REIT Update: Do Serial Exchangers Get Cash, with Extra Time to Boot, under New Letter Ruling?

REITs are big users of 1031 exchanges and also frequent recipients of IRS private letter rulings on 1031 exchanges.  A recent private letter ruling raises issues concerning whether a sequence of like-kind exchanges within a group of related entities, two of which are REITs, effectively gives the group of related exchangers extensions of the Section 1031 45-day and 180-day deadlines and to what extent the group of related exchangers is allowed to partially cash-out their investments in real property.  This article addresses these issues succinctly.  For a more complete analysis, please see my recent article, co-authored with Professor Brad Borden and Alan Lederman, entitled “Do Serial Exchangers Get Cash, with Extra Time to Boot, under New Letter Ruling?”, published in the March 2011 edition of the Journal of Taxation, Thomson Reuters/WG&L publishers, 114 Journal of Taxation 153, © 2011 Kelly E. Alton, Bradley T. Borden and Alan S. Lederman Click Here.

Section 1031(f) prohibits certain types of direct or indirect exchanges between related parties.  In Private Letter Ruling 201048025 (public release date 12/3/2010), Taxpayer, a REIT, sold relinquished property to an unrelated party in an exchange facilitated by a qualified intermediary.  Taxpayer was part of a group of related entities, which included Related Party (also a REIT) and Affiliate.  Taxpayer identified several properties, including at least one owned by Related Party, as potential replacement properties.  Likewise, Related Party planned to sell relinquished property to Taxpayer as part of a 1031 exchange.  Related Party identified several potential replacement properties, including property owned by Affiliate.  In the event that Related Party acquired a replacement property from Affiliate, Affiliate planned to acquire replacement property from unrelated sellers.

If the value of the replacement property that Related Party and Affiliate were acquiring was less than 100% of the value of their respective relinquished properties, the difference would result in gain recognition to Related Party or Affiliate, as the case may be, but the amount of gain recognized by Related Party or Affiliate was stipulated not to exceed x% of the gain realized by the transferor.  The ruling further provided that the cash Related Party and Affiliate would receive, would be a “de minimis” amount.  Under these facts, the IRS ruled that Section 1031(f) did not disqualify Taxpayer’s like-kind exchange from qualifying for tax deferral, provided that Taxpayer, Related Party and Affiliate hold their respective replacement properties for two years following their acquisition.

Adding up all the time periods in the three exchanges allows the related party group to potentially obtain a 540-day exchange period (180 x 3) and a 405-day (180 + 180 + 45) identification period.  The prohibition in Section 1031(f) against related party exchanges is targeted at the specific abuse of basis shifting between the exchanged properties and cashing out, where the cashing out is done wholly or partially on a tax-free basis.  There is no other abuse explicitly mentioned in the legislative history to Section 1031(f).  The ruling at issue raises the question whether by allowing a sequence of otherwise permissible exchanges among related parties creates an abuse that the IRS should factor into its analysis of tax avoidance for purposes of Section 1031(f).  The IRS did not address this point, so it’s unknown whether the IRS considered the time extensions not to constitute a principal purpose for structuring this series of like-kind exchanges, or to be simply beyond the scope of Section 1031(f).

Notably, however, the ruling does not offer as a legal conclusion whether Related Party or Affiliate’s exchanges qualified under Section 1031.  Nevertheless, the ruling states that the de minimis

[cash] amounts received by Related Party and Affiliate are insufficient to support the conclusion that the exchanges were undertaken to avoid the purposes of Section 1031(f).  Unlike prior rulings with similar facts, this time the IRS stated that the amount of the cash received was de minimis, but it did not define “de minimis” or discuss its relevance.