Use of a QI in Sec. 1031 LKEs.

Often, the substance of a transaction, rather than its form, determines whether a like-kind exchange (LKE) qualifies under Sec. 1031.

Related-Party Exchanges

In Rev. Rul. 2002-83, a taxpayer failed to boost his property basis, for a later sale, by using a qualified intermediary (QI) to facilitate a Sec. 1031 LKE with a related party.

Example: A owns Property 1 with a $50 basis and a $150 fair market value (FMV) that he would like to sell to C. A sale to C would trigger $100 gain. To avoid this, A seeks to increase his basis by transferring Property 1 to a QI, from whom C buys the property for $150. B, A's relative, owns Property 2, with a $150 basis and a $150 FMV. B transfers Property 2 to the QI for $150 cash. The QI then transfers Property 2 to A (see Exhibit on p. 79).

Generally, Sec. 1031(a) provides that no gain or loss is recognized on an exchange of property held for productive use in a trade or business or for investment, if the property is exchanged solely for like-kind property to be held for the same purpose. Under Sec. 1031(d), the basis of property acquired in a Sec. 1031 exchange is the same as the basis of the property exchanged, decreased by any money the taxpayer receives, and increased by any gain the taxpayer recognizes.

Under Sec. 1031(a)(3), the property that the taxpayer will receive in the exchange must be (1) identified within 45 days after the transfer of the property relinquished in the exchange and (2) received by the earlier of 180 days after the transfer of the relinquished property or the due date of the transferor's return for the tax year in which the relinquished property is transferred.

For related parties, Sec. 1031(f)(1) provides that a taxpayer exchanging like-kind property with a related person (defined in Secs. 267(b) and 707(b)(1)) could not use the Sec. 1031 nonrecognition provisions if, within two years of the date of the last transfer, either the related person disposes of the relinquished property or the taxpayer disposes of the replacement property. The Sec. 1031 (f)(4) legislative history provides that if a taxpayer "transfers property to an unrelated party who then exchanges the property with a party related to the taxpayer within 2 years of the previous transfer in a transaction otherwise qualifying under section 1031, the related party will not be entitled to nonrecognition treatment under section 1031."

As to the Example, A employed the QI to circumvent Sec. 1031(f). In substance, A would be completing a LKE with B, after which B would sell his newly exchanged property to C. Sec. 1031(f)(1) prevents this basis boost, forcing A to recognize $100 gain. The mere involvement of the QI does not purify the tainted transaction. Rather, Sec. 1031 (f)(4) specifically prohibits this strategy; otherwise, A effectively would be cashing out of his investment in Property 1 without recognizing gain. Thus, in Rev. Rul. 2002-83, the Service rejected the taxpayer's attempt to qualify this transaction as a Sec. 1031 LKE.

LKEs in Cyberspace 

In Letter Ruling 200236026, a corporation sought to dispose of certain properties and reinvest in like-kind properties with the proceeds from the sales. It used a QI to complete these transactions. Through its website, the QI classified the corporation's property and facilitated the sale of the relinquished property to an unrelated third party. The sales proceeds were segregated and restricted to allow only the QI to purchase like-kind replacement property as defined in the contract between the corporation and the QI. To complete this Sec. 1031 transaction, the replacement property was given to the corporation.

Even though the Internet approach to effecting a LKE is novel, the Service concluded that the transactions met all Sec. 1031 criteria and thus qualified as LKEs under Sec. 1031. It also ruled that the QI was qualified under Regs. Sec. 1.1031(k)-1(g)(4)(iii).

FROM MICHAEL R. GOULD, WASHINGTON, DC