Financing Focus
1031 Games
Tax-deferred exchanges have different rules for business relatives.
By Mark Lee Levine, CCIM, JD, LLM (tax) |
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 mlevine@du.edu.