Real Estate Exchanges in the 1990s: Lessons from the Front
| Publication year | 1996 |
| Pages | 1 |
| Citation | Vol. 25 No. 2 Pg. 1 |
1996, March, Pg. 1. Real Estate Exchanges in the 1990s: Lessons from the Front
Real estate is an extremely capital intensive business. For many clients, real estate investments may become large components of their net worth. Moreover, property owners often hold their real estate for several years, possibly for decades. When this happens during a rising market, the income tax basis of the real estate lags behind the property's value and may represent only a fraction of the property's current fair market value. This lag creates a problem when the property owner decides to "sell out."
Responding to the increasing pressures of urbanization, a number of Colorado farmers and ranchers have made the decision to sell their property.(fn1) In many sales, a property owner sells the real estate interests for cash or a carryback note and, in so doing, triggers a significant capital gains tax liability. Under current law, the long-term capital gains tax rate for individuals is capped at 28 percent.(fn2)
This article addresses many of the tax and structuring issues that arise when a client attempts to sell off real estate through an exchange. Although not meant to cover all possible issues,(fn3) the article discusses common practical problems that counsel may face when asked to help structure a real estate exchange.
Unfortunately, in far too many cases, a real estate investor realizes only after the sale that capital gains tax liability could have been avoided if the taxpayer had exchanged his or her real estate in a qualified like-kind exchange or had held the property until death. If an investor retains capital gain property until his or her death, the income tax basis of the property is "stepped-up" to fair market value.(fn4) In other words, the tax law provides that the capital gains tax is eliminated and completely forgiven for appreciated property held until death. This benefit creates a powerful tax incentive to hold appreciated property.(fn5)
If real estate owners insist on disposing of their property interests and, at the same time, avoiding capital gains tax liability, these goals can be met by completing a qualifying like-kind exchange.(fn6) Although exchange transactions are increasingly common, the like-kind exchange must be properly structured to produce the desired result.(fn7)
Assuming a taxpayer properly structures and consummates a like-kind exchange, the transaction does not cancel the gain inherent in the transferred real estate.(fn8) Rather, the like-kind exchange rules allow a taxpayer to defer recognition of such gain until the taxpayer disposes of the replacement property in a taxable transaction or until such gain is eliminated at death. The tax law creates the gain deferral by forcing the taxpayer to take an income tax basis in the like-kind property received, equal to the taxpayer's adjusted basis in the outgoing property, less any cash received, but increased by any gain the taxpayer recognizes in the exchange.(fn9)
For example, if a taxpayer has a tax basis of $200,000 and exchanges this property for like-kind property with a fair market value of $240,000 and cash of $20,000, the taxpayer's basis of the new property would be $200,000. In effect, $40,000 of the $60,000 gain remains deferred since the basis of the new property would be $200,000, even though the property has a fair market value of $240,000.
A like-kind exchange is not the exclusive means to defer a capital gains tax liability. Capital gains tax can be deferred through an installment sale. An investor also might combine a partial cash sale with a taxdeferred exchange, thereby deferring a portion of the gain that would otherwise be recognized. An investor also could exchange his or her relinquished property for both like-kind real estate and a carryback promissory note secured by the relinquished property, thereby avoiding any immediate tax recognition.(fn10) Finally, an investor might engage in a series of like-kind real estate exchanges, thereby building net worth while continually deferring the capital gains tax liability.
The like-kind exchange rule (IRC § 1031) provides that no gain or loss is recognized
Real property received in an exchange is like-kind to investment and business real property transferred if the received property is held either for productive use in a trade or business or held for investment.(fn12) Thus, for example, if the received real property is used as a farm or a ranch (i.e., held for productive use in a trade or business), the property would be like-kind to transferred real property that was held for investment. Real estate used as rental property also would be like-kind to unimproved or vacant real property held for appreciation.(fn13) Real estate held as inventory by a "dealer," however, will not constitute like-kind property, and U.S. real estate will not be like-kind to foreign real estate.
Although the like-kind limitation often poses little problem, a taxpayer must be able to demonstrate that the transaction qualifies as an exchange and not as a sale and subsequent reinvestment of sales proceeds.(fn14) The form of the transaction is absolutely critical and controlling.(fn15) For example, in Nixon v. Commissioner,(fn16) a farmer received an offer to purchase his farmland but expressed to the buyer his desire to avoid any capital gains tax liability. Unfortunately, the farmer could not receive the timely cooperation of the seller of his replacement farm. Responding to pressure from his buyer, the farmer executed a deed and received a check made payable to him for the sale of his property.(fn17) Several days later, he signed over the check to the seller of the replacement property and acquired a new farm.
The farmer reported the transaction as a like-kind exchange. On audit, the Internal Revenue Service ("Service") asserted that the transaction constituted a cash sale of the property and a reinvestment of the proceeds in other property. The Tax Court agreed with the Service and held that the farmer did not consummate an exchange of farm properties. Rather, the farmer received "unfettered and unrestricted" cash through the sale of his property and subsequently reinvested the cash proceeds in new farm ground. The Tax Court held that the transaction constituted a sale and reinvestment and not an exchange of property between owners.(fn18)
The like-kind exchange rules require that the property owner must hold the property received in the exchange either for investment or for productive use in a trade or business.(fn19) This requirement is embodied in the "continuity of interest" concept underlying most tax-deferred transactions.(fn20) Under this concept, a taxpayer should not incur a tax liability where his or her investment remains locked up in similar business or investment assets. Unfortunately, the continuity of interest concept is a creature of the case law created without bright lines.
In a Private Letter Ruling issued ten years ago, the Service's national office ruled that an exchange of real estate met the holding requirement where the taxpayer's intent was to hold the property received in the exchange for at least two years.(fn21) Given the absence of other guidance, many cautious practitioners cite this private ruling as establishing a two-year holding period requirement for planning purposes.
In some cases, where the taxpayer makes a subsequent gift of the replacement property, the Service has used the holding requirement and the associated continuity of interest doctrine to attack purported like-kind exchanges.
In Wagensen v. Commissioner,(fn22) an elderly rancher transferred his cattle ranch to a corporation for another ranch and cash. Approximately nine months after the exchange, the rancher transferred his new ranch (i.e., the replacement ranch) to his children. The Service attacked this transaction and claimed that the subsequent transfer to the children disqualified the exchange. Fortunately, the Tax Court found that the transaction qualified as a like-kind exchange because, even though the rancher disposed of the property shortly after the exchange, he had no firm plan to gift the new ranch to his children at the time of the exchange. The Tax Court also noted that the elderly rancher had operated the new ranch after the exchange and had not informed his children of his intentions to make a gift until shortly before he deeded the property to them.(fn23)
In a case decided two years after Wagensen, a taxpayer was not so lucky. In Click v. Commissioner,(fn24) a taxpayer traded her farmland for two residences selected by her children. The children and their families occupied the homes immediately after the exchange and neglected to pay rent to the taxpayer. Approximately seven months later, the taxpayer deeded the homes outright to her children. Unlike the earlier case, the Tax Court found that this exchange did not qualify as a like-kind exchange since the taxpayer acquired the residences with the intent of giving them to her children and lacked any intent to hold them as business or investment property. The Service successfully alleged that the taxpayer failed the holding requirement since her intent at the time of the...
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