Anti-Abuse Accretion, 1989-2004

Congress enacted the related-person rules of section 1031(f) in 1989. The Service later read the anti-avoidance clause of those rules to reach exchanges routed through qualified intermediaries, and the Tax Court and two courts of appeals agreed. Meanwhile the Service answered two practices that had grown up outside the regulations, reverse exchanges and fractional co-ownership, with revenue procedures rather than regulations, and in 2004 it approved the Delaware statutory trust as a vehicle for replacement property. This chapter traces that accretion. The operative rules are examined in Chapters 21, 30, 40, and 41.

6.1 Enactment of §1031(f) and the two-year rule

The broader House proposal. Section 1031(f) is what survived of a much larger attempt to narrow the statute in 1989. The House version of the Omnibus Budget Reconciliation Act of 1989 would have required that properties exchanged under section 1031, or replaced after a condemnation of real property under section 1033(g), be "similar or related in service or use." That is the standard section 1033 applies to other involuntary conversions, and the conference report described it as "significantly narrower than the like-kind standard," noting that unimproved and improved real estate generally are not considered similar or related in service or use.¹ The House bill would also have required the taxpayer to hold the relinquished property directly for the full year before the exchange and the replacement property directly for the full year after it. The conference report set that proposal beside Bolker v. Commissioner, in which the Ninth Circuit held that a taxpayer who received property in the liquidation of his corporation and contracted the same day to exchange it had held it for investment, and beside Rev. Rul. 77-337, which had reached the contrary conclusion on similar facts.² The House report, as later quoted by the Ninth Circuit, stated that "the 'like-kind' standard as applied to exchanges of property [wa]s too broad," that taxpayers had been granted nonrecognition "in circumstances where they have significantly changed their investment as a result of the exchange or conversion," and that nonrecognition should be limited to exchanges and conversions "where a taxpayer can be viewed as merely continuing his investment."³ Those statements speak to the like-kind standard itself and to involuntary conversions, which is what the House's general rule would have changed. The Ninth Circuit read them as evidence of the purposes of section 1031(f).

What was enacted. The Senate amendment contained neither the similar-use standard nor the holding periods. The conference agreement followed the Senate amendment, adding only a foreign real property rule and limiting that rule to section 1031.⁴ Three subsections resulted. Subsection (f) denies nonrecognition to an exchange between related persons if, within two years after the last transfer in the exchange, the related person disposes of the property it received or the taxpayer disposes of the property it received, with the gain or loss taken into account when the disposition occurs. Dispositions after the death of either party, dispositions in involuntary conversions where the exchange preceded the threat of conversion, and dispositions where it is established to the satisfaction of the Secretary that neither the exchange nor the disposition had tax avoidance as one of its principal purposes do not count. As enacted, "related person" meant a person with a relationship described in section 267(b); in 1990 Congress added partnership relationships described in section 707(b)(1). Paragraph (4) denies nonrecognition to any exchange that is part of a transaction structured to avoid the purposes of the subsection.⁵ Subsection (g) suspends the two-year period while the holder's risk of loss is substantially diminished by a put, another person's right to acquire the property, or a short sale or other transaction.⁶ Subsection (h) provided that real property located in the United States and real property located outside the United States are not property of a like kind. Congress rewrote subsection (h) in 1997 to address foreign personal property as well, and the 2017 Act returned it to a rule for real property alone.⁷ The amendments applied to transfers after July 10, 1989, except transfers under a written binding contract in effect on that date.⁸

Why related persons. The concern with related parties was basis. Because replacement property takes the basis of the relinquished property, related parties could exchange 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," and basis shifting "also can be used to accelerate a loss on retained property." The House report concluded 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."⁹ The conference report summarized the House rule as applying where a taxpayer "directly or indirectly exchanges property with a related party."¹⁰ The enacted text reaches indirect arrangements through paragraph (4), and the House report's example for that clause, a prearranged transfer to an unrelated party who then exchanges with a party related to the taxpayer, became the basis for the Service's later position (6.2).¹¹ The Senate committee report, whose version the conferees followed, contemplated that the non-tax-avoidance exception would generally apply to certain exchanges of undivided interests, dispositions in nonrecognition transactions, and transactions that do not shift basis between properties (Chapter 40).¹²

6.2 Extension to intermediated related-party exchanges

The gap. Section 1031(f)(1) applies when "a taxpayer exchanges property with a related person." Once a qualified intermediary stands between the parties, the taxpayer's exchange is, in form, with the intermediary, which "is not considered the agent of the taxpayer for purposes of section 1031(a)" (5.5). A taxpayer holding low-basis property could therefore have the intermediary sell that property to an outside buyer and use the proceeds to buy a related person's high-basis property. The related person received cash, the taxpayer received like-kind property, and in form no one had exchanged with a related person. The statutory text addressed to that arrangement was paragraph (4): 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."¹³

Revenue Ruling 2002-83. The Service answered in 2002. In the ruling, A owned property worth $150x with a basis of $50x, and B, a related person, owned like-kind property worth $150x with a basis of $150x. Through a qualified intermediary, A's property was sold to an unrelated buyer for $150x, and a week later the intermediary bought B's property with the proceeds and transferred it to A.¹⁴ The ruling relied on the House report's statement that when a related party exchange is followed shortly by a disposition, "the related parties have, in effect, 'cashed out' of the investment," and on the report's example of a taxpayer who, under a prearranged plan, transfers property to an unrelated party who then exchanges it with a party related to the taxpayer.¹⁵ A had used the intermediary "in the same way that the unrelated party was used" in that example. Without section 1031(f), A could have exchanged directly with B, and B could have sold A's former property to the buyer. With the intermediary, "the end result of the transaction is the same," and A had cashed out of its low-basis property without recognizing gain. The ruling held that a taxpayer who acquires replacement property formerly owned by a related party through a qualified intermediary is not entitled to nonrecognition "if, as part of the transaction, the related party receives cash or other non-like-kind property for the replacement property."¹⁶

The courts. The Tax Court applied the same reasoning in Teruya Brothers, Ltd. v. Commissioner, although it described the House report's example as "highly elliptical" and insisted that the non-tax-avoidance exception of section 1031(f)(2)(C) be part of the analysis. The taxpayer, a Hawaii real estate company, had exchanged two properties through an intermediary for replacement properties owned by a related corporation, which ended up with the cash from the sales. The taxpayer offered no explanation for using an intermediary, and the court inferred that it had been interposed "in an attempt to circumvent the section 1031(f)(1) limitations," concluding that the transactions were structured to avoid the purposes of section 1031(f).¹⁷ The Ninth Circuit affirmed, holding that the taxpayer and its related party must be treated "as an economic unit" and that together they had used the exchanges to cash out of an investment in low-basis property.¹⁸ In Ocmulgee Fields, Inc. v. Commissioner, the Tax Court and the Eleventh Circuit reached the same result on similar facts, reasoning that a direct exchange followed by the related party's sale would have been disallowed and that the structure produced the basis shift Congress meant to prevent.¹⁹ Later decisions are examined in Chapter 41.²⁰

What changed. The 1989 statute spoke of exchanges "with a related person." After 2002, the decisive question was no longer the form of the counterparty but whether the related party ended up with cash, and the Service tied its position expressly to that fact. The intermediary, created to solve an agency problem, had become a way around the related-party rules, and the answer was to look through it for that purpose while leaving the safe harbor itself intact.

6.3 Administrative safe harbors: reverse exchanges and co-ownership

Reverse exchanges before 2000. The 1991 regulations did not apply to "reverse-Starker" exchanges, in which the replacement property is acquired before the relinquished property is transferred, and Treasury said only that it would continue to study them (5.5).²¹ A taxpayer cannot exchange property for property it already owns, so practice developed "parking" arrangements. An accommodation party took title to the replacement property and held it until the taxpayer could arrange the transfer of the relinquished property, and the parties tried to give the accommodation party enough of the benefits and burdens of ownership to be treated as the owner.²² The Tax Court's first decision on such an arrangement, DeCleene v. Commissioner, came in November 2000. The taxpayer had tried to carry out a reverse exchange directly with the other party to the transaction, without a third-party facilitator. That party held title to the replacement land for about three months but acquired none of the benefits and burdens of ownership, and the court held that the taxpayer had sold his business property rather than exchanged it.²³

Revenue Procedure 2000-37. Shortly before DeCleene, the Service had published a safe harbor. Treasury and the Service had concluded that "it is in the best interest of sound tax administration to provide taxpayers with a workable means of qualifying their transactions under § 1031" where the taxpayer has a genuine intent to exchange when it arranges to acquire the replacement property and completes the exchange within a short time.²⁴ Under Revenue Procedure 2000-37, property is held in a "qualified exchange accommodation arrangement" if an exchange accommodation titleholder that is not the taxpayer or a disqualified person holds qualified indicia of ownership; the taxpayer has a bona fide intent that the property be part of an exchange; a written agreement is signed within five business days; the relinquished property is identified within 45 days; the property is transferred within 180 days; and the relinquished and replacement properties are not held in the arrangement for more than 180 days combined.²⁵ The safe harbor applies where the titleholder acquired its indicia of ownership on or after September 15, 2000. The Service disclaimed any inference about earlier arrangements and acknowledged that parking "can be accomplished outside of the safe harbor."²⁶ The consequences of that acknowledgment are examined at 30.5 and 30.6 and in Chapter 66.

The 2004 modification. As first issued, the safe harbor said that the Service would not challenge the qualification of property held in the arrangement as replacement or relinquished property. Some taxpayers read that language to permit them to transfer their own property to a titleholder and take it back as replacement property. Revenue Procedure 2004-51 rewrote the promise so that the Service agrees only to treat the titleholder as the beneficial owner, with qualification depending on whether the exchange otherwise meets the requirements of section 1031. It also provided that the safe harbor does not apply to replacement property the taxpayer owned within the 180 days before transferring it to the titleholder, effective for transfers on or after July 20, 2004. The Service said it was continuing to study arrangements in which a related person's leasehold is improved by an accommodation party and then exchanged (Chapter 31).²⁷

Co-ownership, from no rulings to ruling guidelines. Fractional ownership raised a different question. An undivided co-ownership interest in real property is real property, but partnership interests had been excluded from section 1031 since 1984, and co-owners who carry on a business together can be partners for tax purposes whatever state law calls them.²⁸ In 2000 the Service announced that it had "recently" become aware, partly through ruling requests, that taxpayers were taking the position that arrangements in which investors acquired undivided fractional interests in real property were not separate entities, so that the interests could be exchanged. It added the question to its list of subjects on which it would not rule while it studied the matter, and it asked for comments on management and leasing agreements, restrictions such as waivers of the right to partition, and the economics of the arrangements.²⁹ Two years later, Revenue Procedure 2002-22 replaced that refusal with guidelines under which the Service would consider ruling requests. Citing Bergford v. Commissioner and Bussing v. Commissioner, it explained that where a sponsor packages co-ownership interests for sale, courts have looked at the relationships between the sponsor and the co-owners as well as among the co-owners.³⁰ Its fifteen conditions include a limit of 35 co-owners; unanimous approval for any sale, lease, or re-lease of the property, any negotiation or renegotiation of debt secured by a blanket lien, and the hiring of any manager; each co-owner's right to transfer, partition, and encumber its interest, subject to customary lender restrictions; activities limited to those customary for rental real property; and management agreements renewable at least annually (Chapter 21).³¹ The procedure described its conditions as guidelines for ruling requests that "are not intended to be substantive rules and are not to be used for audit purposes."³²

In both areas the Service acted by revenue procedure rather than by regulation, which is why the weight of these documents in litigation is a recurring question (11.2).

6.4 Delaware Statutory Trusts and the fractional-interest market

The market the guidance describes. Revenue Procedure 2002-22 defined a "sponsor" as a person who divides a single interest in property into multiple co-ownership interests "for the purpose of offering those interests for sale," and it required ruling requests to include all promotional documents relating to the sale of the fractional interests.³³ The procedure was written for a market in which sponsors acquired rental property, negotiated master leases, arranged financing, and sold undivided interests to investors, including investors looking for replacement property. The conditions that preserved co-ownership, above all unanimous approval of leases, sales, and debt negotiations, also left no one with authority to manage the property on the co-owners' behalf, a limit examined at 21.3 and 21.4.

Revenue Ruling 2004-86. In 2004 the Service approved a different vehicle. The ruling involved a Delaware statutory trust, the entity described in title 12, sections 3801 through 3824, of the Delaware Code, holding a single rental property subject to a ten-year net lease and nonrecourse financing. The trust agreement limited the trustee to collecting and distributing income. The trustee could not exchange the property, buy assets other than short-term government obligations and bank certificates of deposit, accept new contributions, renegotiate the debt, renegotiate the lease or lease to anyone else except on the tenant's bankruptcy or insolvency, or make more than minor non-structural modifications not required by law.³⁴ The Service first held that the trust was an investment trust under the entity classification regulations. A trust with a single class of undivided beneficial interests is classified as a trust unless there is a "power under the trust agreement to vary the investment of the certificate holders," and this trustee had none.³⁵ It then held that investors who acquired trust interests in exchange for real property were grantors of a grantor trust, treated as owning undivided fractional interests in the property itself. Their exchanges were therefore exchanges of real property for an interest in real property, "and not the exchange of real property for a certificate of trust or beneficial interest" within the exclusion in section 1031(a)(2)(E).³⁶

The limits written into the ruling. The ruling also said what would change the result. If the trustee had powers such as the power to dispose of the property and acquire new property, to renegotiate the lease or lease to other tenants, to renegotiate or refinance the debt, to invest cash to profit from market fluctuations, or to make more than minor non-structural modifications not required by law, the trust would be a business entity. With two or more owners it would be classified as a partnership unless treated or elected as a corporation, and because the beneficiaries would not be co-owners under state law, it could not elect out of subchapter K.³⁷ A Delaware statutory trust that stays within the ruling is therefore a passive vehicle with no means of raising new capital or refinancing, a consequence examined at 21.4.

Where the period ends. By 2004 the framework within which modern exchanges are structured was in place: the statutory periods of 1984, the regulatory safe harbors of 1991, the related-party limits of 1989 as the Service read them in 2002, the reverse exchange safe harbor of 2000 as modified in 2004, and two routes into fractional ownership of replacement property. The next major change narrowed the statute. In 2017 Congress limited section 1031 to real property (Chapter 7).