Financing Focus

1031 Games

Tax-deferred exchanges have different rules for business relatives.

CCIMs are often involved in Internal Revenue Code Section 1031 exchanges for their clients and for their own real property interests. While tax-deferred like-kind exchanges were first authorized in 1921, it was the Tax Reform Act of 1986 that reduced the benefit of preferential capital gains treatment and ignited greater use of tax-deferred exchanges.

However, taxpayers should not forget that, under Section 1031, restrictions apply if the exchange is between related parties. If the taxpayer undertakes an exchange with a related party — defined in IRC to include immediate family, ancestors, lineal decedents, and controlled entities — and there is a transfer within two years by either party to the exchange, the exchange is not treated as deferred within IRC Section 1031.

In the recent case of North Central Rental & Leasing, discussed below, the taxpayers attempted to place form over substance and tried to avoid the limitations on exchanges among related parties.

The Case

The Eighth Circuit Court of Appeals issued its decision in North Central Rental & Leasing, LLC vs. U.S., supporting the reasoning that the related party issue in North Central fell within Section 1031 (f); and, because of the relationships and the transfers by the parties, the exchanges did not comply with Section 1031 deferral requirements.

The court described the factual setting for the taxpayers:

Butler Machinery Company sells agricultural, mining, and construction equipment for manufacturers, primarily Caterpillar, Inc. Prior to 2002, Butler Machinery conducted a rental and leasing business in conjunction with its retail sales business. In 2002, however, Butler Machinery formed subsidiary North Central to take over Butler Machinery’s rental and leasing operations.

Although separate entities, Butler Machinery and North Central are closely related and ultimately controlled by the same family.

The court went on to explain the convoluted like-kind exchange program set up between North Central and Butler.

At issue in this case is North Central’s like-kind-exchange (LKE) program, which commenced less than two months after Butler Machinery formed North Central. In a nutshell, the LKE program allowed North Central to trade used equipment for new equipment and, in the process, defer tax recognition of any gains or losses from the transactions. Per the LKE program, North Central sold its used equipment to third parties, and the third parties paid the sales proceeds to a qualified intermediary, Accruit, LLC (‘Accruit’). Accruit forwarded the sales proceeds to Butler Machinery, and the proceeds ‘went into [Butler Machinery’s] main bank account.’ At about the same time, Butler Machinery purchased new Caterpillar equipment for North Central and then transferred the equipment to North Central via Accruit. Butler Machinery charged North Central the same amount that Butler Machinery paid for the equipment.

Butler Machinery’s use of LKE transactions in this fashion facilitated favorable financing terms from Caterpillar (referred to as ‘DRIS’ financing terms). Caterpillar advised Butler Machinery before it established either North Central or the LKE program that such a transaction structure would enable Butler Machinery ‘to take full advantage of [Caterpillar’s] DRIS payment terms.’ The DRIS payment terms, among other things, gave Butler Machinery up to six months from the date of the invoice to pay Caterpillar for North Central’s new equipment. During that time, Butler Machinery could use the sales proceeds it received from Accruit for essentially whatever business purposes it wanted, such as paying bills or payroll. In other words, Butler Machinery essentially received an up-to-six-month, interest-free loan from each exchange.

North Central claimed nonrecognition treatment of gains under Section 1031 on 398 transactions occurring over a three-year period. The IRS said the transactions did not qualify for nonrecognition treatment because North Central structured the transactions to circumvent related-party restrictions found in Section 1031(f).

The court said that, clearly, the taxpayers were aware of Section 1031’s limits regarding related parties. The court considered the cash that Butler received as the result of each exchange, the complexity of the transactions, and the fact that North Central and Butler could have exchanged the property directly; however, to qualify for nonrecognition of gain under Section 1031 (f), they would have had to hold the exchanged property for two years. The court concluded that the taxpayers structured the transactions with tax motive in mind to attempt to circumvent the restrictions under Section 1031(f). The appellate court affirmed the lower court’s decision that the taxpayers could not employ the deferral under Section 1031.

CCIMs and their clients must be aware of the special limitations in exchanges if the parties are related as defined in Section 1031 (f). Further, using entities that apparently have little purpose, aside from trying to circumvent the limits on related party exchanges, will not solve the enigma for the related party clients that are attempting to employ the benefits of Section 1031.

Mark Lee Levine, CCIM, JD, LLM (tax), is a professor and past director of the Burns School of Real Estate and Construction Management, Daniels College of Business, University of Denver. Contact him at


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