Mackay, Caswell & Callahan, P.C.
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What Related Party Issues Should CPAs Know About?

In one of our recent posts, we discussed the case of Teruya Brothers v. Commissioner (2009). As we saw, Teruya Bros. can easily be counted among the most significant court decisions in IRC Section 1031 tax law because this case added a layer to our understanding of the “related party” rules of Section 1031.

Mar 4th 2020
Mackay, Caswell & Callahan, P.C.
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In one of our recent posts, we discussed the case of Teruya Brothers v. Commissioner (2009). As we saw, Teruya Bros. can easily be counted among the most significant court decisions in IRC Section 1031 tax law because this case added a layer to our understanding of the “related party” rules of Section 1031. And this layer is highly important, because there aren’t too many other cluesthat help us interpret these complex rules.

In fact, the proper interpretation of these rules is among the most openly contested areas of Section 1031 tax law. Some guidance can be taken from IRS publications; however, those aren’t necessarily accurate, and, in some cases, they can even be misleading. Teruya Bros. is among the few pieces of truly authoritative guidance on the interpretation of the Section 1031 related party rules. As such, it is an extremely valuable source for tax lawyers, accountants, facilitators, and others affected by the industry.

In this post, we’d like to dive a bit further into Teruya Bros. and discuss some of the issues raised in this case.

Direct Exchanges vs. Indirect Exchanges

As you may recall, Teruya Bros. involved two separate 1031 exchanges. Both of those exchanges were so-called “indirect exchanges,” which means they involved more than two parties. Normally, whether an exchange is direct or indirect is not necessarily a really significant issue because indirect exchanges have long been officially approved. But in related party exchanges, things get a bit more complicated.

Teruya Bros. clarified the fact that indirect exchanges fall outside the two-year rule imposed under Section 1031(f)(1). If an indirect exchange involves either a related party buyer, related party seller or both, it is governed by the purpose requirement under Section 1031(f)(4). This conclusion may be open to debate, but it is a reasonable inference based on the discussion provided in Teruya Bros.

The Importance of the Two-Year Rule

The underlying purpose of the related party rules is the prevention of abusive tax avoidance. It’s not difficult to see how collaboration among related parties in a 1031 exchange could produce unfairly advantageous tax results. This is precisely what happened in Teruya Bros.

However, one thing accountants and others should keep in mind is compliance with the two-year ownership rule under 1031(f)(1) will most likely create the presumption that this purpose has been followed. The Senate Finance Committee gave an example of the form of collaboration this rule is meant to prevent back in 1989.

The example involved a related party that sold a property to an unrelated party for cash. The latter then swapped properties with the taxpayer in a direct exchange shortly thereafter. The Senate Finance Committee opined that this transaction constituted abusive tax avoidance, as the related party was able to “cash out” of the property and still have that same property eventually exchanged with the taxpayer.

The two-year ownership rule seemingly collapses these forms of collaboration. However, for direct exchanges, the two-year rule is extremely important. In fact, it may be possible for related parties to subvert the purpose of the related party rules even though they comply with the two-year one.

We can imagine a situation in which the two-year rule is complied with, but an unfairly advantageous result is still produced. But this would not be easy for the IRS to prove.

Section 1031(f)(4) is Informed by 1031(f)(2)(C)

As mentioned, the whole purpose of the related party rules is to prevent abusive tax avoidance. Another thing Teruya Bros. did was clarify how the court can interpret whether this purpose was observed. The 9th Circuit Court stated that 1031(f)(2)(C) and 1031(f)(4) effectively work in concert.

Section 1031(f)(2)(C) states that a direct exchange that violates the two-year ownership rule will not be denied nonrecognition treatment if the taxpayer can establish that the transaction wasn’t structured to principally to avoid federal income tax. Section 1031(f)(4) states that no transaction will be accorded nonrecognition treatment that violates the underlying purpose of the related party subsection.

Section 1031(f)(2)(C) essentially limits the scope of 1031(f)(4). If an indirect exchange can demonstrate that it wasn’t structured in order to avoid the purpose of the related party rules, then that indirect exchange may still be accorded nonrecognition treatment.

This is hugely important and gives confidence to those who are looking to structure an indirect exchange that involves a related party. If the taxpayer can clearly show that the transaction wasn’t structured specifically to create an unfairly advantageous tax result, then they have a chance to achieve nonrecognition treatment.

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