rental & Leasing, LLC v. US, DCND (9/3/13), aff'd 779 F.3d 738 (8th Cir. 2015).See Tax Alert 2015-488.

The taxpayer claimed that its use of a QI and the absence of a prearranged plan to conduct a deferred exchange between the related parties show that the transaction qualified for 1031(a) treatment. The Court rejected that argument based on similar analysis in the Ocmulgee Fields case.

Again citing the Omulgee Fields and Teruya Bros cases, the Court looked at the actual tax consequences of the transaction. The Court found that, in this case, the aggregate tax liability of the taxpayer and related person arising from the like-kind exchange is significantly less than the hypothetical tax that would have resulted from a direct sale of the relinquished properties. The taxpayer would have had to recognize about $1.9 million of gain had MBL directly sold the relinquished property to an unrelated third party. The taxpayer had NOLs to offset a portion of the gain, but would have paid almost $400,000 in additional tax for 2007 as a result of a direct sale. The taxpayer would have also owed approximately $260,000 of tax for 2005 because of the loss of the NOL carryback. Because the transaction was structured as a like-kind exchange, however, only MIL was required to recognize gain — and that $3 million of gain was almost entirely offset by its NOLs. The court found that economic effect of the transaction was that the taxpayer was able to cash out of the relinquished property almost tax-free.

The taxpayer contended that the exchange was not structured to avoid tax because there was no basis shifting involved. The court acknowledged that MIL recognized more gain on the disposition of the Hawaii property than MBL realized on the disposition of the relinquished property. The court again cited the Teruya Bros case to reject this argument, however, since the taxpayer used related-party NOLs to offset the gain and achieve net tax savings. A related-party transaction may have a tax avoidance purpose when there is technically no basis shifting.

Since the taxpayer failed to convince the Court that avoidance of federal income tax was not one of the principal purposes the exchange, the Court concluded that the transaction was structured to avoid the purposes of Section 1031(f) and is not entitled to nonrecognition treatment under Section 1031(a)(1).

Implications

This is the fourth case in which the courts have determined that an exchange involving the acquisition of replacement property (through a QI) from a related person will not qualify for nonrecognition treatment under the like-kind exchange rules of Section 1031 when the transaction allows the taxpayer to cash out of a property with little or no federal income tax consequence. In this case, as in the Teruya Bros case, the related party used NOLs to offset the gain on the transfer and achieve net tax savings, negating the argument that there was no basis shifting involved. In addition, the Service has taken essentially the same position in Revenue Ruling 2002-83 (see Tax Alert 2002-973) in which it ruled that the acquisition of replacement property through a QI from a related party will trigger gain under Section 1031(f)(4) if the related party had high basis in the property and received cash upon its sale. Further, as in the prior decisions, the Tax Court did not conclude whether the proper standard of review the taxpayer must satisfy is by a preponderance of the evidence or a heightened "strong proof" standard because taxpayer did not satisfy either standard. Thus, taxpayers should take note of this guidance when structuring like-kind exchanges.

———————————————