If you all are entering or coming out of a 1031 tax free exchange this year, you may want to consider selling your relinquished investment property or purchasing your replacement investment property from a trusted member of your family. Sounds good right? But not so fast. There are two very dangerous IRS traps out there for your Related Party 1031 Tax Free Exchange. So stay with us on TaxView with Chris Moss CPA to make sure your Related Party 1031 Tax Free Exchange is fully protected and your tax return is bullet proof from adverse IRS audit action which could save you big tax bills many years later after the return is filed.
Before we get to IRS traps ahead, let’s review how the Government defines a related party as it would relate to your planned 1031 tax free exchange. IRS Code Section 1031(f) via IRS Section 267(b) or 707(b)(1) defines related party as your spouse, child, grandchild, parent, grandparent, brother, sister, or a related business, trust, or estate. A business related party could be an individual who owns 50% or more of a business, or two corporations which are members of the same controlled group. There are many more specific business related parties in Section 267(b) and also partnership related parties in Section 707(b)(1).
Once you determine you have a related party as part of your 1031 tax free exchange here is an easy IRS trap to watch out for and avoid: If the related party sells or disposes your relinquished property within 2 years or if you sell or dispose of the replacement property within 2 years then the whole gain is immediately taxable on the date of sale or disposition.
Setting off the 2 year 1031 related party trap results in very harsh penalties and interest on the back taxes you would owe. But if the sale or disposition, either for you, or your related party, had a principal purpose other than tax avoidance, the trap opens wide and you are free to leave. But imagine climbing out in victory of this trap only to get wacked with another hideous IRS trap. Indeed, as Ocmulgee Fields vs IRS US Tax Court (2009) found out, there is Section 1031 (f)(4), a catch all trap for anyone and everyone even those folks who escape the first IRS 2 year trap. So keep tuned to TaxView with Chris Moss CPA as we explore the Section 1031(f)(4) trap and see how to best avoid it.
Ocmulgee Fields, developed owned and managed real estate in Georgia since 1973. Owners were Charles Jones, his sons Dwight and Jefferson, and Jones Family Partnership, which was owned 1/3 each by Charles, Dwight, and Jeff. In 2003 Ocmulgee sold the Wesleyan Station property, for $7,250,000. A CPA named Pippin with McNair McLemore Middlebrooks out of Macon suggested a 1031 tax free exchange. After considering at least 6 possible replacement properties Ocmulgee purchased a replacement property called the Barnes and Noble Corner, a recently developed shopping center, which Ocmulgee sold years earlier as raw land in 1996 to a “related company” owned by Dwight and Charles called Treaty Fields for $6,740,000.
Treaty Fields filed its Form 1065 partnership tax return for 2003 with a gain of $4,185,999. Ocmulgee filed its 2004 corporate return form 1120 prepared by CPA Pippin with no gain claiming a deferral of $6,122,736 gain disclosing under part II of Form 8824 that Treaty Fields was a related party. The IRS audited Ocmulgee for 2004 and sent them a bill for $2M and penalty for $400K claiming they failed to qualify for a tax free exchange under Section 1031 (f)(4) which says: This section shall not apply to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection. Ocmulgee appealed to US Tax Court in Ocmulgee Fields v IRS US Tax Court (2009).
Ocmulgee argued that they had a legitimate business reason for working with a related party in that the purchase “reunited its ownership” with the larger shopping center that the land had become since 1996. Ocmulgee also claimed they listened to the advice of CPA Pippin. The IRS countered that this case was like Teruya vs IRS US Tax Court (2005) where the Court found the taxpayer failed to show that tax avoidance was not one of the principal purposes of the transaction.
Judge Halpern agreeing with the Government, citing Teruya v IRS, US Tax Court (2005), opined that Ocmulgee anticipated the sale of its low basis property and was tempted to exchange the low basis property for a high basis property to a related person, with the related person then selling the property at a reduced gain—or possibly a loss—because of the shift to the property of his high basis in the property relinquished.
Applying this law to the facts, the Court notes that if Treaty Fields had received Wesleyan Station from petitioner in exchange for the Barnes & Noble Corner, Treaty Fields’s adjusted basis of $2,554,901 in the Barnes & Noble Corner would have shifted to Wesleyan Station (which, in petitioner’s hands, had a basis of only around $716,164). Because of that step-up in basis, Treaty Fields would have realized a gain on the sale of Wesleyan Station approximately $1.8 million less than Ocmulgee would have realized had it forgone an exchange with Treaty Fields and sold Wesleyan Station itself.
The US Congressional report refers to this as “basis shifting”. In effect, because of basis shifting, related persons are able to “cash out” of their investments in property having an inherent gain at relatively little or no tax cost. Also, in some cases, basis shifting allowed related persons to accelerate a loss on property that they ultimately retained. Congress 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. This policy is reflected in section 1031(f), as enacted in the Omnibus Budget Reconciliation Act of 1989, Pub. L. 101-239, sec. 7601(a), 103 Stat. 2370.
Based on the facts in Ocmulgee, Judge Halperin concluded that “basis shifting” allows the Court in this case to infer that tax avoidance was the principal purpose of the 1031 exchange. While the Court conceded that it is not prepared as a matter of law to find that “basis shifting” precludes the absence of a principal purpose of tax avoidance in all cases, it in fact does show tax avoidance in the unique set of facts in Ocmulgee’s case; namely the immediate tax consequences resulting from the 1031 exchange with Treaty Fields included an approximate $1.8 million reduction in taxable gain. The tax savings are plain and Ocmulgee’s counter arguments were unconvincing or speculative. Therefore Ocmulgee has failed to convince the Court that tax avoidance was not a principal purpose of the 1031 tax free exchange. IRS wins. Ocmulgee loses.
What does this mean for you? If you are planning to Section 1031 tax free exchange with a related party, make certain the property that you sell does not sell again within the 2 year period. Likewise you cannot sell the property you purchase for 2 or more years. Even if you avoid the 2 year trap, make sure your tax attorney records the evidence of a non-tax avoidance purpose and inserts that evidence into the tax return being filed that is deferring the gain to avoid Section 1031(f)(4). If you can gather than facts contemporaneously and record them in your tax return you will be bullet proof from IRS attack. Finally, make sure there is no negative evidence of “basis shifting”. Remember you can be presumed to be avoiding tax if there is evidence of basis shifting regardless of the 2 year rule, so make certain the facts are in your favor, and fully recorded by your tax attorney in your tax return as you file. You will most likely be glad you did when the IRS comes knocking on your door. Thanks for joining Chris Moss CPA on Tax View.
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Chris Moss CPA