The words “simple” and “1031 exchange” are not often used in the same sentence, but in North Central Rental & Leasing, LLC v. United States, 779 F3d 738 (8th Cir 2015), the court held that North Central’s equipment exchanges (there were 398 of them) were fully taxable as impermissible related-party exchanges. The court’s reasoning was that the 1031 exchanges could have been completed with a much simpler structure and that the complex and inefficient structure appeared to be solely for the purpose of avoiding the related-party rules of Section 1031(f) of the Internal Revenue Code.
Congress enacted IRC § 1031(f) to thwart the attempts of creative taxpayers to use related parties to circumvent the intent of IRC § 1031 by cashing out their investments, instead of reinvesting in like-kind property. Section 1031(f) prohibits tax-free exchange treatment if (1) related parties exchange property and either party disposes of the property it received in the exchange within two years after completing the exchange, or (2) the parties structure the transaction purposefully to avoid application of the related-party rules.
In North Central, Butler Machinery Company was in the business of selling and leasing heavy equipment. The family that owned Butler formed North Central, and within two months of its formation, North Central commenced a like-kind exchange program. Through a qualified intermediary (the “QI”), North Central sold its used equipment to third parties and the QI held the sales proceeds. Butler bought new equipment for North Central, and the QI bought the equipment on North Central’s behalf and paid Butler for the equipment from the exchange proceeds. Butler did not mark up the cost of the equipment it sold to the QI, and Butler purchased the equipment with six months’ interest-free loans. When Butler received the exchange proceeds from the QI, instead of immediately paying off the equipment loans, Butler used the exchange proceeds for general business purposes until the interest-free period expired.
Although the exchanges don’t have the hallmark stench of a related-party “cash-out” exchange, the court nonetheless held that the exchanges were fully taxable. The court boiled down the exchanges into the following components: The day before Butler sold the equipment to the QI for the benefit of North Central, Butler had an investment in equipment. The day after the QI paid Butler for the equipment, Butler had cash. The court concluded that this meant that Butler had cashed out its investment in equipment. Oddly, at the beginning of the exchange Butler did not have cash or equipment, and within 180 days after selling the equipment to the QI for North Central’s benefit, Butler had neither cash nor equipment.
The court also held that the QI and Butler were unnecessary parties to the exchange, and that their involvement made the exchange unnecessarily complex and inefficient. The court concluded that North Central or the QI could have purchased the equipment directly from the manufacturer (instead of purchasing the equipment from Butler through the QI) and determined that Butler was involved only so that it could obtain the interest-free use of the exchange proceeds until the equipment loans were due. The court determined that Butler had likely received at least $210 million in interest-free loans over the course of the 398 exchanges and believed this benefit was too great to ignore.
North Central is a good reminder that tax-free exchanges are allowed solely because of the generosity of Congress and that seeking to exploit the benefit of tax-free exchanges further than Congress intended can be risky. In evaluating any proposed 1031 exchange, the following general principles are important to remember.
- Keep it simple (relatively speaking). Although some level of complexity must be tolerated in 1031 exchanges, overly complex structures are less easily comprehended and often more open to suspicion.
- Have a business purpose (other than tax avoidance or interest-free use of exchange proceeds). A business purpose that is solid and can be clearly articulated should be the driving force behind any 1031 structure.
- Keep your hands out of the cookie jar. Seeking to leverage benefits from the exchange proceeds, in the form of profits, interest, or use of the exchange proceeds during the exchange period, stinks of constructive receipt of exchange funds or, at least, overreaching that the IRS doesn’t appreciate.