Section 1031 of the Internal Revenue Code of 1986 generally provides that no gain or loss is recognized when property held for productive use in trade or business or for investment is exchanged solely for like-kind property to be held for the same purpose. Over the years, litigation has focused on whether a taxpayer held the relinquished property and intended to hold the replacement property for productive use in a trade or business or investment.

The IRS has taken the position that ownership of property through an entity is not equivalent to direct ownership for purposes of satisfying the holding-purpose requirement of Internal Revenue Code section 1031.

Despite the IRS’s view, that position has not always been upheld in the courts. The rationale for not viewing the exchange as a taxable event is that the taxpayer remains invested in the same kind of property. (Magneson v. Commissioner, 753 F.2d 1490 [9th Cir. 1985]). In Magneson v. Commissioner, the taxpayer transferred property in exchange for a 10% undivided fee interest in like-kind replacement property. Immediately thereafter the taxpayer transferred the replacement property to a partnership in exchange for an interest in the partnership. The 9th Circuit held that the contribution to the partnership post-exchange was considered by the court as a mere change in the form of ownership rather than the relinquishment of ownership.

In Maloney v. Commissioner (93 T.C. 89 [1989]), husband-and-wife shareholders of a closely held corporation were distributed real property tax-free under Internal Revenue Code section 333 (actions taken prior to passage of the Internal Revenue Code of 1986). The Tax Court upheld nonrecognition treatment when the individuals entered into an IRC 1031 transaction. Applying the principles articulated in Magneson, the court stated “that the difference between a closely held corporation and its shareholders is economically insignificant.” The purpose of the corporation was the same as that of the shareholders; therefore, the holding requirement of IRC section 1031 was satisfied. The taxpayer’s economic intent in the property remained unchanged, satisfying the use requirement of IRC section 1031.

In Bolker v. Commissioner (760 F.2d 1039 [9th Cir. 1985]), a corporation made a liquidating distribution of real property to its shareholder (prior to the passage of the Internal Revenue Code of 1986), who immediately entered into an exchange for like-kind property. The 9th Circuit held that if a taxpayer holds the property with the intent to exchange for like-kind property, the taxpayer will meet the holding purpose requirement of Code section 1031.

In Mason v. Commissioner, 55 TCM 1134 (1988), two partners of two partnerships agreed to exchange their interests in respective properties by “drop and swap.” Following the exchange, each partner would be the sole owner of one property. This required a distribution out of each respective partnership in liquidation, followed immediately by an exchange of tenancy in common interests in a prearranged transaction. The court found that the transaction was a distribution of property that qualified for nonrecognition under IRC section 731, followed by an exchange of the property under IRC section 1031. Otherwise, the partnership interests could not be exchanged under section 1031.

IRC section 1031 does not require ownership of the relinquished property for any particular period, and section 1031 exchanges have involved situations where title to the replacement property was held only briefly and only for the exchange (Alderson v. Commissioner, 317 F.2d 790 [9th Cir. 1963]).

A negative case (Chase v. Commissioner 92 T.C. 874 [1989]) involved a limited partnership in which Mr. Chase caused the limited partnership to liquidate his 46% limited partnership interest and deeded an undivided interest in a partnership asset (apartments) to him in violation of the partnership agreement. Mr. Chase used his control of the partnership to manipulate the sale of the partnership asset to gain a tax advantage while failing to act in a way that was consistent with the transaction form he chose. The partnership (not the partner) was treated as disposing of the property, while it was the partner who acquired replacement like-kind property. Thus, neither the partnership nor the partner was involved in a like-kind exchange.

A taxpayer’s 1031 exchange may be proceeded by a tax-free acquisition of the relinquished property (e.g., where a partnership interest is dropped into real estate), followed by a tax-free transfer of a replacement property. The redemption of the partnership interest in an exchange into a tenancy-in-common (TIC) interest is not a taxable transaction and allows the integration of the stages of a 1031 transaction, promoting continuity of investment and deferral of gain.

This involves the use of a series of reasonable, necessary, and integrated transactions to delay, not avoid, the recognition of gain which section 1031 allows (matter of the appeal of Sharon Mitchell OTA case No. 18011715).

The redemption of the partnership interest allows integration of the stages of a section 1031 transaction, promoting continuity of investment and deferral of gain. The taxpayer is in the same economic position before and after the exchange. The taxpayer remains invested in the same kind of property.

In a Delaware Statutory Trust (IRS Revenue Ruling 2004-86), there can be 1,999 investors. Each investor is considered tenants in common owners. When the sponsor decides to liquidate and sell the property for a profit, each owner can elect to cash out or reinvest the investment into another Delaware Statutory Trust or in real property itself. The taxpayer remains invested in the same kind of property.