U.S. Tax Court Decisions

• Crooks v. Commissioner, 92 T.C. 816 (1989) -- The granting of a lease was not considered a sale, or transfer, for 1031 exchange purposes.

• Chase v. Commissioner, 92 T.C. 874 (1989) -- A partnership’s sale and distribution to the partners does not qualify for non-recognition, determined via the substance over form doctrine.

• Maloney v. Commissioner, 93 T.C. 89 (1989) -- Distribution of 1031 exchange replacement property via a Section 333 liquidation does not disqualify non-recognition treatment under Section 1031.

• Klein v. Commissioner, T.C. Memo. 1993-491 -- Exchange funds cannot be pledged or assigned.

• Fredericks v. Commissioner, T.C. Memo. 1994-27 -- Mortgaging a property pre-exchange is acceptable if there is a legitimate business purpose.

• Blatt v. Commissioner, T.C. Memo. 1994-48 -- Broker’s commissions and other closing costs reduce boot in an exchange.

• Dibsy v. Commissioner, T.C. Memo. 1995-477 -- A sale and acquisition of real property do not constitute a 1031 exchange without the required structure and documents.

• Wittig v. Commissioner, T.C. Memo. 1995-461 -- Addresses liability netting rules between mortgage liability relief on relinquished property and new mortgage on the replacement property.

• St. Laurent v. Commissioner, T.C. Memo. 1996-150 -- Issued prior to the issuance of the Regulations, an indefinite number of properties identified was acceptable because the Taxpayer made a good faith effort to comply with the statute.

• Hillyer v. Commissioner, T.C. Memo. 1996-214 -- Exchange disallowed because the escrow agreement did not limit the Taxpayer’s right to receive or use the cash.

• Dobrich v. Commissioner, T.C. Memo 1997-477 -- Tax court upheld a fraud penalty based on backdated 1031 exchange documents.

• Christensen v. Commissioner, 96-70741 (9th Cir. 1998) -- The exchange was disqualified as the replacement property was not received within the time limits specified in the regulations.

• Knight v. Commissioner, T.C. Memo 1998-107 -- Taxpayers must acquire the replacement property within the limits specified in the regulations (circumstances beyond the control of the Taxpayer notwithstanding).

• Neal T. Baker Enterprises, Inc. v. Commissioner, T.C. Memo 1998-302 -- Property held as ‘work in progress’ was deemed to be held ‘primarily for sale’ and not ‘for investment;’ therefore did not qualify for a Section 1031 Exchange.

• Lincoln v. Commissioner, T.C. Memo 1998-421 -- Taxpayer’s exchange was disallowed as there was no ‘reciprocal transfer of property.’

• DeCleene v. Commissioner, 115 T.C. No. 34 (November 17, 2000) -- Taxpayer’s use of a ‘parking arrangement, prior to the issuance or Rev. Proc. 2000-37, failed and the exchange was disqualified.

• D.G. Smalley v. Commissioner, 116 T.C. No. 29 (2001) -- A taxpayer needed to have only a reasonable belief of receiving replacement property to show his ‘intent’ so close a Section 1031 Exchange.

• Florida Industries Investment Corp. v. Commissioner, 252 F.3d 440 (11th Cir. 2001) -- The exchange was disallowed because the Taxpayer had effective control of the sales proceeds held in escrow.

• Marcia Chama v. Commissioner, TC Memo 2001-53 (September 24, 2001) -- Partnerships closing a Section 1031 Exchange over two tax years are required to recognize net debt relief in year one, notwithstanding the later completion of the exchange.

• Ronning Enterprises, Inc. v. Commissioner, docketed June 1998, reported November 2001 -- Confirms that in an exchange with multiple relinquished properties, the 45-day Identification Period begins on the date of the first relinquished property sale.

• Jose Montes v. Kim Asher, CPA, 182 F. Supp. 2d 637 (N.D.O. 2002) -- Judgment issued in favor of a Taxpayer who sued his accountant for not mentioning a Section 1031 Exchange.

• In re: Nation-Wide Exchange Services, Inc., 291 B.R. 131: 2003 Bankr Lexis 267; 91 A.F.T.R. 2d March 31, 2003 -- Exchange funds held by Nation-Wide Exchange Services, Inc., as Qualified Intermediary, were subject to claims of Nation-Wide’s creditors in bankrupcy, because Nation-Wide commingled customer deposits and failed to use segregated escrow accounts.

• Teruya Brothers, LTD, 124 TC No. 4 (February 9, 2005) -- Acquiring replacement property from a related party may disqualify a Section 1031 Exchange.

Crooks v. Commissioner, 92 T.C. 816 (1989): Tax Court held that granting a lease (while reserving a royalty interest) in consideration for four parcels of real estate did not constitute an exchange for purposes of Section 1031.

The Court reasoned that when a mineral interest is assigned for a lump-sum cash consideration, and the assignor retains a right to receive a specified percentage of all oil and gas produced for the economic life of the mineral deposit, then the transaction is a lease and payments received under such lease are ordinary income. The cash or other consideration paid to the lessor upon execution of the lease and before actual production is treated as an advance royalty or bonus and is ordinary income subject to depletion allowances. However, when a mineral interest is assigned for a cash consideration and no interest is reserved, then the transferor has alienated his economic interest therein. In that instance, the cash payment cannot be considered an advance royalty, but rather is consideration for the transferor's assignment of all his interest.

Since the grant of a lease is not a sale or exchange, the value of the property received constitutes a lease bonus and is reportable as ordinary income.

Chase v. Commissioner, 92 T.C. 874 (1989): Tax Court held that a partnership's disposition of an entire interest in an apartment building did not involve a like kind exchange. The Taxpayers, partners in a partnership holding the building, sought to structure the disposition to facilitate non-recognition to them. They caused the partnership to distribute a 46 percent undivided interest in the property, and then set up a trust into which 46 percent of the net proceeds from the disposition were to be paid and held until suitable like kind property could be found. The Tax Court observed that the Taxpayers did not act as owners except in their roles as partners. The substance over form doctrine applies, said the court, where the form chosen by the parties is a fiction that fails to reflect the economic realities of the transaction, Commissioner v. Court Holding Co. 324 U.S. 331 (1945).

The Court concluded that, in substance, the partnership had sold the property and distributed the proceeds to the Taxpayer, a transaction not meeting the requirements of Section 1031 viewed at either the partnership or the partner level. Several facts were critical to the court's decision that the Taxpayer did not in substance receive the interest in the building to be exchanged. The Taxpayer had not recorded the deed to the property until shortly before the sale, he did not pay 46% of the building's operating costs during the interim period, and he did not receive 46% of the rents during that period.

Contrast the Court's ruling in Chase, (which relies strongly on Court Holdings, (U.S. Supreme Court)), with TAM 9907029 (September 30, 1998); see also TAM 9818003 (December 24, 1997).

Maloney v. Commissioner, 93 T.C. 89 (1989): Tax Court ruled that a Taxpayer corporation's distribution of property acquired in a like kind exchange did not defeat non-recognition under Section 1031. The property was distributed in a Section 333 liquidation to controlling shareholders, who owned 100 percent of the stock, and they continued to hold the property solely for purposes of investment. The Tax Court viewed the transaction as a variant of the transactions it had already blessed in Magneson v. Commissioner, 81 T.C. 767 (1983), aff'd, 753 F.2d 1490 (9th Cir. 1985) (exchange of like kind properties followed by tax free change in form of ownership), and Bolker v. Commissioner, 81 T.C. 782 (1983), aff'd, 760 F.2d 1039 (9th Cir. 1985) (interplay of Sections 1031 and now repealed 333).

Klein v. Commissioner, T.C. Memo. 1993-491: In a pre-Regulation (1988) exchange, Taxpayer assigned its interest in cash held in escrow to the seller of replacement property. Citing Carlton v. United States, and Nixon v. Commissioner, the Tax Court held that there was no exchange obligation on the part of the purchaser of Taxpayer's property and Taxpayer had constructive receipt of the funds held in escrow.

Fredericks v. Commissioner, T.C. Memo. 1994-27: This case involved several pre-safe harbor issues including the placement of a mortgage just prior to the exchange. The IRS lost the case on all issues. The only disturbing aspect of the case is the Court's reference to there being a legitimate business purpose in placing the mortgage just prior to the exchange. It arguably leaves open the question of whether the result would be different in the absence of a legitimate business purpose.

Blatt v. Commissioner, T.C. Memo. 1994-48: Rev. Rul. 72-456 held that broker's commissions can reduce boot in an exchange and its underlying general counsel's memorandum suggested that other types of exchange expenses can reduce boot. In Phillip Blatt the Court stated that "the amount of boot received is decreased by the Taxpayer's exchange expenses." Although this is somewhat limited authority (because it is only a Tax Court Memorandum decision), it does provide some further support for the position that Rev. Rul. 72-456 can be extended to other types of expenses. Following is a listing from the Government's Brief that detail the expenses allowed in the case: escrow fees, document preparation, owner's title insurance premium, lender's title insurance premium, exchange fees, recording charges, transfer taxes, messenger fees.

In general, analysis of exchange expenses should focus on whether the expense would increase the basis of the property under Section 1001, as opposed to an expense related to the procurement of financing. The American Bar Association Tax Section has taken the position in its report on "Open Issues" that virtually all kinds of expenses incurred in connection with the exchange, irrespective of whether they are attributable to the relinquished or replacement property, should offset boot, except expenses attributable to the financing or refinancing of the properties.

Dibsy v. Commissioner, T.C. Memo. 1995-477: In this case, there was a desire to purchase property and a need to dispose of like-kind property to finance the acquisition. The Taxpayer was unable to locate a buyer for the original property and the new property was purchased before the original property could be sold. There was a borrowing against the original property to finance the purchase of the new property and the Taxpayer did not actually receive the cash proceeds of sale of the old property. The purchase of the new property and the subsequent sale of the old property were not structured as a Section 1031 exchange. The escrow documents do not refer to a Section 1031 exchange. There is no indication that the transactions were intended to be a Section 1031 exchange. There was no evidence that Taxpayers relied on Section 1031 until they filed their Federal income tax return. The U.S. Court of Appeals for the Ninth Circuit held that there was no "exchange under the meaning of Section 1031".

Wittig v. Commissioner, T.C. Memo. 1995-461: On September 27, 1995 the Tax Court issued a memorandum opinion holding that new debt incurred by a Taxpayer to acquire replacement property in a like-kind exchange will not offset the Taxpayer's mortgage liability relief on relinquished property. Wittig is the first case to directly apply the liability netting rules of Reg. §1.1031(d)-2 to a new purchase money mortgage. Chicago Deferred Exchange Corporation agreed to finance the appeal and, through its attorney, Howard J. Levine of Roberts & Holland, Washington, D.C. filed a motion for reconsideration on October 26, 1995 arguing on behalf of Wittig that the Tax Court committed a substantial error.

Two cases have implicitly held that an offset should be allowed even where the replacement property is not acquired subject to existing debt: Commissioner v. North Shore Bus Company, 143 F.2d 114 (2d Cir. 1944); and Barker v. Commissioner, 74 TC 555 (1980). Also see TAM 8003004 (Sept. 19, 1979), in which the IRS rules that an offset must be permitted because a purchase money mortgage constitutes either a liability assumed by or cash paid by the Taxpayer. On November 9, 1995, the Tax Court's order in Wittig was withdrawn.

Section 1031(d) was recently amended as part of a Technical Corrections Act to provide that a liability is "assumed" for purposes of §1031 if it is treated as "assumed" for purposes of §357(d). Under new §357(d), a recourse liability is considered assumed if the transferee has agreed to satisfy the debt. In effect, this is a codification of the Wittig result.

St. Laurent v. Commissioner, T.C. Memo. 1996-150: This case involved a deferred exchange in 1988, before the Deferred Exchange Regulations were issued. The Taxpayer identified 20 properties as replacement property. The Service argued that the identification should not qualify because it was clear from a reading of the statute that Congress intended only a limited number of properties could be identified as potential replacement properties.

The Court found that the Taxpayer made a valid identification of properties and it found no need to set a specific number. The Taxpayer made a good faith effort to comply with the statute. However, the Court held that the exchange did not qualify for non-recognition of gain because the Taxpayer did not actually receive the replacement property until after the end of the statutory exchange period, in this case, the date he filed his income tax return for the year the relinquished property was transferred.

Hillyer v. Commissioner, T.C. Memo. 1996-214: This case involved an exchange by an S corporation of land using an escrow account. The Taxpayer received the net proceeds from the sale and deposited them into an escrow account with a bank. The Court found that the exchange did not qualify because the escrow agreement did not expressly limit the S corporation's right to receive or use the cash held in the escrow account as required by the Reg. §1.1031(k)-1(g)(6). The Court found the escrow agreement to be "nothing more than a facade".

Dobrich v. Commissioner, T.C. Memo 1997-477: The Tax Court upheld a fraud penalty on the submission to the IRS of backdated documents, which reflected that an oral identification had been made under Section 1031(a)(3). This case involved a pre-regulation year, so the Court was even willing to assume that a proper identification did not have to necessarily be in writing. Taxpayers misrepresented to the IRS that they had in fact identified replacement property in a timely manner. Taxpayers willfully took steps to disguise the taxable sale as a Section 1031 exchange by fabricating timely identification and obtaining false documents to substantiate their claim. The Court found clear and convincing evidence of Taxpayer's intent to defraud and ruled that Taxpayers were liable for a Section 6663 fraud penalty. The Taxpayer also plead guilty to the criminal charge of causing the delivery of false documents to the IRS.

Christensen v. Commissioner, 96-70741 (9th Cir. 1998): The Ninth Circuit, in an unpublished memorandum, affirmed a Tax Court decision denying like-kind exchange treatment for an individual's transfer of rental property because he did not receive replacement property on or before the earlier of 180 days after the transfer of the relinquished property "or the due date, determined with regard to extensions, for the Taxpayer's return". The court rejected Christensen's argument that the return date includes any extensions available, holding instead that the due date included only extensions actually granted, of which there were none in this case. The deadline the court concluded is "the actual due date, not a hypothetical due date".

Knight v. Commissioner, T.C. Memo 1998-107: Petitioners argued that if circumstances beyond their control prevent them from acquiring replacement property within the 180 day period, then the time for acquiring replacement property pursuant to Section 1031 should be the same as the time for acquiring replacement property where there is an involuntary conversion, and the 180 day period should be extended to two years. In essence, the petitioners requested that the Court ignore the plain language of the statute, and essentially rewrite it to achieve what would be an equitable result. Regrettably, for petitioners, the Tax Court is not a court of equity.

Neal T. Baker Enterprises, Inc. v. Commissioner, T.C. Memo 1998-302: Exchange of unimproved land held by a Taxpayer in the real estate business was disqualified. Property was deemed to be held "primarily for sale" even though the court found it was not held as dealer property. A significant factor in the court's holding that the property was held "primarily for sale" is the fact that the property was classified as "work in progress" on the Taxpayer's books, not an investment, and the Taxpayer's accountants failed to testify on his behalf to explain the disparity. Additionally, the Taxpayer listed his primary occupation as "real estate subdivider and developer."

Lincoln v. Commissioner, T.C. Memo 1998-421: Taxpayer acquired property in Big Sur, California with cash and a note. Taxpayer sold other investment property the following year. Proceeds from the sale were used to make improvements on the Big Sur property. Taxpayers did not report any gain on the sale of their property, nor did they report the transactions as an exchange on Form 8824. Relying on Bezdjian v. Commissioner 845 F.2d 217 (9th Cir. 1988) the Tax Court held that their was no "reciprocal transfer of property", disallowed the exchange and assessed a 20 percent penalty as provided by Section 6662(a). See also Dibsy v. Commissioner.

DeCleene v. Commissioner, 115 T.C. No. 34 (November 17, 2000): Taxpayer transferred property it previously owned (Lawrence Drive) to WLC, in exchange for which WLC was to construct improvements on Lawrence Drive and transfer the property plus improvements back to Taxpayer. At the time of the transfer back to Taxpayer, Taxpayer would transfer McDonald Street property to WLC to complete the two party exchange. Taxpayer proceeded to quit claim the Lawrence Drive property to WLC. WLC gave Taxpayer a non-recourse note and mortgage on the property which was assigned to a bank who provided construction financing. When WLC completed the construction three months later, WLC transferred the improved Lawrence Drive property to Taxpayer, Taxpayer transferred McDonald Street to WLC.

The Tax Court held that Taxpayer never disposed of Lawrence Drive, and remained its owner during the construction period. Because Taxpayer 1. previously owned the property, 2. was obligated to pay for the construction of the improvements and 3. was obligated to re-acquire the property on the completion of the improvements, he remained the beneficial owner of the property. In effect the Service considered this a failed attempt at structuring a "parking arrangement". *Note that this case was decided prior to the issuance of Revenue Procedure 2000-37.

Editor's note: the DeCleene case causes concern for practitioners and Taxpayers who attempt to structure non-safe harbor parking arrangements. Where the Taxpayer desires to "park" the relinquished property with an Accommodation Party in a non-safe harbor parking arrangement, the existence of this case makes it extremely likely that the Service could make a similar argument (i.e. that the Taxpayer never gave up beneficial ownership of the relinquished property during the parking arrangement). Transactions structured outside the safe harbor of Rev. Proc. 2000-37 require thorough and careful planning prior to implementation.

D.G. Smalley v. Commissioner, 116 T.C. No. 29 (2001): An exchange of timber cutting rights granted for two years for a fee simple interest in property qualified under Section 1031 even though no QI was used, and the question of whether the properties were like-kind was not sufficiently addressed by the Court. Relinquished property was transferred in 1994; replacement property was acquired in 1995. The Service initially challenged the transaction based on the argument that the timber cutting rights were not like kind to a fee. Taxpayer argued that even if they were not like-kind properties that the gain should still be reportable in the following tax year (1995) as he was able to demonstrate bona fide intent to complete the exchange. The Tax Court rejected the Service's argument that in order for the Taxpayer to have bona fide intent, that the properties needed to be like-kind, but indicated the Taxpayer only needed to have reasonable belief that he would receive replacement property to show intent. As to the issue of like-kind, the Court held that there was sufficient uncertainty so as to conclude that the Taxpayer's belief that the properties were like kind, while not necessarily correct, were at least reasonable. The Service failed to argue that there was never an "exchange". In any event the Service could have argued that the Taxpayer could not have had a bona fide intent because it is not reasonable to believe that either 1. the exchange requirement was met or 2. that the two year harvest right was like kind.

Florida Industries Investment Corp. v. Commissioner, 252 F.3d 440 (11th Cir 2001): Sale proceeds on an exchange were placed in escrow with a very friendly bank with whom a subsidiary of the Taxpayer had a very close relationship. There was an early release of some of the funds, and the Court held that the Taxpayer was in control of all escrow funds and stated: "Unlike the situations in Garcia, Barker and Hayden, Taxpayer here had effective control over the sales proceeds. The record also shows that the QI/Escrow company's action with respect to the escrow fund and the escrow agreement complied with the wishes of the Taxpayer, regardless of whether those actions violated certain provisions of that agreement." [emphasis added]. (See PLR 200027028 where the Service held that the exchange agreements could not be modified to allow for early distribution of cash where Taxpayer determined that he is unable to reach a contract with a seller of replacement property. The Service ruled that the agreement cannot give the Taxpayer the right to receive the cash back, prior to the end of the exchange period even if he determines in good faith that he will be unable to acquire the property).

Marcia Chama v. Commissioner, TC Memo 2001-53 (September 24, 2001): The Tax Court held that a partner in a partnership had to report her share of partnership gain from a 1031 exchange even though, according to the Court: "it appears the Partnership re-invested petitioner's share of the gain." The Court reached the right result but for the wrong reason. Gain was recognized by the partners because there was apparently a mortgage transferred, but no mortgage offset. This issue arises from the lack of conformity between rules covering partnership liabilities (under Section 752) and like-kind exchanges. If a partnership is doing an exchange where there is debt relief on the sale of the relinquished property, and the exchange straddles a tax year-end - so replacement property is purchased in tax year 2, the partnership technically has to recognize gain on that debt relief it incurs in tax year 1. The language of 752(b) literally compels a gain recognition result, notwithstanding that for purposes of Section 1031, consideration given by the Taxpayer in the form of a liability assumed on the purchase of replacement property offsets consideration received by the Taxpayer in the form of a liability assumed by the purchaser of the relinquished property. See also Rev. Rul. 2003-56 infra which hold that any net decrease in partnership debt resulting in gain is recognized in year 1.

Ronning Enterprises, Inc. v. Commissioner docketed June 1998, reported November 2001: Taxpayer transferred nine non-contiguous parcels of real estate to seven different buyers pursuant to eight different exchange agreements (three of the parcels were exchanged simultaneously). The replacement property consisted of tenancy in common interests in the same parcel of real estate. The IRS took the position on audit and at Appeals that all of the deferred exchanges were part of the "same" deferred exchange for purposes of the Reg. 1.1031(K)-1(b)(2)(iii) which resulted in the latter five exchanges not qualifying [which states: "If, as part of the same deferred exchange, the Taxpayer transfers more than one relinquished property and the relinquished properties are transferred on different dates, the identification period and the exchange period are determined by reference to the earliest date on which any of the properties are transferred.) So, in this case, if the 45 day period for each exchange was determined from the time of the first transfer, the last five transactions would have failed the 45 day identification test. Inexplicably, Appeals also disallowed tax-deferred treatment on the simultaneous exchanges. Finally, in addition to conceding the case, the IRS conceded entitlement to attorneys fees and agreed to pay fees at a higher rate than the statutory rate.

Jose Montes v. Kim Asher, CPA, 182 F. Supp. 2d 637 (N.D.O. 2002): Summary judgment issued for Plaintiff who filed a malpractice claim against his CPA. Jose Montes sold a restaurant and mentioned to his CPA that he was thinking of acquiring a new restaurant. The CPA firm failed to mention the benefits of an IRC Section 1031 exchange. Montes sold the restaurant and recognized his gain. He subsequently filed suit. In summary judgment, the Northern District of Ohio Tax Court ruled in his favor. Damages have not yet been determined.

In re: Nation-Wide Exchange Services, Inc., 291 B.R. 131: 2003 Bankr Lexis 267; 91 A.F.T.R. 2d March 31, 2003: The U.S. Bankruptcy Court of the District of Minnesota held that exchange funds under the control of Nation-Wide Exchange Services, Inc., as Qualified Intermediary were subject to claims of Nation-Wide's creditors in bankruptcy. All disbursements made by Nation-Wide in the 90 days preceding its bankruptcy filing were voided and returned to the bankruptcy trustee. Nation-Wide Exchange Services acted as qualified intermediary on behalf of its customers. It was not obligated, as QI to maximize the return on the sale proceeds it held but was required to give precedence to security and liquidity in its choice of investments. Nation-Wide commingled all of its customer deposits in a brokerage account on which it sustained losses that it never made up. Ultimately, Nation-Wide was unable to meet its obligations to acquire replacement property and filed for bankruptcy. The Bankruptcy Court found that Nation-Wide's de-facto practice of commingling customer deposits - and its failure to use segregated accounts - effectively converted customer deposits to Nation-Wide's property for purposes of bankruptcy law. The court noted: "[Client] was a trusting exchanger. It is painful to observe this in hindsight, but greater prudence would have dictated inquiry into [Nation-Wide's] practices. This case is an unfortunate reminder that Taxpayers and practitioners should exercise the greatest discretion in choosing and hiring a qualified intermediary.

Teruya Brothers, LTD, 124 TC No. 4 (February 9, 2005): Related Party Exchange

This full Tax Court case (as opposed to a Memo decision), is the first case interpreting sec 1031(f). The case is significant because contrary to the position set forth in a TAM, the IRS and the Court seemed to agree that for purposes of 1031(f)(1), the QI is not considered an agent of the Taxpayer and that Sec 1031(f)(1) applies only to direct related party exchanges. The IRS had previously said it can pick and choose between 1031(f)(1) and (f)(4).

Additionally, the Court rejected the IRS's assertion that if an exchange would fail under 1031(f)(1) if it were recast as a direct exchange without the QI, it will necessarily fail under 1031(f)(4). This is similar to the statement in the instructions to the Form 8824, which interpreted Rev. Rul. 2002-83 (which by the way was not even cited by the Court). This should eliminate any assertion that a related party exchange utilizing a QI will necessarily fail. Unfortunately, the Taxpayer's counsel cited no explanation for utilizing a QI or for the structuring of the transaction so it was easy for the Court to conclude that the exchange failed under 1031(f)(4). Taxpayer's arguments were frivolous (e.g., it is irrelevant what happens to the relinquished property as long as Taxpayer continues its investment in like kind property).