In 1979, Oregon family sold 1,843 acres, IRS demanded tax, then mostly lost: How a ruling changed tax-deferred property exchanges

In 1979, a US appeals court ruled that an Oregon family didn't have to pay tax right away on a land deal. The case, T.J. Starker v. United States, involved T.J. Starker, his son Bruce Starker and his daughter-in-law Elizabeth Starker. In 1967, they entered into a land exchange agreement with Crown Zellerbach Corporation involving 1,843 acres of timberland in Columbia County, Oregon.

What exactly happened?

The agreement didn't require Crown to immediately give the family replacement property. Instead, Crown agreed to acquire and transfer other real estate in Oregon and Washington within five years, or pay the outstanding balance in cash.

The Internal Revenue Service later argued that the transactions didn't qualify for tax nonrecognition under Section 1031.

What happened when Starkers transferred the Oregon timberland?

In 1967, T.J. Starker, Bruce Starker and Elizabeth Starker entered into the agreement with Crown. Later, the Starkers transferred their interests in the 1,843 acres of timberland to Crown.

Crown recorded an exchange value credit of $1,502,500 for T.J. Starker and $73,000 for Bruce and Elizabeth. Crown had up to five years to acquire and transfer replacement real estate selected by the Starkers.

Crown agreed to add a 6% annual "growth factor" to the outstanding balance.

Why did the IRS demand taxes?

The Starkers reported no gain from the transaction on their 1967 tax returns. The IRS challenged that treatment. It assessed a deficiency of $35,248.41 against Bruce and Elizabeth and $300,939.31, plus interest, against T.J. Starker.

Notably, Bruce and Elizabeth won their refund case. The government voluntarily dismissed its appeal, while the dispute involving T.J. Starker continued.

T.J. Starker did not receive all his replacement properties immediately. The Ninth Circuit rejected the government's argument that the replacement property had to be transferred at the same time as the original property. It held that the delay itself didn't prevent the transactions from receiving Section 1031 treatment.

But, the court ruled against Starker on the Timian and Bi-Mart properties as Crown transferred them directly to his daughters.

The court ruled that the 6% growth factor represented compensation for the use of money and therefore was interest. But because Starker used the cash method of accounting, the interest was not taxable to him in 1967 before he received it.

The Ninth Circuit affirmed the district court in part and reversed it in part. The ruling became known because it held a long gap between transferring property and receiving replacement property did not, by itself, prevent Section 1031 treatment.