The limited scope of IRS Revenue Ruling 2002-83
Section 1031 exchanges involving related parties present some of the most complex problems in Section 1031 tax law.
This is partly because related-party exchanges have an additional set of rules that must be followed. What’s more, some of the additional complexity is because related-party exchanges may be scrutinized to determine their underlying purpose. The legislative history underlying the related-party rules makes it clear these rules were conceived to prevent abusive tax avoidance. Exchanges involving related parties are subject to a two-year holding requirement: Taxpayers who receive property from a related party may not dispose of the property within two years after the date of the last transfer that was part of the exchange. A related party who acquires property also must hold that property for a minimum of two years. If either the taxpayer or the related party violates this requirement, the exchange will not be accorded nonrecognition treatment.
In addition to this two-year holding requirement, the code also imposes an additional purpose requirement that is expressed in 1031(f)(4). The purpose requirement reads as follows:
“Treatment of certain transactions: This section shall not apply to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection.”
This is a reiteration of the step transaction doctrine. If a taxpayer structures an exchange specifically for the purpose of avoiding the purpose of the related party rules — and the purpose is to prevent abusive tax avoidance — then that transaction may collapse following the application of the related party rules.
Numerous cases have been litigated that involved issues deriving from the related-party rules. In addition, the IRS has issued various procedural and technical documents in an effort to interpret the related-party rules in different fact scenarios. One well-known example is Revenue Ruling 2002-83. This IRS document attempts to show that its hypothetical fact pattern is functionally equivalent to an example of abusive tax avoidance outlined by the Senate Finance Committee. Back when Congress first passed the related-party rules in 1989, the Senate Finance Committee gave an example of a step transaction that involved abusive tax avoidance. Revenue Ruling 2002-83 states that a hypothetical transaction involving an unrelated qualified intermediary and related-party seller who receives cash is functionally equivalent to this example given by the Finance Committee. In doing so, Revenue Ruling 2002-83 is attempting to make an impact on how 1031(f)(4) can be interpreted in fact patterns similar to the facts used in its analysis. Ultimately, the conclusion reached in Revenue Ruling has limited value and should not serve as a basis for an understanding of 1031(f)(4).
Step transaction violation
In its attempt to clarify 1031(f)(4), the Senate Finance Committee gave a hypothetical example of a step transaction that would violate 1031(f)(4). The example can be stated as follows: Taxpayer A transfers property 1 to unrelated party B. Unrelated party B then exchanges property 1 for a second property, property 2, which is owned by a party related to the taxpayer (related party C). If this exchange between unrelated party B and related party C occurs within two years of the original transaction (i.e., property 1 transferred from taxpayer A to unrelated party B), then the exchange will be denied nonrecognition treatment. The Finance Committee specifically stated that the separate transactions in this hypothetical take place according to a “pre-arranged plan.” In other words, these transactions constitute abusive tax avoidance because there is a clear attempt to circumvent the related party rules through intelligent planning.
The facts described in Revenue Ruling 2002-83 are determined to be functionally equivalent to those in the example given by the Finance Committee. In 2002-83, the IRS describes a situation involving three persons: A, B and C. Person A owns a low-basis property (property 1, fair market value of $150,000, basis $50,000), and person B owns a high-basis property (property 2, FMV $150,000, basis $150,000). Person C is not related to either A or B. Person A engages a qualified intermediary to facilitate an exchange. Using the QI, person A transfers property 1 to C for $150,000. Person A then acquires property 2 from person B for $150,000. The funds are sent to person B from the QI.
Revenue Ruling 2002-83 reasons that what has occurred in this set of facts is a step transaction not unlike the example given by the Finance Committee. However, unlike in the Finance Committee example, in 2002-83 the QI sends the funds to the related party instead of the unrelated exchanger sending the funds to the related party. Revenue Ruling 2002-83 claims that this type of hypothetical transaction involving a QI and a related party buyer is precisely the kind of “structured transaction” contemplated by 1031(f)(4). In 2002-83, person A has clearly developed a plan to engage a QI and acquire a property from a related party seller. Person A may suppose that the unrelated buyer (person C) may provide a means to avoid the two-year holding requirement on the part of the related-party seller. This would seem to be a reasonable assumption based on a superficial reading of the facts. But, because the plan was predesigned, the related-party seller is actually subject to the two-year holding requirement, and so when person B receives the funds, this is treated as though the funds were sent directly from the unrelated buyer. In other words, the facts of Revenue Ruling 2002-83 are considered to be a slightly more sophisticated attempt to avoid the related-party rules, but these facts still violate 1031(f)(4).
On its surface, Revenue Ruling 2002-83 appears to shut down the feasibility of exchanges involving unrelated buyers and related-party sellers (with a QI) in all instances in which there is a transfer of a low-basis property and acquisition of high-basis property. The Senate Finance Committee example makes it clear that there was a pre-arranged plan between the taxpayer, the unrelated buyer of the high-basis property and the related party that owned the low-basis property. The IRS simply reasoned that the fact pattern in 2002-83 is functionally the same because there is a “plan” developed between the taxpayer and the QI to conduct a deferred exchange. The soundness of this reasoning is open to debate.
In the Finance Committee’s example, the prearranged plan between the three persons was central to the determination that the transaction ran afoul of 1031(f)(4). But is it really correct to say that a pre-arranged “plan” to engage a QI as described in Revenue Ruling 2002-83 necessarily indicates an intent to avoid the purposes of the related party rules? Is a plan to engage a QI really functionally equivalent to a plan that directly involves an unrelated buyer as described in the example by the Finance Committee? These are questions that are arguably not settled by Revenue Ruling 2002-83.
The facts of Revenue Ruling 2002-83 raise the question of whether the mere fact that income tax avoidance occurs necessarily indicates a pre-arranged plan to circumvent the related-party rules? Based on the conclusion in Revenue Ruling 2002-83, the answer from the IRS appears to be in the affirmative. But the central point of the Finance Committee’s example is that there was a pre-arranged plan among all involved persons to deliberately circumvent the purpose of the related party rules of 1031(f)(1)(C). Just because the end result of the facts described in Revenue Ruling 2002-83 led to income tax avoidance doesn’t necessarily indicate a conscious attempt to circumvent 1031(f)(1)(C).
Section 1031(f)(4) necessitates a case-by-case analysis because it is testing for intent. The problem with Revenue Ruling 2002-83 is that it infers intent from the mere presence of factors that lead to income tax avoidance. The best way to view Revenue Ruling 2002-83 is to say that the facts described in its analysis may lead to a determination that there was abusive tax avoidance. But this determination does not necessarily follow from the facts described in the analysis. The conclusion of 2002-83 is open to criticism. What’s more, even if we grant that the facts described in 2002-83 do demonstrate an intent to circumvent the purposes of the related-party rules, this conclusion would only apply to identical fact scenarios. In 2002-83, the high basis property had an FMV of $150,000 and a basis of $150,000. What would be the outcome if the basis of the high-basis property were to be slightly lowered, say to $125,000? Would we infer the same intent from this slightly altered set of facts? What about if we change the basis to $100,000? At some point, it would be incorrect to interpret the facts as evidence of abusive tax avoidance given that at least one person recognizes taxable gain immediately.
A transaction is not in violation of 1031(f)(4) simply because it is structured in such a way that it leads to income tax avoidance. A transaction is in violation of 1031(f)(4) when the relevant facts surrounding the transaction indicate that avoidance of federal income tax was its principal purpose. The Revenue Ruling takes the example from the Finance Committee and reasons that 1031(f)(4) has been violated because the QI makes its fact pattern functionally the same as though person B received cash directly from person C. Superficially, this appears to be sound, but the problem is that it doesn’t account for the principle that there must be evidence of intent to circumvent the purpose of the related-party rules. It is not necessarily sound logic to infer intent simply based on the fact that income tax avoidance occurred as a consequence of the transaction. At most, we can say that the facts of Revenue Ruling 2002-83 present an example that may violate 1031(f)(4). And we can also say that the value of these facts is limited because even a slight adjustment may alter the conclusion reached in 2002-83.