Like-kind exchanges either followed or preceded by a nontaxable transfer to or from an entity.

• Author: Miller, Walter R., Jr.

More than a decade after the Tax Reform Act of 1986, real estate values in many parts of the country are finally beginning to recover. In certain areas, values have recovered sufficiently such that many taxpayers are now facing the happy dilemma of how to dispose of substantially appreciated real estate without being hit with a huge tax bill. If they are interested in reinvesting the proceeds in the real estate market, the like-kind exchange provisions of Sec. 1031 can be a powerful and attractive tool. Because of the many unanswered questions and associated uncertainty involving like-kind exchanges, however, this tool is not for the weak of heart. One of the more vexing questions is "What happens when a like-kind exchange is either followed or preceded by a nontaxable transfer to or from an entity?"

This question presents itself often, usually in one of two basic scenarios. Sometimes a sole investor has substantially appreciated real estate he would like to liquidate--reinvesting the proceeds in a more desirable piece of property in conjunction with other investors who are providing expertise, cash or other assets. Other times, the appreciated property is in the hands of an entity in which the owners want to part ways. Often, certain owners want to "cash out," others want to continue to hold the property, while still others want to exchange the property for new property and defer any potential taxable gain.

In each case, it is important to remember the requirement that to have an exchange, the party relinquishing the old property must be the same taxpayer as the party receiving the new property, This principle was recently hammered home in IRS Letter Ruling (TAM) 9818003: Partnership P had certain appreciated property that it wanted to sell. Some of the partners wanted to sell; others wanted to exchange. The partnership apparently attempted to bifurcate the disposition by selling the property and receiving a certain portion of the proceeds in cash, which it distributed to the exiting partners who wanted to cash out. The remaining proceeds went directly into an exchange trust for the benefit of the remaining partners, who directed the trust to purchase replacement property. The replacement property was then deeded directly to the remaining partners. The IRS failed to bless the "exchange" part of the transaction, arguing that because the relinquishing party (the partnership) and the party(ies) receiving the property (the individual partners)...