In 1977, US couple swapped apartment building, transferred property to a partnership the same day: Why a court told IRS their tax break stays

A US couple who exchanged an apartment building for a stake in another property and transferred the acquired real estate to a partnership on the same day won a tax dispute after a federal appeals court ruled that their investment still qualified for tax-deferred treatment.

The US Court of Appeals for the Ninth Circuit upheld the decision in favour of Norman J. and Beverly G. Magneson in February 1985, rejecting the Internal Revenue Service's challenge to their property exchange.

The case centred on whether the couple could claim tax-deferred treatment after exchanging one property for another and immediately contributing the acquired property to a partnership.

What property did the couple exchange?

The Magnesons owned an apartment building on Iowa Street in San Diego, California. They exchanged their ownership interest in the building for a 10% undivided ownership interest in another commercial property, known as the Plaza Property.

On August 11, 1977, the transaction took place.

They transferred the newly acquired interest in the Plaza Property to U.S. Trust Ltd., a limited partnership formed to acquire, hold and operate the commercial property. N.E.R. also transferred its interest in the property on the same day.

In return for their property interest and cash, the Magnesons received a general partnership interest in U.S. Trust. Their interest included a 10% equity stake and 9% share in net profit and losses.

The Magnesons argued that they should not have to pay tax on the gains from either transaction. The IRS challenged the first transaction.

The court noted that the Magnesons continued to own an interest in income-producing real estate through the partnership. They had not withdrawn cash or other non-like-kind property from the transaction.

It also distinguished a partnership from a corporation, noting that general partners retain ownership rights and management control over partnership property in ways that differ from shareholder's relationship with corporate assets.

Why did the court reject the IRS's other argument?

The IRS said the deal should be treated as a single transaction in which the couple effectively exchanged their apartment building for a partnership stake.

The appeals court rejected the argument that the approach disqualified the transaction. It concluded that even when viewed as a whole, the exchange qualified for tax-deferred treatment under the circumstances.

The court affirmed the Tax Court's ruling in favour of Magnesons.

However, the decision was limited to cases in which taxpayers exchanged property for like-kind real estate intending to contribute it to a general partnership that held the property for investment and whose assets were predominantly like-kind property.

The court also noted that Congress had amended Section 1031 to exclude exchanges of partnership interests for transactions executed after July 18, 1984.