Mixing-Bowl Transactions and Like-Kind Exchanges

index Mixing Bowl Transactions and Like Kind ExchangesA recently published article in the Tax Management Real Estate Journal has provided an interesting interpretation of the IRS and Treasury Department's regulations concerning partnership tax law “abuse.” The regulations in question, §§704(c)(1)(B) and 737, are particularly relevant in the context of §1031 like-kind property exchanges, which have grown to be an important part of the commercial real estate industry. The relevance–and arguably, the biggest reason for recent commentary–is based more on the exceptions than the rules themselves. The rules, for example, were meant to close transactional loopholes that allowed otherwise taxable events (at least outside a partnership) to be treated tax-free.

Before explaining the details of the rule, however, it may be useful to describe the mechanics of a mixing-bowl transaction. Professors Laura E. Cunningham and Noel B. Cunningham offer this useful description:

There were two basic types of mixing bowl transactions. The first was a contribution of appreciated property to a partnership, followed by a distribution of that property to a different partner. As a result, the contributor was essentially permitted to exchange the contributed property for an undivided interest in the partnership's other assets, without recognition of gain. The second variation involved a contribution of appreciated property, followed . . . by a distribution to the contributor of different property. Again, the contributor was permitted to exchange her appreciated property for different property without recognition of gain.

 

Under both scenarios, it is easy to understand the appeal (see here for a numerical example). Partners can freely assign and distribute property between partners, and with different bases, without fear of a recognized gain. And that's the general appeal of a partnership, right? Distributions from a partnership to a partner are typically tax-free (though there are some limitations). From a tax collection standpoint, however, there's potential revenue left on the table. For that reason–well maybe the rules were intended to end partnership tax abuse–”Congress enacted the complex anti-abuse rules found in §§704(c)(1)(B) and 737.” Importantly though, Congress seemingly acknowledge the benefits of 1031 exchanges when it carved out specific nonrecognition transactions.

But are the rules explicit enough to truly support an incorporation of §1031 basis rules into §704(c)(2)? I tend to disagree with the authors' view that “a careful reading reveals that the reference to §1031 has limited significance.” While they are correct to point out that the regulation does not “adopt the §1031 requirement that the transferred property and the acquired property be held for productive use in a trade or business or for investment.” And correct that it fails to explicitly mention other requirements found under the language of §1031. Their conclusion seems to be labored. For example, accepting their conclusion would render the the mention of §1031 under the rule completely meaningless and Section 704(c)(2)(B) superfluous. What would be the benefit of such an interpretation? It's hard to say, and the authors do little to address the question. What do you think?

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