In Ocmulgee Fields, Inc. v. Commissioner (132 T.C. No. 6, March 31, 2009), the U.S. Tax Court held that the Taxpayer failed to prove that the avoidance of federal income tax was not a principal purpose of the exchange. Additionally, the court held the exchange of properties, facilitated by a qualified intermediary, was structured specifically to avoid the related party rules under IRC Section 1031(f).
 
The Taxpayer, Ocmulgee Fields, Inc., owned and developed real estate in middle Georgia. In 1996, Taxpayer sold three parcels of real property it owned in Macon, Georgia to a related party known as Treaty Fields, L.L.C., so that the related party could develop the property.
 
On October 10, 2003, Taxpayer sold relinquished property in a transaction designed to qualify for non-recognition of gain under IRC Section 1031.  On October 15, 2003, Taxpayer entered into a purchase agreement to re-acquire, as replacement property, the developed real estate in Macon, Georgia that was owned by Treaty Fields, L.L.C.  Then, on November 3, 2003, Treaty Fields, L.L.C. transferred the Macon property, to Taxpayer's qualified intermediary, which in turn transferred the property to Taxpayer.
 
Prior to closing on the sale of the relinquished property, Taxpayer consulted with its CPA, real estate lawyer and two real estate brokers in an attempt to locate suitable replacement property. Taxpayer represented that its intent was to acquire replacement property from an unrelated party and that it had reviewed and rejected at least six possible replacement properties presented by the two real estate brokers.
 
As the relinquished property closing date drew nearer, and no viable replacement property option emerged, Taxpayer considered re-acquiring the Macon property owned by Treaty Fields, L.L.C. as its replacement property.  Taxpayer argued the acquisition was made for valid business purposes and was consummated despite the advice from Taxpayer's CPA that the acquisition would result in higher taxes.  Taxpayer contended that these factors prove it lacked the intent to structure the transaction in a manner to avoid the related party rules.
 
The IRS disagreed and compared the facts here to Teruya Bros., Ltd. & Subs. v. Commissioner (124 T.C. 45 February 9, 2005) where the court found that the qualified intermediary was used specifically in an attempt to circumvent the rules limiting exchanges between related parties.
 
In Teruya, the taxpayer effectuated two separate simultaneous exchanges.  In both transactions, the Taxpayer acquired replacement property from a related party and made no representation that any other replacement property was ever considered. Indeed, the exchange agreement Teruya signed with its qualified intermediary provided that in the event the Taxpayer was unable to locate suitable replacement property by the time the relinquished property was scheduled to close, then the exchange agreement and the relinquished property sale would be terminated. 
 
The court deemed the transaction the economic equivalent of a direct exchange between the related parties followed by an immediate disposition of the relinquished property by the related party, resulting in "cashing out".  Further, the court concluded that interposing a qualified intermediary could not otherwise conceal this result.
 
While Ocmulgee's facts were slightly different - Taxpayer did consider other replacement property and the exchange was a delayed exchange so (presumably) the qualified intermediary's role was essential - the court was not convinced that tax avoidance was not a principal purpose of the transaction.
 
The court did state that the finding of basis shifting among related parties and a subsequent cashing out did not, as a matter of law, preclude a Taxpayer from successfully arguing that tax avoidance was not a principal purpose of the transaction. In this case, however, that argument did not prevail.
 
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