Magneson v. Comm'r of Internal Revenue

• Citation: 81 T.C. 767,81 T.C. No. 47
• Decision Date: 20 October 1983
• Docket Number: Docket No. 28473–81.
• Parties: NORMAN J. MAGNESON and BEVERLY G. MAGNESON, Petitioners v. COMMISSIONER OF INTERNAL REVENUE, Respondent
• Court: U.S. Tax Court

81 T.C. 767

81 T.C. No. 47

NORMAN J. MAGNESON and BEVERLY G. MAGNESON, Petitioners

v.COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 28473–81.

United States Tax Court

Filed October 20, 1983.

Petitioners exchanged their fee simple interest in I real property for an undivided 10-percent interest in P real property which they immediately contributed to a partnership for a general partnership interest. P and I are properties of like kind. Held: The exchange of I for P qualifies for nonrecognition of gain under sec. 1031(a), I.R.C. 1954, because petitioners held P for productive use in trade or business or for investment. Thomas W. Bettles, for the petitioners.

Kevin M. Bagley, for the respondent.

OPINION

GOFFE, Judge:

The Commissioner determined a deficiency in petitioners' Federal income tax for the taxable year 1977 in the amount of $19,563. The sole issue for decision is whether the exchange of petitioners' fee simple interest in real property for a 10-percent undivided interest in other real property followed immediately by contribution of the 10-percent interest to a partnership for a 10-percent interest therein qualifies for nonrecognition treatment under section 1031(a).¹

This case was submitted fully stipulated pursuant to Rule 122 of the Court's Rules of Practice and Procedure. The facts and exhibits are incorporated herein by this reference.

Petitioners, husband and wife, resided in San Diego, California, when they filed their petition in this case.

Prior to August 11, 1977, petitioners were the sole owners of a fee simple interest in real property and an apartment building located at 4060 Iowa Street, San Diego, California (Iowa Street Property), which was held by them at all times for productive use in trade or business or for investment within the meaning of section 1031(a).

Prior to August 11, 1977, N.E.R. Plaza, Limited (N.E.R.), a limited partnership under California law, was the owner of commercial property located at 2251 San Diego Avenue, San Diego, California, known as the Plaza Property (Plaza Property) which the partnership was organized to acquire, own, maintain and operate.

Pursuant to a prearranged transaction consummated on August 11, 1977, petitioners transferred their fee interest in Iowa Street Property to N.E.R. solely in exchange for a 10-percent undivided interest in Plaza Property. Thereafter, on the same day, they contributed cash and their undivided interest in Plaza Property to U.S. Trust Limited (U.S. Trust) for a general partnership interest consisting of a 10-percent capital (equity ownership) interest and a 9-percent interest in net profits and losses. U.S. Trust was a limited partnership under California law. The remaining 90-percent undivided interest in Plaza Property was acquired by U.S. Trust on the same day. It is undisputed that the contribution of petitioners' interest in Plaza Property and cash to U.S. Trust for their general partnership interest is nontaxable under the provisions of section 721.

It is agreed by the parties that petitioners' interests in Iowa Street Property and Plaza Property are properties of a like kind within the meaning of section 1031(a).

The Commissioner determined that the exchange of Iowa Street Property for Plaza Property did not qualify for nonrecognition under section 1031(a) because petitioners did not hold Plaza Property for productive use in trade or business or for investment as required by section 1031(a). The distinction between “trade or business” and “investment” is immaterial for our purposes, so for convenience, we will use the term “held for investment.” Sec. 1.1031(a)-1, Income Tax Regs.

We have previously decided that if a taxpayer holds the property received in a “like-kind” exchange for sale, the taxpayer does not hold the property for investment and, therefore, is not entitled to the benefits of nonrecognition under section 1031(a). Regals Realty Co. v. Commissioner, 43 B.T.A. 194 (1940), affd. 127 F.2d 931 (2d Cir. 1942). We have also decided that if a taxpayer holds the property received in a like-kind exchange for the purpose of making gifts, the taxpayer is deemed not to hold it for investment and, thus, is not entitled to nonrecognition treatment under section 1031(a). Click v. Commissioner, 78 T.C. 225 (1982). On the other hand, we have decided that if a taxpayer holds the property for investment, even though he contemplates eventually passing it to his children, his holding under such circumstances is acceptable within the requirement of section 1031(a). Wagensen v. Commissioner, 74 T.C. 653 (1980).

Petitioners did not hold Plaza Property for sale, personal use, or for transfer as a gift. Rather, petitioners held Plaza Property for making a nontaxable contribution of it to U.S. Trust; hence, we must decide whether such “holding” qualifies for holding as an investment.

Section 1.1000–1, Income Tax Regs., provides that gain or loss realized from the exchange of property differing materially either in kind or in extent is treated as income or as loss sustained.

Section 1.1002–1, Income Tax Regs.,² provides as follows:

Section 1.1002–1. Sales or exchanges.

(a) General rule. The general rule with respect to gain or lose realized upon the sale or exchange of property as determined under section 1001 is that the entire amount of such gain or loss is recognized except in cases where specific provisions of subtitle A of the Code provide otherwise.

(b) Strict construction of exceptions from general rule. The exceptions from the general rule requiring the recognition of all gains and losses, like other exceptions from a rule of taxation of general and uniform application, are strictly construed and do not extend either beyond the words or the underlying assumptions and purposes of the exception. Nonrecognition is accorded by the Code only if the exchange is one which satisfies both (1) the specific description in the Code of an excepted exchange, and (2) the underlying purpose for which such exchange is excepted from the general rule. The exchange must be germane to, and a necessary incident of, the investment or enterprise in hand. The relationship of the exchange to the venture or enterprise is always material, and the surrounding facts and circumstances must be shown. As elsewhere, the taxpayer claiming the benefit of the exception must show himself within the exception.

(c) Certain exceptions to general rule. Exceptions to the general rule are made, for example, by sections 351(a), 354, 361(a), 371(a)(1), 371(b)(1), 721, 1031, 1035 and 1036. These sections describe certain specific exchanges of property in which at the time of the exchange particular differences exist between the property parted with and the property acquired, but such differences are more formal than substantial. As to these, the Code provides that such differences shall not be deemed controlling, and that gain or loss shall not be recognized at the time of the exchange. The underlying assumption of these exceptions is that the new property is substantially a continuation of the old investment still unliquidated; and, in the case of reorganizations, that the new enterprise, the new corporate structure, and the new property are substantially continuations of the old still unliquidated.

(d) Exchange. Ordinarily, to constitute an exchange, the transaction must be a reciprocal transfer of property, as distinguished from a transfer of property for a money consideration only. [Emphasis added.]

The principle embodied in the regulations, i. e., that to qualify for nonrecognition the new property is substantially a continuation of the old investment still unliquidated, springs from the committee reports covering the predecessor of section 1031(a). H. Rept. 704, 73d Cong., 2d Sess. (1934), 1939–1 C.B. (Part 2) 554, 564. Wagensen v. Commissioner, supra at 658.

In Koch v. Commissioner, 71 T.C. 54, 63–64 (1978), we explained:

The basic reason for allowing nonrecognition of gain or loss on the exchange of like-kind property is that the taxpayer's economic situation after the exchange is fundamentally the same as et was before the transaction occurred. “[I]f the taxpayer's money is still tied up in the same kind of property as that in which it was originally invested, he is not allowed to compute and deduct his theoretical loss on the exchange, nor is he charged with a tax upon his theoretical profit.” * * * The rules of section 1031 apply automatically; they are not elective. * * * The underlying assumption of section 1031(a) is that the new property is substantially a continuation of the old investment still unliquidated. * * *

Section 1.1031(a)-1(a), Income Tax Regs., refers to section 1.1002, Income Tax Regs. Applying the rationale of the regulations, committee reports, and case law to the instant case, the “holding question” should be resolved by deciding whether the contribution of Plaza Property to U.S. Trust was a liquidation of petitioners' investment or a continuation of the old investment unliquidated in a modified form. We conclude that it is the latter.

The contribution of Plaza Property to U.S. Trust admittedly is a nontaxable transaction under section 721 which, together with section 1031(a), is unequivocally described above in section 1.1002–1, Income Tax Regs., as representing a continuation of the old investment, not a liquidation.

Other provisions treat a contribution of property to a partnership under section 721 as a change in form but not a liquidation of the investment. First, there is no recapture of the investment credit when property is contributed to a partnership because such a transfer is not a “disposition” but is, instead, a mere change in the form of doing business. Sec. 47(a)(1); sec. 1.47–3(f), Income Tax Regs. “Formal” differences in the property parted with and the property acquired are not controlling. Sec. 1.1002, Income Tax Regs., quoted in full, supra. This rule also applies to both property held...