Related Party Messes Up a 1031 Exchange

Published on: 17:28PM Jan 02, 2014

In the North Central Rental & Leasing, LLC v. US decision out of North Dakota just released this week (the cite is AFTR 2d 2013-7045 (I do not have a link to the actual case on a free site yet)), the Court found that the taxpayer's use of related parties to help accomplish a Section 1031 exchange was too much of a good thing and required all gains to be recognized as income. The sad part is if the taxpayer had simply not used the related party, the Section 1031 exchange would have been allowed.

North Central Rental & Leasing, LLC (North Central) was formed by Butler Machinery Company (Butler), a Caterpillar dealer located in North Dakota to operate their equipment rental activities. Before the formation, all of the rentals were done by Butler Machinery. It appears that Caterpillar in conjunction with Price Waterhouse Coopers had recommended a structure whereby the subsidiary would own the rental equipment (which is depreciated while being rented) and whenever a sale of equipment occurred, North Central would transfer the equipment to a Qualified Intermediary (QI), who would then sell the equipment to an unrelated third-party.

Within 180 days of the sale (usually much quicker), Butler would then purchase equipment from Caterpillar and sell it to the QI which would then transfer the equipment to North Central. Since Butler was a related party to North Central, under the related party rules of Section 1031, these transactions did not qualify for 1031 deferral treatment. Since over the time period involved in the audit, there were 398 like-kind exchanges with large six-figure gains on each sale, you can envision how much gain was involved.

However, if North Central had simply had the QI purchase the equipment directly from Caterpillar, most likely, the Section 1031 deferred gain treatment would have been allowed. By simply putting Butler between North Central and Caterpillar, it messed it up. Now you may ask why Butler got involved. Caterpillar offered a six months same as cash terms for Butler to purchase the equipment. Therefore, they could have up to six months free use of the cash from the sale of the equipment by North Central and that appears to be the only primary reason why Butler got involved.

Therefore, the bottom line is that the free use of money for six months (worth about 5% at the most), caused all of the deferred gain to be taxed at most likely 40% plus since most it not all of these gains were not capital gain (depreciation recapture).

Anytime you have a Section 1031 exchange and if any related party is involved in the exchange (whether purchasing or selling), you must discuss it with a qualified tax advisor. There have been way too many cases where the related party invalidates the exchange. Don't let it happen to you!