Like-kind exchanges with disregarded entities.

• Author: Bakale, Anthony

Often a taxpayer considers the potential tax benefits of a like-kind exchange when selling and acquiring real estate. Although the like-kind exchange rules of Sec. 1031 are complex, the benefit of tax deferral can be enormous. Basically, Sec. 1031 provides that gain is deferred when a taxpayer exchanges property held for use in a trade or business or for investment purposes for like-kind property. There are four required elements in a Sec. 1031 exchange: (1) It must involve a transfer of real or personal property; (2) the property must be held for a qualified purpose (i.e., as investment or in a trade or business); (3) the property relinquished must be like-kind with the replacement property; and (4) an exchange is required.

The determination of whether properties are like-kind is based on their nature or character, not their grade or quality. Because real estate is generally real estate for like-kind purposes, Sec. 1031 is a useful tool when contemplating a sale of real estate. Sec. 1031 specifically excludes the applicability of the like-kind provisions to exchanges of stock in trade or other property held primarily for sale; stocks, bonds or notes; other securities or evidences of indebtedness or interest; interests in a partnership; certificates of trust or beneficial interests; or choses in action. Regs. Sec. 1.1031(a)-1 states that Sec. 1031(a)(1) "does not apply to any exchange of interests in a partnership regardless of whether the interests exchanged are general or limited partnership interests or are interests in the same or different partnerships."

The IRS has ruled that one of the integral requirements of a like-kind exchange is the exchange requirement. For example, in Letter Ruling (TAM) 9818003, the Service ruled that a partnership did not qualify for like-kind exchange treatment when it relinquished property but had deeded replacement properties directly to partners in liquidation of their partnership interests. The partnership owned the relinquished property and sold it to a third party. The transaction provided that each partner could designate one or more properties that the partnership would acquire using the respective partner's share of the net proceeds from the sale. The exchange trust disbursed funds to acquire the replacement properties for the partners, which were deeded directly to the individual partners in liquidation of their partnership interests. The IRS ruled that, to meet the exchange requirement of Sec...