Mackay, Caswell & Callahan, P.C.
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What to Know About Step Transactions in Exchanges

Part of the difficulty in dealing with a supposed step transaction has to do with understanding the boundaries of rules.

Mar 23rd 2020
Mackay, Caswell & Callahan, P.C.
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Step Transactions and Exchanges

Step transactions are not the easiest things to understand. At essence, step transactions involve a transgression against the purpose of a rule, even though the form of that rule may be followed.

Part of the difficulty in dealing with a supposed step transaction has to do with understanding the boundaries of rules, as well as the full scope of a rule’s purpose. In some cases, depending on the circumstances, there may be wide room for debate as to whether the steps of a transaction violate a rule’s purpose.

The more fluent accountant’s become with this concept, the better they will be able to serve their clients. If a client’s steps end up falling into the step transaction classification, that client can suffer very negative financial consequences. Learning how to identify potential violations can end up saving a client a lot of money. In the process, you will create a bigger and more loyal client base.

In this post, we will provide a couple of concrete examples which should help accountants better understand the mechanics of this idea. Both of these examples will involve step transactions in 1031 exchanges; but it’s possible to have a step transaction in virtually any transaction with a tax consequence.

Step Transactions Come in Different Forms

One of the keys to understanding step transactions is knowing that these transactions can come in any form. The step transaction doctrine is essentially a series of tests which are used to determine the “true nature” of a given transaction, and it does so by analyzing how certain steps relate to a given rule. In other words, the doctrine isn’t really focused on examining the steps by themselves, it’s focused on analyzing the steps with respect to the purpose of specific rules.

Steps Must Have Substance to Have Validity

Another good way to understand this concept is to remember that steps within a transaction must have “substance” to be valid, and substance essentially refers to economic substance. A step must have an independent reason for occurring, it must have its own independent economic justification.

If something is done simply in order to “get around” a rule, or to create an advantageous financial condition, then one of the tests of the step transaction doctrine likely will apply. This is a useful device for showing how this concept works because you can easily apply to any type of situation.

Example #1: Sell to Relative to Invest in Your Own Property

In this first example, we will use the rule which states that a taxpayer cannot exchange into a home which he or she already owns at the outset of the exchange. In other words, in an exchange, the “replacement property” cannot be a property already owned by the taxpayer; it must be owned by another entity.

Let’s look at a simple scenario which would very quickly be classified a step transaction if it were to happen:

Suppose that a taxpayer owns two properties, Rental Property A and Rental Property B. This taxpayer wants to invest heavily in B, because the market in which B is located has suddenly jumped in value.

It will make much more financial sense to sell A and invest the proceeds in B. To avoid a tax bill on the sale of A, this hypothetical taxpayer sells B to a related party – in this case, let’s suppose it’s his or her sister.

Our hypothetical taxpayer then waits one year, and then initiates a 1031 exchange by engaging a facilitator and selling A. Then, our taxpayer quickly acquires Rental Property B as the replacement property from his or her sister.

Even without diving into the related party rules, we can see that this transaction is clearly a step transaction because the sale to the taxpayer’s sister had no function other than to avoid the rule which forbids buying a replacement property owned by the taxpayer. In this case, the taxpayer would be able to create a vastly superior outcome by simply selling to his or her sister to create an exchange. But this violates the purpose of the rule.

Example #2: Related Party Sells to Unrelated to Avoid 1031(f)(1)

The main related party rule states that neither the taxpayer nor the related party in an exchange can dispose of its property within 2 years. But, suppose that a taxpayer and a related party concoct a plan to avoid this rule.

Consider the following scenario: a taxpayer has a property with a low basis. The taxpayer knows of a related party which owns a high basis property. The taxpayer wants to avoid the heavy tax bill which would follow from a sale; however, the related party doesn’t want to exchange, but wants cash for its property.

To avoid the 2 year ownership rule, the related party sells its property to an unrelated party in a straightforward sale. Then, the unrelated party exchanges the same property with the taxpayer in seemingly non-related party exchange. This clever bit of maneuvering allows the taxpayer to obtain the property previously owned by the related party, and the related party to obtain cash.

This is precisely the kind of scenario which the 2 year ownership rule is designed to prevent. In fact, this scenario was actually envisioned by the Senate Finance Committee when the 2 year rule was first proposed.

If such a scenario were to be examined under audit, the exchange between the taxpayer and the unrelated party would be collapsed, because the steps taken clearly show a desire to avoid the 2 year rule to produce a superior outcome. The taxpayer would be required to pay tax just as if the property had been sold for cash.

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