Chief Counsel Corner August 2020 Tax News

1031 transactions: The importance of determining which party conducted the sale

Jozel Brunett, Taxpayers' Rights Advocate.

Jozel Brunett
Chief Counsel

In the nonprecedential Appeal of Sharon Mitchell decision,[1] the Office of Tax Appeals (OTA) applied several longstanding tax principles to a unique set of facts concerning the disposition of property. The OTA determined the taxpayer, with the assistance of her partnership's managing partner, in the capacity as the taxpayer's agent, effected a qualifying exchange of property under Internal Revenue Code (IRC) section 1031,[2] as incorporated into California tax law. The OTA's panel of judges engaged in the same inquiry as the courts in Commissioner v. Court Holding Co.,[3] Bolker v. Commissioner,[4] and Chase v. Commissioner,[5] to determine the fundamental question of who negotiated and controlled the sale of property. The Tax Court's opinion in Bolker, supra, begins: "The first question we must consider is who made the exchange… [t]his question is one of fact."[6] The Appeal of Mitchell decision's dependence on its particular facts does not negate the application of standard legal doctrines to future factual inquiries.

Courts have long engaged in the review of which party actually participated in the transaction to secure a tax benefit, or which person should realize and recognize income.  For example, there are a number of decisions which address this inquiry. California taxpayers continue to have a published Board of Equalization decision[7] to serve as guidance in a 1031 exchange, where the statute's criteria were reviewed. Taxpayers can also look to the persuasive federal decision in Chase, supra, which dealt with who effected the sale of California real property in a disallowed 1031 exchange. Doctrines such as substance over form, and the assignment of income, where income must be realized by the person who earned it,[8] are not limited to 1031 exchanges, and remain viable arguments in a variety of transactions to ensure proper tax reporting by all California taxpayers. A 1031 exchange requires the same person to relinquish and receive like-kind property. In order to determine the person who must satisfy all the criteria of IRC section 1031, as considered in Chase, supra, proper attribution of any realized income must reflect the reality of the sale.

Tax practitioners have recently attempted to cite the nonprecedential decision in Appeal of Sharon Mitchell in response to Franchise Tax Board (FTB) audit inquiries regarding whether the required elements of a 1031 exchange were satisfied, including ensuring the party negotiating the disposition of its relinquished property obtained replacement property. Courts have long distinguished between civil law formalities such as deed preparation, and the tax effects resulting from a transaction, as confirmed by the statement: "The labels, semantic technicalities, and formal written documents do not necessarily control the tax consequences of a given transaction. Rather, we are concerned with economic realities and not the form employed by the parties."[9]

In fact, in the Appeal of Sharon Mitchell, the decision undertook the required inquiry of determining which party engaged in a series of required acts, as opposed to precluding such an inquiry. The OTA panel determined the partnership's managing partner, as agent for the taxpayer, negotiated the independent sale of property by the taxpayer, allowing the taxpayer to complete the exchange with the use of a qualified intermediary. The result in this particular appeal affirms an adjudicatory body's duty to examine the objective economic realities of a transaction, rather than rely on the satisfaction of the technical requirements for the passage of title under state law.[10]

FTB continues to apply the longstanding rule "the incidence of taxation depends upon the substance of a transaction," and will determine whether or not a person was used as a conduit to effect a sale by other parties. Taxpayers continue to have the opportunity to establish independence in sales negotiations, including the sales terms, timing of the sale, price, and other conditions, to establish whether they, or some other person or entity, was the true seller of property, whether in a reported 1031 exchange, or some other transaction.[11]

[1] 2018 – OTA – 210, nonprecedential; 2020 – OTA – 001, nonprecedential Opinion on Petition For Rehearing.

[2] Referred to herein as a "1031 exchange."

[3] Commissioner v. Court Holding Co. (1945) 324 U.S. 331.

[4] The Tax Court analyzed the facts as to whether Mr. Bolker negotiated the sale of the relinquished property for his own behalf, or on behalf of his corporation. Bolker v. Commissioner (9th Cir. 1985) 760 F.2d 1039 affg. (1983) 81 T.C. 782.

[5] Chase v. Commissioner (1989) 92 T.C. 874.

[6] Bolker, supra, 81 T.C. 782, 794.

[7] Appeals of Brookfield Manor, Inc., et. al, 89-SBE-002, decided January 11, 1989.

[8] Commissioner v. Culbertson (1940) 337 U.S. 733,739-40.

[9] Houchins v. Commissioner (1982) 79 T.C. 570, 589, citing Frank Lyon Co. v. United States, 435 U.S. 561 (1978); Estate of Franklin v. Commissioner, 64 T.C. 752 (1975), aff'd. on other grounds 544 F.2d 1045 (9th Cir. 1976).

[10] Gaggero v. Commissioner, T.C. Memo. 2012-331 (citing Frank Lyon Co. v. United States (1978) 435 U.S. 561, 573.

[11]Salvatore v. Commissioner (1970) 29 T.C.M. 89, T.C. Memo 1970-30.