Magneson v. Commissioner , 81 T.C. 767 ( 1983 )

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 Tax Court Rules of Practice and Procedure. The facts and exhibits are incorporated herein by this reference.

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

Prior to August 11,1977, petitioners were the sole owners of a free simple interest in real property and an apartment building located at 4060 Iowa Street, San Diego, Calif. (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, Ltd. (N.E.R.), a limited partnership under California law, was the owner of commercial property located at 2251 San Diego Avenue, San Diego, Calif., 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 Ltd. (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)-l, 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 loss 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, and 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 unliquidat-ed.

(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 it 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)-l(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(0, 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 for the production of income and property used in a trade or business. Sec. 1.47-3(0(3), Income Tax Regs. Second, a contribution of "section 1245 property” to a partnership does not require the application of section 1245. Sec. 1.1245-4(c)(2)(vi), Income Tax Regs. Nor does the contribution of "section 1250 property” to a partnership require the application of section 1250. Sec. 1250(d) and sec. 1.1250-l(c)(2), Income Tax Regs.³ Finally, the contribution of an installment obligation to a partnership under section 721 does not accelerate reporting of the entire gain or loss resulting from a disposition of an installment obligation under section 453. Sec. 1.453 — 9(c)(2), Income Tax Regs.

Further, we note that section 1033 is not listed in section 1.1002-1(c), Income Tax Regs., quoted above because an involuntary conversion is not an exchange but is, instead, more akin to a sale, the gain from which is not recognized if the proceeds are used to purchase property similar or related in service or use. It is true, that in determining whether the replacement property is similar or related in service or use to-the real property converted, reference is made to the "like kind” provision of section 1.1031(a)-1(b), Income Tax Regs. Sec. 1.1033(g)-1(a), Income Tax Regs. Section 721, however, has no requirement of "like kind”; the contribution to the partnership is not a sale; and there is no issue of "like kind” in the instant case. See M.H.S. Co. v. Commissioner, 575 F.2d 1177 (6th Cir. 1978), affg. a Memorandum Opinion of this Court.

As further support for the proposition that petitioners merely effected a change in the form of the ownership of their investment instead of liquidating their investment, it must be pointed out that U.S. Trust’s basis in the Plaza Property for computing gain or loss is petitioners’ basis, i.e., their cost basis in Iowa Street.⁴ U.S. Trust "tacks on” to petitioners’ holding period for Plaza Property pursuant to section 1223(2), and the Commissioner has acknowledged that it is the partnership’s holding period with respect to the property, rather than the partner’s holding period for his partnership interest, which determines whether the gain or loss is long term or short term. Rev. Rul. 68-79,1968-1 C.B. 310.

Although not controlling, under the facts in the instant case, if U.S. Trust were liquidated before it disposed of Plaza Property, petitioners would receive a 10-percent interest— identical with the interest they held prior to their contribution of Plaza Property to U.S. Trust. Similarly, if Plaza Property were sold by U.S. Trust, petitioners would be taxable upon 9 percent of the proceeds of the identical long- or short-term capital gain realized which would, instead, be 10 percent of the same amount if they had sold Plaza Property individually instead of contributing it to U.S. Trust.⁵

Plaza Property was stipulated by the parties to be "commercial property.” N.E.R. was organized to "acquire, own, maintain and operate” Plaza Property. If petitioners had not contributed Plaza Property to U.S. Trust, they might, nevertheless, be taxable as a partnership together with the other owners of undivided interests depending upon the level of their activity. Section 301.7701-3(a), Proced. & Admin. Regs., provides in part as follows:

Mere co-ownership of property which is maintained, kept in repair, and rented or leased does not constitute a partnership. For example, if an individual owner, or tenants in common, of farm property lease it to a farmer for a cash rental or a share of the crops, they do not necessarily create a partnership thereby. Tenants in common, however, may be partners if they actively carry on a trade, business, financial operation, or venture and divide the profits thereof. For example, a partnership exists if co-owners of an apartment building lease space and in addition provide services to the occupants either directly or through an agent.

This demonstrates that, for tax purposes, joint ownership of the property and partnership ownership of the property are merely formal differences and not substantial differences as set forth in section 1.1002(c), Income Tax Regs., and petitioners did not liquidate their investment in Plaza Property when they contributed it to U.S. Trust.

On brief, petitioners argue that respondent "has taken certain unreasonable actions, which entitle petitioners to interest payment relief, legal fees, or such other relief as may be determined appropriate by the Court.” With respect to this case, which was submitted fully stipulated on November 18, 1982, this Court does not have jurisdiction to award interest (American Rolbal Corp. v. Commissioner, 220 F.2d 749 (2d Cir. 1955), affg. a Memorandum Opinion of this Court; Chapman v. Commissioner, 14 T.C. 943 (1950), affd. 191 F.2d 816 (9th Cir. 1951)), or attorney’s fees. McQuiston v. Commissioner, 78 T.C. 807 (1982), affd. without published opinion 711 F.2d 1064 (9th Cir. 1983); Key Buick Co. v. Commissioner, 68 T.C. 178 (1977), affd. 613 F.2d 1306 (5th Cir. 1980). See new sec. 7430(a)(2).

Decision will be entered for the petitioners.

Reviewed by the Court.

1 All section references are to the Internal Revenue Code of 1954 as amended, applicable to the taxable year 1977.

2 This section of the regulations does not reflect repeal of sec. 1002 of the Code and incorporation of the gist of sec. 1002 into sec. 1001 as sec. 1001(c) applicable to taxable years beginning after 1976. Pub. L. 94-455 (Tax Reform Act of 1976), 90 Stat. 1520. In T.D. 7665, 1980-1 C.B. 319, filed in the Office of the Federal Register on Jan. 24, 1980, the Treasury removed sections of the regulations, including sec. 1.1002, Income Tax Regs., which no longer conformed to the Internal Revenue Code as amended. The Treasury Decision was effective Jan. 25,1980, and by its terms intended no substantive changes in the regulations. Secs. 1.1001-1 and 1.1002-1 of the regulations are, therefore, applicable to the taxable year 1977 which is before the Court in this case. ...

3 Sec. 1250 does, however, override other nonrecognition provisions. Sec. 1.1250-l(c)(2), Income Tax Regs.

4 This assumes that U.S. Trust has not availed itself of the elective provisions regarding basis.

5 furthermore, a partnership is not a taxpaying entity separate from its partners. Sec. 701. In noting this principle which distinguishes it from a corporation, however, we decline to decide whether property received in a sec. 1031(a) "like kind” exchange and immediately contributed to a corporation qualifying for sec. 351 treatment is "held” for investment as required by sec. 1031(a). See Rev. Rul. 75-292, 1975-2 C.B. 333; but also see 17 Wm. & Mary L. Rev. 599 (1976).