Update on intermediaries and related-party exchanges.

This item is an update of the May 1997 Tax Clinic item (Vol. 28, No. 5, p. 276) that raised several questions on application of the related-party like-kind exchange provisions to exchanges involving a qualified intermediary (QI). A QI is someone who (1) acquires relinquished property from the taxpayer, (2) transfers the relinquished property to the buyer of that property, (3) acquires replacement property from the seller of that property and (4) transfers the replacement property to the taxpayer. The QI allows for an exchange when the buyer of the relinquished property is unwilling to acquire and transfer replacement property.

Related-party exchanges can accelerate deferred gain when the taxpayer or the related party disposes of property received in the exchange within two years of the exchange (Sec. 1031(f)(1)). An exception exists for dispositions that lack a principal purpose of tax avoidance (Sec. 1031(f)(2)(C)). Form 8824, Like-Kind Exchanges (and non-recognition of gain from conflict-of-interest sales), is used to report like kind exchanges; a special section must be completed to report related-party exchanges. If the "no tax avoidance" exception is relied on to avoid acceleration of gain from the exchange, the taxpayer must attach an explanation as to why it applies.

The May 1997 item noted that an exchange using a QI, in which a related party was the seller of replacement property, did not squarely fit within the definition of a Sec. 1031(f)(1) related-party exchange, because, technically, the exchange was made with the QI. It also mentioned that the IRS would likely view such an exchange as a related-party exchange, but that the taxpayer may be justified in not completing the related-party section of Form 8824.

In Letter Ruling (TAM) 9748006, the Service applied the related-party exchange rules to a QI exchange involving related parties. However, the facts and analysis of this ruling leave unanswered several of the questions raised in the May 1997 item.

Example: T, a taxpayer, owned a one-third interest in land and RP, a related party, owned a two-thirds interest in that land. B, a buyer, wanted the entire tract; T and RP contracted with B to transfer full ownership of the land. A QI was used to acquire and transfer the land from T and RP to B. Independent of the exchange, RP purchased a house to be used as a principal residence. Twanted to defer gain from the sale of his one-third interest in the land and attempted to acquire replacement property from URP, an unrelated party. Failing to negotiate the purchase from URP, yet still desirous of deferring gain, T acquired the residence from RP and used it for investment purposes. The QI acquired and transferred the residence as T's replacement property. At the close of the transaction, RP had cash and T had investment property.

The IRS ruled that the transaction was a related-party exchange, albeit an indirect one, because it had the same effect as RP directly exchanged the residence for T's one-third interest in the land and RP then sold the entire tract to B. Such a direct exchange would clearly fall within Sec. 1031(f)(1) and would have to be reported as a related-party exchange on Form 8824. Because RP received cash, a direct exchange would be taxable to T under the two-year disposition rule unless the Sec. 1031(f)(2)(C) "no principal purpose of tax avoidance" exception could be satisfied.

The Service did not classify this exchange as a Sec. 1031 (f)(1) transaction, because the exchange was made indirectly through a QI, but did apply Sec. 1031 (f)(4), which treats a transaction structured to avoid Sec. 1031 (f)(1) as a related-party exchange. It is not clear whether Sec. 1031(f)(2)(C) applies to a Sec. 1031 (f)(4) transaction, but the Service ruled that the exception was not met and could not be applied.

It is difficult to quarrel with the Service's legal analysis as it applies to the facts of the ruling. However, those facts are different from that which is commonly encountered in QI exchanges. In the ruling, there was no purpose for the QI other than to avoid a literal application of Sec. 1031 (f)(1); RP was involved in the sale of both the relinquished and replacement properties, and the transaction could have been structured as a simultaneous two-party exchange between T and RE More commonly, T will sell relinquished property to B and then look for replacement property using a QI. If the most suitable replacement property is owned by RP, a four-party exchange will be completed with B, RP, T and QI. Such a transaction is likely a related-party exchange under Sec. 1031(f)(4), but cannot be as easily attacked under a substance-over-form argument (as was the transaction in the ruling).

Form 8824 clearly requires reporting of a Sec. 1031(f)(1) transaction (a direct related-party exchange), but does not seem to require reporting of a Sec. 1031 (f)(4) transaction (an indirect related-party exchange). Of course, a Sec. 1.031 (f)(4) exchange does not generally allow for ,gain deferral, and it could be argued that Form 8824 is not relevant because the gain is currently reported on Form 4797, Sales of Business Property (Also Involuntary Conversions and Recapture Amounts Under Sections 179 and 280F(b)(2)), or Schedule D. However, if a Sec. 1031 (f)(4) exchange is eligible for the Sec. 1031(f)(2)(C) exception, it is arguable that if the tax adviser believes that the exception applies, the gain need not be reported, the related-party section of Form 8824 need not be completed and no explanation of why the taxpayer believes Sec. 1031(f)(2)(C) applies need be attached.

It was earlier noted that the IRS failed to rule on the application of Sec. 1031 (f)(2)(C) to an indirect related-party exchange, because the facts of the ruling did not support use of the exception. In support of this conclusion, the ruling stated that the Use of a QI for the sole purpose of avoiding the related-party rules of Sec. 1031(f) "manifests Taxpayer's intent to avoid application of the related party rules" and denies possible application of the Sec. 1031(f)(2)(C) exception. The more common transaction will use a QI to consummate a four-party exchange and not for the sole purpose of avoiding the application of Sec. 1031(f).

It remains unclear whether Sec. 1031(f)(4) can be avoided by demonstrating no principal purpose of tax avoidance or whether a taxpayer who uses a QI and acquires replacement property from a related party can avoid completing the related-party section of Form 8824 and advance disclosure of why Sec. 1031(f)(2)(C) should apply. The tax adviser must first determine that the Sec. 1031(f)(2)(C) exception may realistically apply to the QI exchange and, if so, then evaluate whether Form 8824 may be filed without the related-party disclosures. If there is a legitimate use of a QI (unlike the facts of the ruling), the adviser may then avoid calling attention to the related-party issue subject to the normal caveats included with aggressive tax planning.