In only the second Tax Court decision to interpret the related party rules for like-kind exchanges using a qualified intermediary (QI), an exchange was deemed to have been structured to avoid the related party rules, and to have tax avoidance as one of its principal purposes (Ocmulgee Fileds v. Comm'r, 132 T.C. No. 6 (March 31, 2009)).
In Ocmulgee, a Georgia corporation owned several shopping centers and office buildings; it arranged to sell one low-basis appreciated shopping center to an unrelated party. The corporation intended to carry out the transaction as a like-kind exchange. It began hunting for sutiable replacement property, but was unable to locate an acceptable replacement other than a parcel (the "replacement property") which the corporation had previosuly sold to a related party (an LLC). The replacement property was part of three contiguous parcels; the corporation already owned the other two. Perhaps not coincidentally, the LLC had a relatively high basis in the replacement property.
To carry out the transaction, the corporation transferred the shopping center to a QI, which sold it, using the proceeds to purchase the replacement property from the LLC. The LLC reported the disposition of the replacement property as a sale, paying tax on the gain. The QI then transferred the replacement property to the corporation. Functionally this was no different from the related parties swapping properties, followed by the LLC immediately selling the property it received in the exchange. Had the transaction been structured without the use of a QI, it would have run afoul of Code Sec. 1031(f)(1).
Although this is not the first time a taxpayer has attempted to use a QI to in essence swap low basis property (“relinquished property”) for high basis property (“replacement property”) with a related party (see Teruya Brothers et. al. v. Comm’r, 124 TC 45 (2005)), what made this case interesting was that the taxpayer argued that there were important non-tax considerations for the exchange. This included the seemingly logical desire to reunite ownership of the replacement property with the two adjacent parcels the corporation already owned. Moreover, the corporation offered proof that an exchange with a related party didn't drive the transaction; the corporation intended to dispose of the shopping center and find suitable replacement property from an unrelated third party. It only entered into an exchange with the LLC when appropriate replacement property could not be located.
While the Tax Court questioned the factual and logical integrity of some of the corporation’s arguments, the following language from the decision confirms that even being able to prove an independent business motive is inadequate to circumvent Code Sec. 1031 (f)(2) and (4) when a principal purpose is tax avoidance:
“ [E]ven had petitioner shown a legitimate business purpose for the acquisition of the replacement property], that would not necessarily preclude a finding that either the deemed exchange of [the relinquished property] for the [replacement property] or [the related party’s] deemed sale of [the relinquished property] had as a principal purpose the avoidance of Federal income tax."
The language shows that the standard is “a” principal purpose, not “the” principal purpose. When a taxpayer has dual motives or objectives, any one of which is tax avoidance, the like-kind related party rules will be invoked, and use of a QI will not cure the problem.
As to the issue of intent at the time that an agreement is reached to dispose of the relinquished property, Ocmulgee provides a judicial explication of the analysis in Letter Ruling 9748006, issued in 1997. In the PLR the Service concluded that not having an intent to engage in a related-party exchange from the outset did not negate the transaction from being deemed to have tax avoidance as a principal purpose; the use of a QI in the PLR, as in Ocmulgee and Teruya, failed to save the day.