Applies related-party exchange exception to later nonrecognition transfers

Plain-English summary

A partnership acquired two real properties from a related corporation in a section 1031 exchange and proposed disposing of both within two years. One property would enter another like-kind exchange under section 1031, while the other would be contributed to a partnership in a section 721 transaction. The taxpayer represented that neither disposition would produce cash or other consideration that triggered gain, the related corporation still held the property it received in the original exchange, and the later transactions were not prearranged. The IRS ruled that both proposed dispositions qualified for the non-tax-avoidance exception in section 1031(f)(2)(C), so neither would cause gain recognition on the original related-party exchange.

Ruling snapshot

• Question: Would two nonrecognition dispositions within two years of a related-party like-kind exchange qualify for the section 1031(f)(2)(C) exception?
• Outcome: Approved for both the second like-kind exchange and the partnership contribution.
• Key authorities: IRC §§ 721 and 1031(a), (f)(1), (f)(2)(C), and (f)(4)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201834010 Third Party Communication: None
Release Date: 8/24/2018 Date of Communication: Not Applicable
Index Number: 1031.00-00
Person To Contact:
-------------------------------- ---------------------, ID No. -----------
---------------------------------------------- Telephone Number:
------------------------------------------ ----------------------
-------------------------------------- Refer Reply To:
CC:ITA:B04
PLR-135714-17
Date:
May 22, 2018

LEGEND

Taxpayer = ----------------------------------------------
--------------------------
LLC1 = --------------------
LLC2 = ----------------------
LLC3 = ------------------------------------------------
-------------------------
LLC4 = -----------------------------------------------
--------------------------
Affiliate --------------------------------------------
= --------------------------
X = ---------------
Y = -----------------
Date 1 = --------------------
$a = ---------------------
$b = ---------------------
$c = -----------------
$d = -------------------
$e = ---------------------
$f = ---------------------

Dear --------------:

This is in response to a request for a private letter ruling submitted on your behalf by
your authorized representative. Specifically, you request a ruling that certain
dispositions of real property acquired from a related party in a previous like-kind
exchange satisfy the requirements of §1031(f)(2)(C) of the Internal Revenue Code.

FACTS

Taxpayer is a multi-member limited liability company that is treated as a partnership for
federal income tax purposes. Taxpayer uses the calendar taxable year and the accrual
method of accounting for federal income tax purposes. LLC1 and LLC2 are each a
single-member limited liability company, wholly owned by Taxpayer, that is disregarded
for federal income tax purposes. LLC3 is a partnership for federal income tax purposes,
with Taxpayer and others as partners, each holding a capital interest in LLC3.

LLC4 is a single-member limited liability company, wholly owned by LLC3 through five
tiers of other wholly-owned single-member limited liability companies, each of which is
disregarded for federal income tax purposes. Taxpayer will continue to own indirectly
more than X percent of the interests in LLC4 through LLC3.

Affiliate is treated as a corporation for federal income tax purposes, and uses the
calendar year and the accrual method of accounting for federal income tax purposes.
On Date 1, Affiliate was a “related person” to Taxpayer as that term is defined under §
1031(f)(3) of the Code.

On Date 1, Taxpayer, through disregarded entities, acquired (i) two parcels of land
(collectively, Property 1) and (ii) one parcel of land (Property 2), as replacement
property in a direct like-kind exchange between Taxpayer and Affiliate, treating the
transaction as an exchange under § 1031 (Initial Exchange). In the exchange, LLC1
acquired Property 1 with an aggregate estimated market value of $ a and an aggregate
estimated tax basis of $ b, and LLC2 acquired Property 2 with a fair market value of $ c
and an estimated tax basis of $ d, in exchange for relinquishing several properties, with
an aggregate estimated market value of $ e and an aggregate estimated tax basis of $
f, to Affiliate. All relinquished and replacement properties transferred as part of the
Initial Exchange were free and clear of any debt.

Taxpayer, through LLC1, will dispose of Property 1 as part of a second like-kind
exchange under § 1031 of the Code (Second Exchange). The purpose of this
transaction is to acquire further property as replacement property to be utilized as
Taxpayer continues its trade or business. Taxpayer will not receive any cash or other
non-like kind property in the Second Exchange.

In addition, Taxpayer, through LLC2, will dispose of Property 2 to LLC4 (by merger,
which will be accounted for as a contribution of Y percent of Taxpayer’s interest in
LLC2) through LLC3 (Contribution). The Contribution will be solely in exchange for an
additional interest in LLC3, the value of which will equal the value of the property
contributed, with no cash or other consideration received by Taxpayer. The
Contribution will be treated as a contribution to a partnership under § 721 of the Code.

Affiliate still owns all the property it acquired from Taxpayer in the Initial Exchange and,
to Taxpayer’s knowledge, Affiliate has no intent to dispose of the property.
Furthermore, at the time of the Initial Exchange, Taxpayer did not intend, nor had a
prearranged plan, to enter into the subsequent transactions discussed in this ruling.

REQUESTED RULINGS

1. Whether the disposition of Property 1 as part of the Second Exchange will qualify for
   the non-tax avoidance exception under § 1031(f)(2)(C).

2. Whether the disposition of Property 2 to LLC4 through LLC3 as part of the
   Contribution will qualify for the non-tax avoidance exception under § 1031(f)(2)(C).

APPLICABLE LAW & ANALYSIS

Section 1031(a)(1) of the Code provides that no gain or loss is recognized on the
exchange of real property held for productive use in a trade or business or for
investment if the property is exchanged solely for real property of like kind to be held
either for productive use in a trade or business or for investment.

Section 1031(f)(1) provides that if—(A) a taxpayer exchanges property with a related
person (the first disposition), (B) there is nonrecognition of gain or loss to the taxpayer
under § 1031 on the first disposition (determined without regard to § 1031(f)), and (C)
before the date 2 years after the date of the last transfer that was part of the first
disposition—

(i) the related person disposes of the property, or
(ii) the taxpayer disposes of the property received in the exchange from the
related person that was of like kind to the property transferred by the taxpayer
(both (i) and (ii) referred to as the second disposition),

there is no nonrecognition of gain or loss under § 1031 to the taxpayer on the first
disposition. Any gain or loss recognized by the taxpayer by reason of § 1031(f) must be
taken into account as of the date on which the second disposition occurs.

Section 1031(f)(2)(C) provides that, for purposes of the application of § 1031(f)(1)(C), a
second disposition is not taken into account if it is established to the satisfaction of the
Secretary that neither the first disposition nor the second disposition had as one of its
principal purposes the avoidance of federal income tax.

Section 1031(f)(4) provides that § 1031 does not apply to any exchange that is part of a
transaction (or series of transactions) structured to avoid the purposes of § 1031(f).
Thus, if a transaction with a related party is set up with tax avoidance as one of its
principal purposes, § 1031 will not apply to this series of transactions.

Both the Ways and Means Committee Report and the Senate Finance Committee Print,
describe the policy concern that led to enactment of § 1031(f):

Because a like-kind exchange results in the substitution of the basis of the
exchanged property for the property received, related parties have engaged in
like-kind exchanges of high basis property for low basis property in anticipation of
the sale of the low basis property in order to reduce or avoid the recognition of
gain on the subsequent sale. Basis shifting also can be used to accelerate a loss
on retained property. The committee believes that if a related party exchange is
followed shortly thereafter by a disposition of the property, the related parties
have, in effect, ‘cashed out’ of the investment, and the original exchange should
not be accorded nonrecognition treatment.

H.R. Rep. No. 247, 101st Cong., 1st Sess., 1340 (1989); S. Print. No. 56, at 151 (1989).

The Senate Finance Committee Print, however, also gives three examples of situations
for which it is deemed established for purposes of § 1031(f)(2(C) that neither the
exchange nor the subsequent disposition has as one of its principal purposes the
avoidance of federal income tax. One of the three involves “... dispositions of property in
nonrecognition transactions.” S. Print. No. 56, 152.

In the present case, the acquisitions of replacement property by Taxpayer through LLC1
and LLC2 from Affiliate, a related party to Taxpayer, in the Initial Exchange will be
followed by dispositions, within 2 years of the Initial Exchange, of the property in
nonrecognition transactions. LLC1 will dispose of Property 1 as part of a like-kind
exchange under § 1031 in the Second Exchange and Taxpayer has represented that it
will not receive any cash or other non-like kind property in the Second Exchange. In
addition, LLC2 will dispose of Property 2 in a nonrecognition transaction under § 721,
with no cash or other consideration received by Taxpayer. LLC1 and LLC2 are
disregarded entities so the dispositions of both Property 1 and Property 2 are
considered to have been made by Taxpayer. Since both dispositions are in
nonrecognition transactions and Taxpayer receives neither cash nor other consideration
that would trigger gain in the dispositions, the dispositions are, under § 1031(f)(2)(C),
ignored in determining whether § 1031(f) applies to require gain recognition in the Initial
Exchange.

RULINGS

1. The disposition of Property 1 as part of the Second Exchange will qualify under §
   1031(f)(2)(C). Thus, the disposition of Property 1 as part of the Second Exchange will,
   under § 1031(f)(2)(C), not be taken into account in determining whether Taxpayer
   disposed of Property 1 within 2 years of the Initial Exchange.

2. The disposition of Property 2 to LLC4 through LLC3 will qualify under § 1031(f)(2)(C).
   Thus, the disposition of Property 2 as part of the Contribution will, under § 1031(f)(2)(C),
   not be taken into account in determining whether Taxpayer disposed of Property 2
   within 2 years of the Initial Exchange.

CAVEATS

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or referenced in
this letter. In particular, we express no opinion concerning whether the disposition of
Property 1 is in a transaction to which § 1031 applies, or whether the disposition of
Property 2 is in a transaction to which § 721 applies.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code
provides that it may not be used or cited as precedent.

A copy of this letter must be attached to any income tax return to which it is relevant.
Alternatively, taxpayers filing their returns electronically may satisfy this requirement by
attaching a statement to their return that provides the date and control number of the
letter ruling.

The rulings contained in this letter are based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. While this office has not verified any of the material submitted
in support of the request for rulings, it is subject to verification on examination.

Sincerely,

Stephen J. Toomey
Senior Counsel, Branch 4
Office of Associate Chief Counsel
(Income Tax & Accounting)