When doing a 1031 exchange, it is important to be aware of the rules that can disqualify your exchange from receiving tax-deferred treatment. The rule this article examines is the step transaction doctrine. The step transaction doctrine can be used by courts to characterize a transaction that appears to be an exchange as a sale, and if a transaction is classified as a sale, it is ineligible for section 1031 treatment.
One of the benefits of working with a real estate management firm is that you rarely have to think too deeply about the law behind your 1031 exchange—much of that is taken care of for you by our experts. However, it is valuable for you and the entire investment community to have a basic grasp of this concept because it has the potential to bar non-recognition treatment under section 1031.
Step Transaction Doctrine Determines Purpose of 1031 Exchange
In essence, the step transaction doctrine was conceived to prevent the spirit of the law from being abused even if the letter of the law were being strictly observed. In certain instances, it is possible to act lawfully even though your actions clearly violate the stated or implied purposes of a law. This is the sort of thing the step transaction doctrine was designed to combat.
The step transaction doctrine is based on the idea that viewing a transaction in its entirety, rather than viewing its component parts in isolation, gives a better sense of its overall purpose and therefore gives a better idea of whether it conforms to the purpose of the law.
As one example, in the case of Commissioner v. Clark (1989), the Supreme Court rejected the IRS’s attempt to characterize boot exchanged in a stock-to-stock swap transaction as a dividend. If the boot had been classified as a dividend, it would have been taxable as ordinary income. The Supreme Court applied the step transaction doctrine and determined that characterizing the boot as a dividend would have severed it from its context and taken away its proper meaning. The IRS’s argument was struck down.
Ultimately, the step transaction doctrine is all about determining the true intent of a given transaction and creating equitable outcomes even when the law appears to have been superficially abided. As an honest investor, this should be comforting: This doctrine has been created to ensure that the true purpose of your actions receives the highest legal weight rather than any isolated piece of your behavior.
Examples of How the Rule Can Affect Tax Deferral
To avoid having the step transaction doctrine work against your favor, the best advice is to make sure that there is consistency between your thoughts and actions. Don’t take steps you wouldn’t normally take simply because you think you will receive the best tax treatment, because steps that appear artificial or out of place within a transaction will almost certainly raise eyebrows and cause your transaction to be scrutinized intensely. Let’s look at one example of how the step transaction doctrine has disallowed financial benefits to a taxpayer to get a better sense of its significance.
In the case of Kornfeld v. Commissioner (1998), the taxpayer structured a transaction in such a way as to receive an amortization deduction for a life estate interest in a bond. The bond was held through a revocable trust established solely by the taxpayer. The bond was purchased jointly with the taxpayer’s daughters and secretary, but the taxpayer made gifts to these other parties that amounted to precisely their respective interests in the asset.
To claim the deduction, the taxpayer needed to show that he had only a limited interest in the asset and that the involvement of his daughters and secretary was not motivated solely to produce favorable tax treatment. The court relied heavily on the step transaction doctrine and determined that the multiple steps of the transaction were better characterized as a single integrated whole and that, consequently, the taxpayer should not be entitled to the amortization deduction.
The Kornfeld case has a lot to offer investors involved with 1031 exchanges. In the Kornfeld case, the taxpayer thought that he had created an airtight strategy to obtain the amortization deduction because he did not foresee that his behavior surrounding the underlying transaction would be so heavily scrutinized.
This is exactly what you and other investors need to realize: Just because certain actions are seemingly disconnected from a given exchange does not mean that they can’t be considered by courts. If your actions before and during a 1031 exchange strongly suggest that what has taken place was actually a sale, then the IRS will be able to make a compelling case the step transaction doctrine demands that the transaction is classified as a sale.
Let’s use a quick hypothetical to show how this doctrine could impact your exchange. Suppose, for instance, that immediately after receiving your replacement real property, you transfer ownership of this property to a partnership entity. And also suppose that, prior to the exchange, you established this partnership entity with no apparent reason or motive. In this scenario, you would run the risk of triggering the application of the step transaction doctrine, and the end result could be disqualification of section 1031 because of the fact that partnership interests are not exchangeable under section 1031 in its current form.
CWS Capital Partners has experienced staff members who understand these kinds of minute details and who know how to use their expertise to help you steer clear of undesirable outcomes. If you want to begin a smooth, hassle-free exchange, reach out to us today.
The information provided here is for your general informational purposes only. It should not be considered a recommendation or personalized advisory advice. CWS has made this third party information available from authors it believes are knowledgeable and reliable resources. However, its accuracy or completeness cannot be guaranteed and sentiment may change due to legal or economic conditions.
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