Taxpayer Loses Related-Party 1031 Exchange Case Involving Heavy Equipment

Posted by Todd Keator  On Monday, the Eighth Circuit Court of Appeals issued its decision in North Central Rental & Leasing, LLC vs. U.S., holding that North Central Rental & Leasing, LLC (“Taxpayer”) had improperly excluded gain in a purported like kind exchange under Section 1031 of the Internal Revenue Code.  The Eighth Circuit rejected Taxpayer’s argument that Section 1031(f) did not apply to the transaction at hand.  A copy of the opinion is available here. BackgroundTaxpayer was engaged in the business of leasing heavy equipment.  As part of its business, Taxpayer routinely sold used equipment and directed the sales proceeds to a “qualified intermediary” (“QI”) account pursuant to a like kind exchange program.  To complete its exchanges, Taxpayer’s parent entity, Butler Machinery Company (“Parent”), which owned a 99% interest in Taxpayer, would purchase new equipment from Caterpillar and then would resell the equipment to Taxpayer, with the purchase price paid to Parent from the QI account.  The reason for this structure was because Parent was able to take advantage of six month interest-free financing from Caterpillar, whereas Taxpayer was ineligible for these favorable terms.  Thus, to get the favorable financing, Parent had to purchase from Caterpillar, meaning Parent also had to resell to Taxpayer. District Court DecisionPredictably, the District Court held that Section 1031(f) – which applies to 1031 exchanges conducted between related parties – applied because Taxpayer sold low basis property and acquired high basis property from Parent, which clearly was a related party.  Because Parent cashed-out in the transaction, Taxpayer’s purported 1031 exchange failed.  The district court relied heavily on Teruya Brothers and Ocmulgee Fields for its conclusion. Eighth Circuit DecisionThe Eighth Circuit affirmed and held that Taxpayer structured the transaction with Parent in order to avoid the purposes of Section 1031(f).  This was due to the six month interest free cash that Parent received as a result of the complex transaction structure.  According to the Eighth Circuit, “we simply cannot ignore the significant and continuous financial benefits Butler Machinery derived from these hundreds of de facto interest-free loans.” CommentaryThis is a classic case where business and tax interests were at odds.  If Parent bought the equipment, Parent received interest-free financing from Caterpillar for six months.  However, because Parent bought the equipment, Parent also had to resell it to Taxpayer, which created a Section 1031(f) problem.  Going forward, Taxpayer would need to buy directly from Caterpillar to overcome the Section 1031(f) problem.  However, by doing so, Taxpayer and Parent presumably would no longer receive the interest-free financing from Caterpillar, unless they could convince Caterpillar to also offer the favorable financing terms to Taxpayer.  Presumably, the Section 1031 deferral is the more valuable benefit.   Although Taxpayer lost this decision, it is important to remember that related parties clearly are allowed to undertake Section 1031 exchanges with each other.  To do so, they must comply with the complexities of Section 1031(f), which generally requires that both related parties to the exchange remain invested in their respective replacement properties for at least two years following the exchange (subject to certain exceptions) and that the parties not structure transactions to avoid the purposes of Section 1031(f).  With awareness of the nuances of Section 1031(f) and proper planning, related party exchanges may indeed be accomplished.  The key problem in North Central Rental & Leasing was the fact that Parent received cash in the transaction, which was an obvious violation of Section 1031(f).  The parties clearly undertook the chosen structure to gain the incremental financial benefit from the Caterpillar interest-free financing, thus illustrating the time-honored principle that “pigs get fat and hogs get slaughtered.” If you have any questions about this case, related-party 1031 exchanges or related issues involving 1031 exchanges in general, please contact Todd D. Keator at Thompson & Knight.