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Improper Basis Shifting in a 1031 Transaction

Contrary to what some people believe, tax avoidance doesn’t normally constitute a crime. Tax fraud is a crime, as is tax evasion. But the avoidance of tax doesn’t necessarily constitute a criminal offense.  That is, provided that the person avoiding tax only takes steps that comply with both the letter and spirit of the law. After all, tax avoidance is one reason why our tax code provides for so many lawful credits and deductions. We allow them because we see them as legitimate ways to reduce one’s tax burden.  Accordingly, as long as substantiation of a claim is possible, they are permissible under the law. 

In determining whether to permit tax avoidance in a given situation, one key question is whether the transaction has independent economic justification. If a taxpayer takes steps lacking independent economic justification, that could be a violation of the spirit of the law. This type of behavior is often challenged in court under the so-called “step transaction doctrine” (or the “substance over form” doctrine).  Its application may result in collapse of the entire transaction. If a court successfully applies the step transaction doctrine to a series of steps, they may be discounted.  The result is that outcomes produced by those steps may be overturned. In its place, an entirely new outcome may be produced as a result.  

Related Party Basis Shifting

One interesting example of improper tax avoidance is the practice of “basis shifting” between related parties. The context in which this practice traditionally occurs is within related party Section 1031 transactions. In this post, we will cover the practice of basis shifting and discuss the implications of this practice for tax avoidance practices in general. As we will see, this type of practice serves as a good model for the sort of behavior which is typically frowned upon by our legal system.  

Section 1031 Related Party Rules 

As we’ve mentioned in a previous post, Section 1031 has special rules pertaining to so-called “related party” transactions. The reasoning behind them is straightforward.  Related party deals are much more likely to abuse the underlying purpose of Section 1031.  Accordingly, tax code sec. 1031(f)(1)(C) imposes an additional two year holding period on transactions involving related parties.  As a result, a sale to a related party requires the related party to hold the property for a minimum of two years.  Similarly, a purchase from a related party requires the taxpayer to hold the property for at least two years.

If the taxpayer, or related party, complies with the two year requirement, the foregoing transaction will be granted nonrecognition treatment. However, sec. 1031(f)(4) includes a special exception to this set of rules.  That is, any such transaction structured specifically to avoid the “purpose” of that subsection will result in a denial of nonrecognition treatment.  

In essence, then, subparagraph 1031(f)(4) codifies the established tax law position that tax avoidance must have independent economic substance. Anytime there are related parties involved merely to avoid income tax, nonrecognition is possible. Each factual scenario is unique, though.  Determinations are on a case-by-case basis.

Basis Shifting as Improper Tax Avoidance

One strategy which violates 1031(f)(4) is known as “basis shifting.” The mechanics of related party transactions and basis shifting can be described with a simple fact pattern.  A taxpayer holding investment or business property with a high cost basis finds a related party with property with a relatively low cost basis. The parties then complete a 1031 exchange in a “direct swap” transaction.

Direct swaps do not require a qualified intermediary.  In such a scenario, the taxpayer’s original cost basis will transfer directly to the replacement property.  The same is true with respect to the related party’s basis in their relinquished property. Then, after satisfying the holding requirement, the related party sells the relinquished property.  The related party thereby takes advantage of his or her relatively lower cost basis and corresponding relatively higher profits. The Taxpayer receives the higher profits, or at least a portion of them.  The relinquished property is either then managed on behalf of the taxpayer or eventually transferred back to the taxpayer.  

Basis Shifting Example

Let’s look at a concrete example to get a better sense of what’s going on. A taxpayer has a property which has appreciated.  It currently has a market value of $1 million, with a cost basis of $100,000. This taxpayer wishes to conduct an outright sale.  If that happens, though, the taxpayer would incur a significant liability because of the sizable gain. The taxpayer, therefore, finds a related party who has a much higher basis of, say, $950,000 on a property with a current market value of $1.1 million. The parties then conduct a direct swap exchange.

Based on the foregoing example, the related party receives a property with a market value of $1 million.  Meanwhile, the cost basis of $950,000 stays the same. The related party then ultimately sells the relinquished property and incurs a much, much, smaller liability from the sale. The two parties then distribute the profits between themselves.  Eventually, the related party reacquires the replacement property with a deed back.

This type of transaction may not run afoul of the requirements of Section 1031 on paper.  Clearly, though, it offends the underlying purposes of Code Section 1031. The sole purpose of the related party is to realize greater profits. The courts have now collapsed these types of transactions. “Basis shifting” is now a well-established violation of the related party rules. 

Get Section 1031 Help From a Tax Attorney in NYC

Here at Mackay, Caswell & Callahan, P.C., we pride ourselves on bringing little gems of knowledge such as these about basis shifting. Our well trained professionals spend a great deal of time poring over the tax code, including Sec. 1031, tax journals and other materials so that our readers and clients can enjoy these highly valuable pieces of information. Please reach out if you have questions.  We have offices in Albany, New York City, Rochester and Syracuse, so a nearby New York tax attorney is available to help. Call us today and a top New York tax attorney will respond to your case right away. 

Image credit: March Verch