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Exchange of Property Between Related Parties Doesn't Qualify as a Like-Kind Exchange

(Parker Tax Publishing November 2016)

The Tax Court held that an exchange of property between related parties did not qualify for deferred recognition of gain under the like-kind exchange rules of Code Sec. 1031. The court determined the transaction was structured with a tax avoidance purpose, noting that the aggregate tax liability of the taxpayer and the related person that arose from their like-kind exchange and a sale transaction was significantly less than the hypothetical tax that would have arisen from the taxpayer's direct sale of the relinquished property. The Malulani Group, Limited and Subsidiary v. Comm'r, T.C. Memo. 2016-209.


The Malulani Group, Limited (Malulani Group), is a Hawaii corporation that leased commercial real estate in various states, including Hawaii and Maryland. For the years at issue, The Malulani Group, Limited filed a consolidated return with its wholly owned subsidiary, MBL Maryland, Inc. (MBL). The Malulani Group also owned approximately 70 percent of the common shares of Malulani Investments, Limited (MIL), which owned real estate throughout the United States.

On October 26, 2006, MBL received a letter of intent from an unrelated third party offering to purchase commercial real estate that it owned in Maryland. It reserved to MBL the right to effect an exchange of the property under Code Sec. 1031 and obligated any third-party purchaser to cooperate toward that end. MBL's representative signed the letter of intent on October 31, 2006, and thereafter the Malulani Group and MBL began a search for suitable replacement property. On January 4, 2007, MBL engaged First American Exchange Co. (FAEC) to serve as an intermediary through which the Maryland property could be exchanged. MBL thereupon assigned its rights under the letter of intent to FAEC, and on January 10, 2007, MBL transferred the Maryland property to FAEC and FAEC sold the Maryland property to the third party for approximately $4.7 million. MBL's basis in the Maryland property was almost $2.8 million at the time of transfer.

In order to meet the requirements of Code Sec. 1031(a)(3), MBL had to identify replacement property on or before February 24, 2007 (i.e., 45 days after the sale of the Maryland property). Between October 31, 2006, and February 23, 2007, brokers presented numerous properties owned by unrelated parties to the Malulani Group and MBL as potential replacement properties, and MBL attempted to negotiate the purchase of an office building and an apartment building for that purpose. As of the date of the sale of the Maryland property (January 10, 2007), neither the Malulani Group nor MBL had considered acquiring a replacement property from MIL or any other related party. On February 23, 2007, MBL first identified three potential replacement properties, all belonging to MIL.

On July 3, 2007, FAEC purchased certain Hawaiian real property owned by MIL for $5.52 million and transferred it to MBL as replacement property for the Maryland property. MIL's basis in the Hawaii property was approximately $2.4 million. On its consolidated return for 2007, the Malulani Group reported a realized gain of approximately $1.9 million from the sale of the Maryland property but deferred recognition of the gain under the like-kind exchange rules of Code Sec. 1031. MIL recognized on its 2007 Form 1120 an approximately $3.1 million gain from the sale of the Hawaiian property, which would have increased its regular income tax liability by approximately $1.1 million; however, MIL had sufficient NOLs to fully offset its regular tax liability relating to the sale.

Following an examination, the IRS, citing Code Sec. 1031(f), determined that the $1.9 million gain realized on the sale of the Maryland property did not qualify for Code Sec. 1031 deferred recognition treatment and assessed a deficiency.


Code Sec. 1031(f) limits nonrecognition treatment under Code Sec. 1031(a) in the case of like-kind exchanges between related persons. Code Sec. 1031(f)(1) generally provides that if a taxpayer and a related person exchange like-kind property and within two years either one disposes of the property received in the exchange, the nonrecognition provisions of Code Sec. 1031(a) do not apply, and gain or loss must be recognized as of the date of the disposition. Although Code Sec. 1031(f)(1) disallows nonrecognition treatment only for direct exchanges between related persons, Code Sec. 1031(f)(4) provides that nonrecognition treatment does not apply to any exchange which is part of a transaction or series of transactions structured to avoid the purposes of Code Sec. 1031(f). Therefore, Code Sec. 1031(f)(4) may disallow nonrecognition treatment of deferred exchanges that only indirectly involve related persons because of the interposition of qualified intermediaries.

Code Sec. 1031(f)(2) provides exceptions to the disallowance-upon disposition rule for related parties in Code Sec. 1031(f)(1). Specifically, Code Sec. 1031(f)(2)(C) provides that any disposition of the relinquished or replacement property within two years of the exchange is disregarded if the taxpayer establishes to the satisfaction of the IRS, with respect to the disposition, that neither the exchange nor such disposition had as one of its principal purposes the avoidance of federal income tax.

Before the Tax Court the IRS argued that MBL's exchange was disqualified from nonrecognition treatment pursuant to Code Sec. 1031(f)(4) as a transaction structured to avoid the purposes of Code Sec. 1031(f). The Malulani Group argued that the exchange of the Maryland and Hawaiian properties was not structured to avoid the purposes of Code Sec. 1031(f) because MBL had no "prearranged plan" to conduct a deferred exchange with MIL.

The Tax Court agreed with the IRS and held that the transaction at issue did not qualify for nonrecognition of gain treatment under Code Sec. 1031. The court cited its decisions in Ocmulgee Fields, Inc. v. Comm'r, 132 T.C. 105 (2009), aff'd, 613 F.3d 1360 (11th Cir. 2010), and Teruya Bros., Ltd. & Subs. v. Comm'r, 124 T.C. 45 (2005), aff'd, 580 F.3d 1038 (9th Cir. 2009) which involved transactions where taxpayers received replacement property from related persons in deferred exchanges involving qualified intermediaries, followed by the related persons' sales of the relinquished property. In those cases, the Tax Court concluded that the transactions were the economic equivalent of direct exchanges of property between the taxpayers and the related persons, followed by the related persons' sales of the relinquished property and retention of the cash proceeds. Thus, the investment in the relinquished property had been cashed out, contrary to the purpose of Code Sec. 1031(f). The court also noted that where the aggregate tax liability of the taxpayer and the related person arising from their like-kind exchange and sale transaction is significantly less than the hypothetical tax that would have arisen from the taxpayer's direct sale of the relinquished property, this is an inference that the taxpayer structured the transaction with a tax avoidance purpose.

For a discussion of the rules relating to like-kind exchanges involving related parties, see Parker Tax ¶113,160.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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