Tax Court Rules on the Transfer of Benefits and Burdens of Ownership in Tax-Deferred Exchanges

In the recently decided case of Estate of George H. Bartell v. Commissioner, 147 T.C. No. 5 (August 10, 2016), the U.S. Tax Court held that the like-kind exchange engaged in by the taxpayer’s S corporation should be respected for Federal income tax purposes. In so holding, the Tax Court rejected the IRS’s contention that the benefits and burdens of ownership of the Replacement Property passed to the exchangor prior to its sale of the Relinquished Property.


The taxpayer in this case owned shares of Bartell Drug Co. (“BD”), which operated a chain of retail drugstores. BD owned certain real property, including Property E.  In 1999, BD negotiated a purchase of Property L. BD then proceeded to negotiate new borrowing facilities with KeyBank National Association, part of which was intended to be used to acquire Property L and construct a new retail drugstore on that property. On July 31, 2000, BD entered into an agreement with EPC Two, LLC (“EPC”), an entity set up by an unrelated third-party exchange facilitator to serve as an exchange intermediary in the transaction. In the agreement, BD identified the replacement property as Property L and the property to be relinquished as Property E. The agreement also assigned BD’s rights under its purchase agreement for Property L to EPC and required EPC to construct certain improvements on Property L as directed by BD.  

On August 1, 2000, EPC closed on the acquisition of Property L for a final purchase price of $1,878,640. EPC proceeded with construction of the improvements, with BD involved in, among other things, securing performance bonds and working with city authorities to grant all necessary easements. Upon completion of the construction on June 1, 2001, EPC and BD entered into a lease pursuant to which EPC leased Property L to BD for a period of 24 months.  

On September 21, 2001, BD entered into a sale agreement pursuant to which BD would sell Property E for $4,300,250. On December 17, 2001, BD entered into an agreement with a qualified intermediary (“SS”), pursuant to which BD would exchange Property E for Property L in a tax-deferred exchange under Section 1031 of the Internal Revenue Code (“Code”). In accordance with the agreement, SS sold Property E to a third-party buyer and used the funds therefrom to acquire Property L from EPC.

BD reported the above-described transactions as a tax-deferred exchange under Section 1031 of the Code. On audit, the IRS disallowed BD’s claimed deferral of gain under Section 1031 of the Code. Specifically, the IRS contended that BD owned Property L prior to the disposition of Property E because BD was enjoying the benefits and burdens of ownership of Property L (the ability to benefit from appreciation in the value of Property L, the risk of loss from any reduction in value, the liability to pay taxes attributable to the property, etc.).  

Generally, a taxpayer must recognize gain or loss from the sale of property.  However, under Section 1031, a taxpayer’s gain or loss is deferred if, rather than selling the property, the taxpayer exchanges it for property of a like kind. There are four general requirements for a tax-free exchange: (1) there must be a transfer of qualified real or personal property (the “Relinquished Property”); (2) the Relinquished Property must be held for investment or used in a trade or business; (3) the Relinquished Property must be of like kind with the property received in exchange (the “Replacement Property”); and (4) the transaction must be an exchange, as distinguished from a sale with a new purchase. A significant number of tax free exchanges are so called “deferred exchanges.” In a deferred exchange, the taxpayer causes the Replacement Property to be acquired by an intermediary and, after such acquisition, sells the Relinquished Property. Once the Relinquished Property is sold, title to the Replacement Property is transferred to the taxpayer. To qualify as a like-kind exchange, however, the Replacement Property must be acquired by an independent third-party; the exchanging taxpayer cannot own the Replacement Property until completion of the exchange.

At the outset, the Tax Court noted that the transfer of Property L occurred prior to the IRS’s publication of Revenue Procedure 2000-37, which sets forth certain requirements and prohibitions on such reverse exchanges. Accordingly, the Tax Court did not apply the provisions of Revenue Procedure 2000-37 to the facts in Bartell, but instead relied on general tax law principals. Specifically, both the Tax Court and the U.S. Court of Appeals for the Ninth Circuit previously rejected the concept “that a person who takes title to the replacement property for the purpose of effecting a Section 1031 exchange must assume the benefits and burdens of ownership in that property to satisfy the exchange requirement.” Bartell, at 92. The Tax Court noted that taxpayers engaging in these types of exchanges are permitted to negotiate contracts to acquire the Replacement Property, oversee improvements, and advance funds towards the purchase price of the Replacement Property. Accordingly, the Tax Court determined that, although the benefits and burdens associated with Property L may have passed to BD, the transaction was nonetheless a tax-deferred exchange under Section 1031. In so holding, the Tax Court put particular emphasis on the fact that BD had used a third-party exchange facilitator in conducting the transaction and that BD had not taken bare legal title to Property L prior to the sale of Property E.

Tax-deferred exchanges under Section 1031 of the Code are an excellent way to defer the payment of tax while at the same time diversifying one’s investments.  Bartell presents another fact pattern where the Tax Court, consistent with its prior holdings, has broadly interpreted the provisions of Section 1031. Taxpayers should be cautioned, however, that any current or future exchanges would be subject to Revenue Procedure 2000-37, which sets forth strict guidelines for reverse exchanges. Accordingly, taxpayers interested in pursuing a like-kind exchange should seek the assistance of counsel to ensure all requirements are satisfied.  

Opinions and conclusions in this post are solely those of the author unless otherwise indicated. The information contained in this blog is general in nature and is not offered and cannot be considered as legal advice for any particular situation. Any federal tax advice provided in this communication is not intended or written by the author to be used, and cannot be used by the recipient, for the purpose of avoiding penalties which may be imposed on the recipient by the IRS. Please contact the author if you would like to receive written advice in a format which complies with IRS rules and may be relied upon to avoid penalties.