IRS: Like-kind exchange related party rules not triggered by property contribution

Tax Hot Topics newsletterThe IRS recently ruled in PLR 201834010 that a taxpayer who acquired replacement property in a like-kind exchange with a related party and seeks to contribute that property to a partnership less than two years later, lacks a principal purpose of tax avoidance and is not disqualified from non-recognition treatment for the original like-kind exchange. 

The taxpayer is an LLC treated as a partnership for U.S. federal income tax purposes, and previously obtained two properties in a like-kind exchange with a related party. Within two years of the like-kind exchange, the taxpayer will contribute one of the properties received to a partnership for an additional interest in that partnership. 

Section 1031, as modified by the Tax Cuts and Jobs Act (TCJA), provides non-recognition treatment for certain like-kind exchanges of real property. However, if the parties to the exchange are related under Sections 267(b) or 707(b)(1), and one disposes of the property it receives in within two years, then the parties may have to recognize gain or loss on the date of disposition. However, if it is established to the satisfaction of the IRS that neither the initial like-kind exchange nor the subsequent disposition had as one of its principal purposes the avoidance of U.S. federal income tax, then the subsequent disposition is disregarded in determining whether the party has disposed of the exchanged property within the two-year period.

The taxpayer in the PLR would not receive any cash or other consideration, other than a partnership interest, in connection with the contribution of the property to the partnership. Citing the legislative history, which indicates that the disposal of exchanged property through a non-recognition transaction will generally lack a principal purpose of tax avoidance, the IRS concluded that the contribution of the exchanged property to the partnership was disregarded in determining whether the taxpayer disposed of the exchanged property within two years of the initial like-kind exchange.

While the result may not be surprising, the ruling appears to be the first instance of the IRS identifying a contribution of property to a partnership under Section 721 as a disposition that could be subject to the related party exception of the like-kind exchange rules. 

The ruling also illustrates some of the potential collateral consequences where a purported tax-free contribution to a partnership under Section 721 is re-characterized at least partially as a disguised sale of property. Because a partnership contribution that is re-characterized as a disguised sale is treated as a sale for all purposes under the Code, in situations similar to those presented in the private letter ruling, the re-characterization could affect the treatment of not only the contribution, but also of the earlier like-kind exchange. Taxpayers that undergo a like-kind exchange of real property with a related party should be cautious as to the effect of a subsequent transfer of the replacement property within a two-year period.

Grace Kim
Principal, Partnerships
Washington National Tax Office 
T +1 202 521 1590 

Jose Carrasco
Senior Manager, Partnerships
Washington National Tax Office 
T +1 202 521 1552

Whit Cocanower
Senior Associate
Washington National Tax Office 
T +1 202 521 1541

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