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Exchanges of realty and IRS "step transactions." (Tax Issues)

In a previous article in the Journal, we reviewed the tax rules on deferred like-kind exchanges of realty. Since then, a few real estate practitioners have asked us whether they could arrange certain other exchanges of real estate that would avoid the payment of income tax on the exchange. In response, we offer the following illustrations.

Imagine this scenario: John owns Whiteacre, a piece of unimproved real estate that he is holding as an investment. John paid $10,000 for Whiteacre several years ago, and this amount remains as his cost basis for federal income tax purposes. At the present time, however, the value of Whiteacre is $100,000.

John also owns Blackacre, another piece of unimproved land. John bought Blackacre two years ago for $100,000, but since then it has failed to increase in market value. John had planned to hold Blackacre as a long-term investment in the hope that it will appreciate later on.

Wishing to cash in on his investment, John would like to sell Whiteacre and has found a willing buyer, Bill, who has agreed to pay $100,000. John is not happy, however, about paying income tax on the $90,000 tax gain that would result from the sale.

However, in order to avoid the taxes on a $90,000 gain, John agrees to sell Blackacre to Bill for $100,000. Bill will then exchange Blackacre for Whiteacre. Through this "sale-tradeback," John has been able to retain Blackacre for future investment and sell Whiteacre for $100,000--without a tax penalty.

Under federal tax law, what John and Bill have tried to arrange in the exchange of Whiteacre for Blackacre is a "like-kind exchange" or "1031 exchange." Under Section 1031 of the Internal Revenue Code, if a taxpayer consummates a qualifying exchange of "like-kind" property--like Whiteacre and Blackacre--no taxable gain can be recognized by the taxpayer, even if the value of what is received exceeds the cost basis for tax purposes of what was relinquished. Thus, when John received Blackacre from Bill in exchange for Whiteacre, he incurred no taxable gain even though the value of Blackacre ($100,000) exceeded the cost basis of Whiteacre ($10,000) by $90,000.

However, Section 1031 of the code requires that John must place a cost basis of $10,000 on the re-acquired property, even though he paid $100,000 for it. Because John had sold Blackacre, when he took it back from Bill, the IRS would view the transaction as if John was receiving the property for the first time. Under Section 1031, if a taxpayer exchanges property in a like-kind exchange, the cost basis of the property relinquished is placed on the property acquired. This lower cost basis is the "price" for not recognizing any gain on Whiteacre.

In essence, the tax law treats the acquired property (Blackacre) as nothing more than a "continuity of investment" in the property relinquished. Thus, the unrealized gain of $90,000 inherent in Whiteacre is transferred to Blackacre.

If John retains Blackacre for a long period of time, the inherent gain in the property (its value of $100,000, less its cost basis of $10,000) can be postponed. Considering the time value of money, and therefore delayed payment of taxes, John appears to have gained a true economic benefit through the sale-tradeback arrangement.

The IRS and the step transaction doctrine

Unfortunately for John, the IRS would view his transaction with a very skeptical eye.

In this case, the IRS undoubtedly would invoke its so-called "step transaction" doctrine, a practice of evaluating two or more separate transactions that appear to be so mutually dependent that they were made only to avoid tax. When it determines that such transactions have been engineered, the IRS will disregard the seemingly legal steps and consolidate the entire process into one--illegal--transaction.

In this example, the IRS would recharacterize John and Bill's efforts as simply a sale of Whiteacre to Bill at a gain of $90,000, disregarding the intermediate steps of sale and tradeback. According to the IRS, the important point would be that John now has $100,000 cash, still holds Blackacre, but no longer owns Whiteacre.

Thus, although John and Bill met the "form" of the tax rules under Section 1031, the "substance" of the steps showed that the intent of the taxpayers all along was simply to arrange a sale of Whiteacre from John to Bill. John would, however, retain his $100,000 cost basis in Blackacre because the IRS would say that he never sold the property in the first place.

The reach of the doctrine

What if John and Bill had tried another series of steps? Assume that John agrees to sell Blackacre for $100,000 to Ted, who will act as an intermediary between John and Bill. Ted then sells Blackacre to Bill for $100,000, recouping the cash he had paid to John, and Bill exchanges Blackacre to John for Whiteacre.

Unfortunately for John, the IRS would reach the same conclusions in this case. Despite the fact that an intermediate party was used to disguise the fact, John ultimately wanted to sell Whiteacre to Bill.

The IRS would simply collapse the entire series of steps into one: the sale of Whiteacre to Bill by John. Ted would be ignored by the IRS because he is in the same position after the arrangement as before; his initial parting of $100,000 of cash to John has been refunded by the sale of Blackacre to Bill for $100,000. The fact that he might be paid a commission by either John or Bill would not change this result.

Even more sophisticated arrangements than those already described may be recharacterized by the IRS. For example: John wishes to sell Whiteacre, but does not want to pay taxes on the $90,000 gain he would recognize on the sale. Bill wants to buy Whiteacre, but they both realize that the arrangements described above will simply be discarded under the step transaction doctrine of the IRS. So, John finds Joe, who owns a piece of land called Greenacre, which also is valued at $100,000. John is willing to exchange Blackacre for Greenacre, so the three agree to the following arrangement.

John sells Blackacre to Ted for $100,000 in cash. Because his cost basis in Blackacre is $100,000, John recognizes no gain. Ted then sells Greenacre to Bill for $100,000, who exchanges the property with John for Whiteacre.

Notice that in this instance John does not end up with Blackacre. Thus, he reasons, he will be able to use Section 1031 on the exchange of Whiteacre for Greenacre, because he has recognized no gain on the receipt of Greenacre (valued at $100,000) in exchange for Whiteacre. Bill has Whiteacre, his desired goal, and Ted has Blackacre.

However, John will probably not be able to take his $100,000 cash tax-free. Instead, the IRS could make the argument that, as John did not retain Blackacre in the end, the form of the transaction should be honored and there should be no gain recognized by John on the exchange of Whiteacre for Greenacre.

However, the IRS would be more likely to assert that the series of transactions should be collapsed into the fact that John and Ted have merely traded Blackacre for Greenacre and, thus, have both engaged in a qualifying "like-kind exchange" under Section 1031 of the Internal Revenue Code.

No gain is recognized by either on the exchange of Blackacre for Greenacre, and John's cost basis in Blackacre of $100,000 is transferred to Greenacre. In addition, because John sold Whiteacre to Bill for $100,000, he must recognize a taxable gain of $90,000; the intermediate step whereby Ted sells Greenacre to Bill would be ignored.

Because John has parted with Whiteacre and now has $100,000 cash in hand, the IRS will be on very strong ground in stating that two separate events have occurred: the exchange of Blackacre for Greenacre between John and Ted and the sale of Whiteacre from John to Bill.

Conclusion

One question is critical to the IRS' analysis of a like-kind exchange: "Could the taxpayers have arranged the same end result without resorting to the series of intermediate steps?" If the answer to that question is "yes," then the intermediate steps will be disregarded.

Thus, when arranging any sophisticated transaction involving a series of steps, the taxpayer must be careful to realize that the steps of the deal, even if they are in full accordance with the form and letter of the law, can always be disregarded by the IRS.

James A. Fellows, Ph.D., CPA, is a professor of accounting and taxation at the University of South Florida in Fort Myers, Florida.

Michael A. Yuhas, LL.M., is associate professor of taxation at Grand Valley State University in Allendale, Michigan.

Legal Issues authors wanted

JPM welcomes submissions of articles on legal topics related to real estate and property management. Current topics of interest include manager liability for acts of employees and issues affecting lease language and landlord/tenant relations. For more information, please call Martha Schindler at (312) 329-6059.
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Author:Fellows, James A.; Yuhas, Michael A.
Publication:Journal of Property Management
Date:Nov 1, 1992
Words:1528
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