An Analysis of the Oregon Department of Revenue v. Marks, Or Tax (2009)
Internal Revenue Code Section 1031(a)(1) provides that “[n]o gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanges solely for property of like-kind to be held either for use in a trade or business or for investment.” The requirement that both the property relinquished in a tax deferred exchange and the replacement property received be held for use in a trade or business or for investment, often referred to as the “holding requirement,” has been the subject of significant litigation between the IRS, state tax authorities and taxpayers over the years.
One area of significant litigation between taxpayers and tax authorities involves deferred exchanges in which a selling taxpayer changes the manner in which the relinquished property has been owned immediately before a sale, or changes the form of ownership of the replacement property soon after the exchange has been completed. To the extent that the change in the form of ownership is viewed by tax authorities as a transfer of the property to another person or legal entity, the exchanger may be treated as having not satisfied the holding requirement.
In a typical case, the exchanger is a partner in a partnership or a member in a limited liability company that owns investment property that would qualify for a tax deferred exchange under Section 1031(a), but the partner wants to engage in a 1031 exchange separate from the partnership. Alternatively, the exchanger may own investment property in fee or with others as tenant-in-common, but desires to contribute the replacement property to a limited liability company or partnership in which the exchanger would be a member or partner following the completion of the exchange. Unfortunately, the exchanger’s ownership interest in the investment property (either before the exchange or following its completion) is held in the form of a partnership interest or membership interest (treated as a partnership interest under federal tax law). In either such case, Internal Revenue Code Section 1031(a)(2)(D), a provision added in a 1984 amendment, specifically excludes partnership interests from among the classes of property eligible for tax deferral, whether the partnership interest is relinquished property or replacement property.
Given the foregoing constraints, an exchange client who is a partner in a partnership may ask: “so what if I take a distribution of a fractional interest in the relinquished property in liquidation of my partnership interest ahead of the sale and transfer my newly acquired interest in the investment property to the buyer as part of a standard delayed exchange?” This strategy is sometimes referred to as a “drop and swap.” Alternatively, an exchanger may complete a tax deferred exchange in a manner consistent with the taxpayer’s longstanding ownership structure and, following the exchange, contribute the replacement property to a partnership or distribute the replacement property to the partners as tenants-in-common. This strategy is sometimes referred to as a “swap and drop.” Either approach presents an issue under Section 1031 to the extent that the partnership and the partner or tenants-in-common, as the case may be, are considered different legal entities for purposes of federal income tax laws.
Regardless of the holding period issue associated with the “drop and swap” or “swap and drop” approaches, there are several Ninth Circuit cases that have permitted deferral despite a change in the form of ownership immediately before the exchange or after the completion of the exchange. A 2009 Order of the Oregon Tax Court in Dep’t of Revenue v. Marks, Or. Tax (Case No. TC 4797; http://www.ojd.state.or.us/tax/taxdocs.nsf/) illustrates that these favorable Ninth Circuit cases are still good law (at least in Oregon), provides a good analysis of the arguments in those cases as they relate to the holding requirement under Section 1031, and, perhaps most importantly, demonstrates that the controversy between taxpayers and tax collectors over the timing of changes in ownership prior to or following an a tax deferred exchange continue.
The exchangers in the Marks case were family members who owned several apartment houses in Oregon. Louis and Marie Marks, husband and wife, owned one apartment complex as tenants by the entirety. Louis’s mother and sister owned another complex as tenants in common. Commencing in 1999, both apartment properties were sold in separate tax deferred exchanges and the Marks family members acquired a third property in 2000 as replacement property to complete the exchange. Although the replacement property was initially received by the exchangers as tenants-in-common, the family members transferred the replacement property to a general partnership shortly after the exchange. In 2005, the Oregon Department of Revenue (“Department”) issued a notice of assessment for 2000 and subsequent tax years. The deficiency in 2000 resulted from the Department’s determination that both tax deferred exchanges failed to meet the holding requirement under Section 1031 and resulted in taxable sales.
The Marks family appealed the determination in the Magistrate Division of the Oregon Tax Court. The Magistrate Division ruled in favor of the taxpayers and the Division appealed the Magistrate’s decision. On appeal, the taxpayers filed a motion for partial summary judgment seeking an order confirming that the transfer of the replacement property did not violate Section 1031(a)’s holding requirement as a matter of law.
The principal case cited by the taxpayers, Magneson v. Commissioner, 753 F2d 1490 (9th Cir 1985), involved an exchange of a fee simple interest in real property for an interest as a tenant-in-common in other real property and, immediately afterwards, the property was contributed to a partnership in exchange for a partnership interest. Id. at 1492. The issue of “first impression” before the Ninth Circuit was “whether property acquired in a like-kind exchange with the intention of contributing it to a partnership under Internal Revenue Code § 721 is “held” for investment within the meaning of Internal Revenue Code § 1031(a).” Id. The Ninth Circuit found that the “crucial question in a section 1031(a) analysis [was] continuity of investment in like-kind property.” Id. at 1495-96.6 The economic situation of the taxpayers must be fundamentally the same as before to qualify for nonrecognition. Id. at 494. Applying the law as determined in Magneson to the facts, Judge Breithaupt concluded that taxpayer’s in Marks were entitled to a judgment in their favor provided that the purpose of the partnership was to continue to hold the replacement property for investment.
In response, the Department argued that Congress’ amendment of Section 1031(a) in 1984 to add subsection 1031(a)(2)(D) specifically excluding “any exchange of ‘interests in a partnership’” legislatively overturned Magneson. Reviewing the legislative history, Judge Breithaupt noted that:
“The aim of the 1984 amendment was to prohibit the exchange of one partnership interest for another. . . . section 1031(a)(2)(D) does not speak to exchanges for a partnership interest “for” property, but rather is limited to exchanges “of” interests in a partnership. The law at the time, as the House-Senate Conference Committee saw it, did not “state specifically whether an interest in one partnership may be exchanged for an interest in another partnership as a tax-free exchange of like-kind property.” HR Rep No 861, 98th Cong, 2d Sess, reprinted in 1984 USCCAN 1445, 1554 (Conf Rep). In the House Ways and Means Committee Report (the House Report), what “particularly concerned” the committee was the potential abuse of the IRC section 1031 provisions that could occur if the provisions were used “to facilitate the exchange of interests in [‘burned out’] tax shelter investments for interests in other partnerships.” HR Rep No 432, pt 2, 98th Cong Sess, reprinted in 1984 USCCAN 697, 897-98.” Marks, at p. 10.
Since the purpose of subsection 1031(a)(2)(D) was to prevent exchanges of partnership interests and did not address the question whether a property could be held for investment in a partnership (a matter that was addressed in Magneson), Judge Breithaupt concluded that the amendment did not implicate the Magneson decision.
Finally, the Department argued that changes to Oregon’s partnership law should change the result reached in Magneson. The rationale in support of the result in Magneson was based on a comparison of interests of tenants-in-common and the interests of partners in partnership property. Under the California law applied in Magneson, a partnership was not treated as an entity separate from its owners for non-tax purposes. Amendments to Oregon’s partnership law in 2000 made clear that “[a] partnership is an entity distinct from its partners” and “property owned by an Oregon general partnership in 2000 is property of the partnership and not of the partners individually.” (citing ORS 67.060).) Under these principals, the property was transferred to an entity separate from its owners thereby violating the holding requirement.
In rejecting the Department’s contention that Oregon non-tax law should control, Judge Breithaupt noted that the Magneson court’s analysis of interests of tenants-in-common and the interests of partners turned on the question of control and the purpose of the partnership: “[O]f paramount importance is not so much the details of the state law rights as between co-tenants and partners, but rather whether there is continuity of investment as opposed to a “cashing out” and the purpose of any partnership to which property received in an exchange is contributed. See Magneson at 1496.
The Department made two other related arguments: (i) that the substance of the exchange was a transfer of an interest in real property for a partnership interest such that the form of the exchange should be disregarded (a “substance over form” argument) and (ii) that the court should apply the step transaction doctrine to ignore the receipt of replacement property as tenant-in-common (the “step transaction doctrine”). Both legal doctrines may be applied by courts in tax controversy cases in which a taxpayer has engaged in a series of transactions to reach a result that avoids tax at any intermediate step but which would produce a tax if certain intermediate steps where removed. In this case, however, the court found no policy reason that would justify reformulating the exchange as an exchange of real property for a partnership interest.
“in this case, . . . the steps and substance of what . . . [occurred] are . . , each permitted. The point of Magneson is that taxpayers may engage in IRC section 1031 transactions and then, pursuant to a pre-existing plan or intent, contribute replacement property to a partnership. What taxpayers did they are permitted to do. The department is not authorized or permitted to rearrange facts to produce a different transaction.” [Citation]
Since the limitation on the exchange of a partnership interest in Section 1031(a)(2)(D) did not implicate the holding requirement under Section 1031(a), changes in state law regarding the partnership as a separate legal entity did not, in the opinion of Marks court, contradict the logic of Magneson and the court granted the motion for summary judgment in part, but remanded the case for further factual development on the question whether the partnership was formed for the purpose of continuing to hold the property for investment.
Despite the reasoning of the court in Magneson, there are a variety of reasons that taxpayers should continue to exercise caution when changing the form of ownership immediately before or after a tax deferred exchange. First and foremost, the taxpayer favorable decision in the Marks case is binding only in Oregon for purposes on state income tax. The IRS or a federal Tax Court in Oregon could reach a contrary decision despite the state tax court’s decision. Second, there are conflicting cases in other jurisdictions in which courts have reached a contrary result on similar facts.
For example, in True v U.S., 190 F3rd 1165 (1999), the Court of Appeal for the 10th Circuit applied the step transaction doctrine to a case in which the taxpayer took title to the replacement property as tenants-in-common and thereafter transferred the replacement property to a partnership. In so holding, the court determined that the taxpayers received the replacement property as an agent for the partnership, so the taxpayer’s momentary receipt of replacement property was ignored and the exchange failed.
Despite the reasoning in Marks, a tax authority might conclude that changes in state law regarding the legal nature of a partnership as an entity separate from the partners would amount to more than a mere change in the form of ownership as discussed in Magneson. The state partnership law applied in Magneson assumed that the partnership was a mere aggregation of ownership interests of the individual partners. By extension, a transfer to an entity other than a state law general partnership, such as a limited partnership or limited liability company, would provide additional problems under the rational in Magneson. The rights and liabilities of the investors in those entities may be more limited than those of a partner in a general partnership.
Finally, a court might not agree that Section 1031(a)(2)(D)’s exclusion of partnership interests from property that may be exchanged under Section 1031 is as narrow as the Marks court concluded. In Marks, the court reviewed the legislative history surrounding the adoption of Section 1031(a)(2)(D) and concluded that Congress was concerned with the exchange of partnership interests as a means to exit burned out tax shelter partnerships. As such, the court determined that the limitation on the exchange of partnership interests should be limited to “exchanges of partnership interests” rather than a conversion of a direct ownership interest in property to a partnership interest in the same property following an exchange. Although the reasoning of the Marks court is compelling (at least in this author’s view), there is certainly no guarantee that a court in another jurisdiction would agree.
In the end, there is still substantial risk that the IRS or a state tax authority will challenge a “drop and swap” or “swap and drop” scenario along the lines discussed in the Marks case. Where a party anticipates a change in the form of ownership before or after the completion of a tax deferred exchange, there is no substitute for careful advanced planning. Given enough time and careful planning, most or all of the pitfalls of a change in the form of ownership illustrated in the Marks case can be avoided. The trouble is, too often there is little or no tax planning until just before or after the initiation of a tax deferred exchange.