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Tax Court Grants Drug Store Significant Latitude in Structuring 1031 Exchange

(Parker Tax Publishing August 2016)

The Tax Court held that a drugstore's exchange of properties through the use of a third-party facilitator qualified as a like-kind exchange under Code Sec. 1031. The court noted that under existing case law principles, the fact that the taxpayer, and not the facilitator, had the benefits and burdens of ownership of the property did not preclude nonrecognition treatment for the exchange. Est. of Bartell, Jr. v. Comm'r, 147 T.C. No. 5 (2016).


Bartell Drug Co., an S corporation, owned and operated a chain of retail drugstores in Seattle and surrounding areas for more than 100 years. Ownership of the company remained in the Bartell family since its founding in 1890.

In 1999, Bartell Drug entered into a sales agreement to purchase property in Lynnwood, Washington, located across the street from its existing store in that area. In contemplation of structuring and financing the sale transaction, Bartell Drug approached Section 1031 Services, a corporation that provided qualified intermediary services to taxpayers, and expressed interested in employing a Code Sec. 1031 exchange in connection with the Lynnwood property. In March of 2000, the companies agreed that EPC Two, LLC (EPC), a single purpose disregarded entity formed for the exclusive purpose of providing services to Bartell Drug, would serve as the exchange intermediary and would take title to the Lynnwood property.

Bartell Drug assigned its rights in the Lynnwood property sales agreement to EPC, and ECP acquired title to the Lynwood property in August 2000, using bank financing guaranteed by Bartell Drug. The two companies then entered into an agreement under which Bartell Drug would manage construction of a new drugstore that, once complete, EPC was required to lease to Bartell Drug. In addition, EPC had no responsibility to be involved in the construction, and was required to disburse funds from the financing to cover construction costs.

Also in August, Bartell Drug acquired a retail drugstore in Everett, Washington, intending to use that property to facilitate the Code Sec. 1031 exchange. In September 2001, the company entered into an agreement to sell the Everett property to William and Theresa Eng.

In December 2001, Bartell Drug as "Exchangor" and Section 1031 Services as "Intermediary" executed an agreement for the exchange of relinquished property, identified as the Everett property, for replacement property, identified as the Lynnwood property, in a transaction intended to qualify for tax deferred treatment under Code Sec. 1031. Under the exchange agreement, the sales agreement with the Engs and Bartell Drug's rights under its agreement with ECP were assigned to Section 1031 Services, which then transferred the relinquished property to the Engs, acquired the replacement property from EPC, and transferred the replacement property to Bartell Drug.

On its Form 1120S for 2001, Bartell Drug included Form 8824, Like-Kind Exchanges, addressing the transfers of the Everett and Lynnwood properties. The fair market value of the property received was shown as $4,134,592 and the basis of the property given up as $1,329,729, for a deferred gain of $2,804,863. In 2004, the IRS audited this return, and disallowed the tax deferral treatment under Code Sec. 1031 for the like-kind exchange. Accordingly, the IRS determined that Bartell Drug's shareholders, George H. Bartell, Jr., and his two children George D. Bartell and Jean Barber (collectively, "the taxpayers"), had deficiencies in their income related to the transaction.

Nonrecognition Treatment for Like Kind Exchanges

Under Code Sec. 1031(a), no gain or loss is recognized on the exchange of property held for the productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment (a "like-kind exchange"). Reg. Sec. 1.1031(a)-1(b) provides that the term "like kind" refers to the nature or character of the property and not to its grade or quality. Thus, the fact that any real estate involved is improved or unimproved is not material, because that fact relates only to the grade or quality of the property and not to its kind or class. The gain realized in the exchange does not escape tax, but is merely deferred until the replacement property is sold.

Originally, Code Sec. 1031 was enacted to cover simultaneous exchanges between two parties. Following case law that found broader reach, the IRS issued regulations in 1991 to facilitate "forward" exchanges, where the taxpayer receives replacement property after the date the relinquished property is transferred. The regulations expressly declined to address whether "reverse" like-kind exchanges (i.e., where the taxpayer receives replacement property before the date of the transfer of relinquished property) qualified for nonrecognition treatment under the like-kind exchange rules.

Administrative guidance on reverse like-kind exchanges was not issued until October 2000, when the IRS issued Rev. Proc. 2000-37. That revenue procedure provides a safe-harbor under which the IRS will not challenge the qualification of property as either replacement property or relinquished property for purposes of Code Sec. 1031, or the treatment of the "exchange accommodation titleholder" (i.e. a person other than the taxpayer who holds legal title to, or other indicia of ownership of, the property to be exchanged) as the beneficial owner of the property for tax purposes if the property is held in a qualifying exchange accommodation arrangement. The revenue procedure is effective for exchanges on or after September 15, 2000.

Observation: The taxpayers in the instant case were unable to avail themselves of this safe-harbor because the exchange facilitator, EPC, acquired title to the relevant property prior to the effective date of the revenue procedure.

IRS and Taxpayers' Arguments

Before the Tax Court, the IRS argued that a benefits and burdens test (e.g., the capacity to benefit from any appreciation in the property's value, the risk of loss from any diminution in its value, and the other burdens of ownership such as taxes and liabilities arising from the property) should be applied in the context of a claim of Code Sec. 1031 treatment to determine who owns the replacement property. The IRS argued that EPC did not possess any of the benefits and burdens of ownership because it had no equity interest in the property and made no economic outlay to acquire it. Thus, the IRS argued, Bartell Drug was the true owner of the property and nonrecognition treatment under Code Sec. 1031 was not applicable.

The taxpayers argued that EPC was required to be treated as the owner of the Lynnwood for purposes of Code Sec. 1031, noting that the Ninth Circuit (to which an appeal of the instant case would ordinarily lie) in Alderson v. Comm'r, 317 F.2d 790 (9th Cir. 1963), expressly rejected the proposition that a person who takes title to the replacement property for the purpose of effecting a Code Sec. 1031 exchange must assume the benefits and burdens of ownership in that property to satisfy the exchange requirement under Code Sec. 1031.

Tax Court's Opinion

The Tax Court agreed with the taxpayers and held that the transaction qualified as a Code Sec. 1031 exchange. The court noted that it has followed Alderson in according Code Sec. 1031 treatment in a variety of transactions where the taxpayers used a third-party exchange facilitator, who was contractually insulated from any beneficial ownership of the replacement property, to take title to the replacement property in order to effect a Code Sec. 1031 exchange. The Tax Court noted that courts have permitted taxpayers great latitude in structuring Code Sec. 1031 exchange transactions; taxpayers can locate suitable property to be received in exchange, can enter into negotiations for the acquisition of such property, can oversee improvements on the land to be acquired, and can even advance money toward the purchase price of the property to be acquired by exchange. Provided the final result is an exchange of property for other property of a like kind, court stated that the transaction will qualify under Code Sec. 1031.

The court noted that in Biggs v. Comm'r, 69 T.C. 905 (1978), a case similar to the one at issue, it found the taxpayer was permitted to advance the funds for the purchase of the replacement property, where title was transferred from the seller to a third-party exchange facilitator and held by it until the exchange was completed. The court distinguished the instant case from its more recent decision in DeCleene v. Comm'r, 115 T.C. 457 (2000), in which it used a benefits and burdens analysis to hold that the taxpayer had beneficial ownership of the replacement property at the time of the exchange, even though he had arranged for the transfer of legal title to the replacement property to the purchaser of his relinquished property. The Tax Court noted that in reaching its decision in that case, it put considerable emphasis on the taxpayer's failure to use a third-party exchange facilitator.

The Tax Court held that Alderson and Biggs establish that where, as in the instant case, a Code Sec. 1031 exchange is contemplated from the outset and a third-party exchange facilitator, rather than the taxpayer, takes title to the replacement property before the exchange, the exchange facilitator need not assume the benefits and burdens of ownership of the replacement property in order to be treated as its owner for Code Sec. 1031 purposes before the exchange. Accordingly, the court held that under existing case law principles, Bartell Drug's disposition of the Everett property and acquisition of the Lynnwood property in 2001 qualified for nonrecognition treatment pursuant to Code Sec. 1031.

For a discussion of reverse like-kind exchanges, see Parker Tax ¶113,150.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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