Like-kind exchange rules: continued evolution.

• Author: Schnee, Edward J.

For many years, taxpayers have been able to defer recognition of gain on the disposition of assets by engaging in Sec. 1031 like-kind exchanges. Consequently, many questions and issues surrounding these transactions have been addressed, but many cases and rulings continue to arise each year. For example, in the past two years, several rulings and a case have discussed the restriction on related-party sales in Sec. 1031(f). Although the courts continue to apply the rules strictly, Treasury may have created a reasonable exception.

Several rulings have examined transactions to determine whether the taxpayer should be treated as having received boot. This is especially complex when a transaction involves liabilities. In addition, cases and rulings have discussed what properties qualify as like-kind and when a qualified intermediary (QI) should be treated as an agent. This article analyzes these cases and rulings and identifies questions that still need to be answered.

Like-Kind Exchanges Generally

Sec. 1031 provides that no gain or loss is recognized if property used in a trade or business or held for investment is exchanged for like-kind property.(1) The law excludes exchanges of inventory, stocks, bonds, interests in partnerships, and chases in action from nonrecognition treatment.(2) The property that the taxpayer transfers is usually referred to as relinquished property, and the property received is referred to as replacement property Deferred transactions may qualify as like-kind exchanges if they are completed by the earlier of the due date of the tax return for the tax year in which the transfer of the relinquished property occurs or 180 days after such transfer.(3)

If the taxpayer receives cash or other property in addition to the like-kind property, then gain, but not loss, is recognized equal to the lesser of the boot received or the gain realized. The basis of the qualified property received is equal to the basis of the property transferred, increased by gain recognized and decreased by loss recognized.(4)

To prevent some abusive transactions, Sec. 1031(f) provides that if the exchange occurs between related parties, then the gain or loss is recognized if either party disposes of the exchanged property within two years. There are exceptions for dispositions following the taxpayer's death, involuntary conversions, and transactions whose principal purpose was not tax avoidance.

Property Types and Uses

Real and Personal Property

Regs. Sec. 1.1031(a)-1(b) states that to be of like kind, the exchanged properties must be of the same nature or character. The grade or quality is not relevant. Therefore, the exchange of improved real estate for unimproved real estate can qualify as like-kind, but a like-kind exchange generally involves either personal properties or real properties.

In Chief Counsel Advice (CCA) 201238027, the IRS examined the relevance of state-law classification of property as either real or personal. The CCA contains several examples. The first is an exchange of a gas pipeline classified as personal property by a state for another gas pipeline classified as real property by another state. In another example, both a steam turbine and the building it is attached to as a fixture are classified by the state in which they are located as real property. They are exchanged for raw land classified as real property by another state.

The CCA mentions that the Supreme Court has held that state law dictates the classification of property as either real or penonal.(5) Therefore, if a state defines the exchanged properties as real, the exchange will qualify as like-kind in most situations. However, the CCA points out that in Fleming, (6) the Tax Court, affirmed by the Supreme Court, concluded that an exchange of real property for carved-out oil payment rights that state law classified as real property did not qualify under Sec. 1031 because the payment rights were not of the same nature or character as the real property

In Clemente, Inc., (7) the Tax Court applied similar reasoning to deny like-kind exchange of real property with limited gravel extraction rights. Therefore, the CCA concluded that an exchange of the turbine for raw land would not qualify as like-kind since they are of different nature and character. Conversely, the gas pipelines would be treated as like-kind real property despite their differing state classifications, because they are of the same nature and character.

The CCA noted that not all case law has distinguished between real property and extraction rights in the same way as Fleming, however. For example, in Crichton, (8) the Fifth Circuit held that an overriding royalty interest in minerals was of like kind with a city lot.

In Koch(9) (not cited in the CCA), the Tax Court explained that the different conclusions reached in these two cases were based on duration. The overriding royalty in Crichton continued until the minerals were exhausted, while a carved-out oil payment right, as in Fleming, usually terminates when a specified quantity of oil or minerals is removed.

The CCA supplements these prior cases by indirectly concluding that "nature or character" includes the structure and use of the property in addition to duration. Taxpayers will need to examine exchanged properties' structure and use, in addition to duration, in deciding whether they are of like kind. The fact that both properties are real property under state law does not guarantee a nontaxable exchange.

The CCA conclusion regarding the gas pipelines is a significant expansion of the cited cases and rulings, which dealt with similarly defined properties. This example involves properties with different classifications. The fact that the properties are not both real or personal does not mean that an exchange cannot qualify under Sec. 1031, as long as they are of similar nature and character.

Goodwill

Regs. Sec. 1.1031(a)-2(c)(2) states that goodwill or going-concern value of a business is not of like kind with goodwill or going-concern value of a different business. In these transactions, the goodwill transferred is treated as sold, and the goodwill received is treated as boot. In Deseret Management Corp., (10) the Court of Federal Claims applied this rule to the exchange of a radio station for another radio station. The taxpayer was able to prove, however, that any goodwill transferred in the exchange had minimal value. Therefore, no gain was recognized.

Used in Trade or Business or Held for Investment

The nature and character of two properties must be similar for a like-kind exchange, but that fact alone is not sufficient. The properties must also be used in a trade or business or held for investment. A personal residence will not qualify as either. However, if the property received in the exchange is initially held for investment or to be leased and is then converted into a personal residence, can the exchange still qualify as nontaxable? The Tax Court considered this question in Yates (11) and Reesink. (12)

Investment property received in an exchange can be converted into a residence and the exchange still qualify under Sec. 1031, depending on whether the taxpayer intended to acquire the property as an investment at the time of the exchange--a matter that is a question of fact. In Yates, the taxpayers moved into the property as their residence four days after acquiring it. The only evidence the taxpayers presented of an investment intent was that they asked the seller to obtain permission for them to use the property as a bed-and-breakfast establishment. Given the lack of proof of business intent and an almost immediate personal use, the court ruled that the property did not qualify for a like-kind exchange. (13)

In Reesink, on the other hand, the taxpayers were able to prove a primary investment motive, even though they converted the property into their personal residence shortly after acquisition. The taxpayers proved that they distributed fliers listing the acquired property as available for rent and did not move into the property as their residence for eight months. In addition, the taxpayers did not decide to sell their original residence until six months after the exchange. These facts, plus testimony that the taxpayers had planned to stay in their original residence until their sons (the oldest being only 14) graduated from high school, were sufficient to convince the Tax Court that they intended to acquire the property as an investment at the time of the exchange.

Long-Term Leases and Improvements

The Tax Court in VIP's Industries Inc. (14) held for the IRS regarding an exchange of a long-term lease on real property for real property fee interests but left two interesting questions unanswered. The lessee corporate taxpayer leased real property for 33 years. It built and operated a motel on the leased property When the lease had 21 years and four months remaining, the taxpayer used a QI to sell the leasehold interest and acquire fee interests in two real properties. The taxpayer treated the transactions as a like-kind exchange; the IRS disagreed.

Regs. Sec. 1.1031(a)-1(c) provides as an example of a like-kind exchange the exchange of a leasehold of real property with a remaining term of 30 years or more for a fee interest in real property. In Peabody Natural Resources Co., (15) the Tax Court referred to the regulation as providing a safe harbor. On the other hand, in Capri, Inc., (16) the Tax Court stated that the regulation requires the leasehold term to be at least 30 years. Therefore, the Tax Court's opinions leave open whether the leasehold can be shorter than 30 years. Does the regulation provide a safe harbor rather than a requirement?

Rather than address this issue, the Tax Court referred to its decision in May Department Stores Co., (17) in which it held that a 20-year leasehold was not equivalent to a fee interest. It held that the leasehold interest in VIP's Industries was closer in...