Like-kind exchanges - common problems and solutions.

• Author: Briskin, Robert A.

EXECUTIVE SUMMARY

* Exchanges of real estate often involve personal property issues; clients should be advised of planning strategies involving improvements to the replacement property.

* Like-kind exchanges involving partners and partnerships often create potential obstacles to gain deferral; tax advisers and clients should carefully consider solutions and planning.

* Clients engaging in like-kind exchanges should become familiar with the identification and replacement period requirements and know how to maximize them.

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A tax adviser's help is crucial to properly plan a like-kind exchange. This article focuses on some of the most common issues, solutions and strategies that should be considered in structuring a tax-deferred exchange under Sec. 1031.

Clients selling real estate and engaging in Sec. 1031 tax-free exchanges often rely on professional exchange companies--such as affiliates of escrow and title companies--to draft documents, advise on tax and legal issues and close the transaction. Professional exchange companies, in turn, attempt to limit their liability with document language stating that the exchanging property owner "does not rely on the professional exchange company for legal or tax advice." They advise clients to "use their own separate tax professionals." Despite these warnings, clients often fail to engage separate professional help and rely solely on the exchange company.

However, without proper tax advice, clients can make mistakes in structuring exchanges, resulting in taxable income. (1) Some of the more common mistakes and solutions are discussed below.

Exchange of Real Estate Including Personal Property

A basic Sec. 1031 exchange requirement is that the property transferred (relinquished property) and the property received (replacement property) must be "like-kind." Generally, real estate is classified as like-kind to other interests in real estate. Thus, land can be exchanged for improved real estate under Regs. Sec. 1.1031(a)-1(b), and a 30-year-or-more leasehold can be exchanged for a fee interest in real estate under Regs. Sec. 1.1031 (a)-1(c). (2)

If the relinquished or replacement property also consists of personal property, the other property must consist of similar like-kind personal property or, alternatively, "like-class" personal property (3) to other depreciable tangible personal property. Depreciable tangible personal properties are of a like-class if they are within the same "General Asset Class" or "Product Class." (4)

Real estate cannot be exchanged tax free for personal property. Unfortunately, some clients unwittingly violate this requirement when a building includes personal property (e.g., refrigerators, washers and moveable stoves in apartment buildings) or when cost-segregation studies have been performed.

Incidental Property

Under the "incidental property exception" in Regs. Sec. 1.1031(k)1(c)(5)(i), minor items of personal property do not have to be separately identified in a deferred tax-free exchange. (5) However, this exception only applies to determine whether a property is being properly identified for purposes of complying with the time requirements of the deferred-exchange rules; it does not apply to the Sec. 1031 like-kind exchange requirements. If even a small amount of personal property is transferred or received along with real property, then like-kind or--class personal property must also be transferred or received to meet Sec. 1031's requirements.

Reclassified Building Parts

Parts of a building can be reclassified from real to personal property. Reclassification allows sophisticated building owners to reduce their income taxes, by accelerating depreciation and amortization deductions (6) and avoiding the 39-year straight-line recovery period for commercial property or the 27 1/2-year straight-line period for residential property. Reclassified personal property can be amortized and depreciated over shorter time periods (usually five or seven years) using the double-declining-balance method. (7) Prior to 2005, an even greater tax incentive existed to reclassify building parts as personal property--first-year bonus depreciation deductions of 30% and 50% were available. (8)

To reclassify parts of a building as personal property, clients and their advisers commonly perform cost-segregation studies. Such studies are based on rules described in Hospital Corp. of America. (9) The reclassified personal property is then depreciated over a shorter recovery life than the real property. Thus, carpet and window coverings can be recovered over five years. (10) Similarly, specialized refrigeration, restaurant, medical, manufacturing or computer equipment, as well as the plumbing, electrical, ventilation and flooring systems connected with them, can be classified as personal property. (11) Other potential personal property includes office cabinetry, carpeting, special lighting fixtures, (12) gasoline pump canopies (13) and retail signs. (14)

Matching Personal Property

Even minor amounts of personal property involved in real property exchanges can trigger gain recognition. To meet the Sec. 1031 like-kind property requirement, when personal property comprises part of the relinquished or replacement property, like-kind or -class personal property should be included in the other property. Under Kegs. Sec. 1031(j)-1, the multiple-property like-kind rules determine the classification of the various properties when both real and personal property are being exchanged.

If only the relinquished property (or only the replacement property) contains personal property, the gain recognized by exchanging the non-like-kind personal property is limited to the personal property's FMV. Thus, if the personal property has little or no value, the recognized gain may not be significant. Clients can obtain an appraisal to substantiate a low value, as well as an agreement on that value from the relinquished property's buyer (however, such buyer may prefer a higher valuation to increase its own depreciation deductions).

An alternative tax strategy for exchanging into like-kind property following a cost-segregation study is to argue that reclassified personal property remains "real estate" for Sec. 1031 purposes, based on the definition of real property under state law. (15) Exchanging parties can argue that reclassified personal property is still real estate for Sec. 1031 purposes, because Secs. 168 and 167 allow parts of buildings to be classified as personal property only for tax depreciation purposes. For Sec. 1031 purposes, however, state law determines whether property is personal or real. (16)

Exchanges Involving Future Improvements

Clients sometimes wish to sell the relinquished property and then exchange into the replacement property when improvements are to be constructed on the latter later. However, contracts to construct improvements are not like-kind to real property for Sec. 1031 purposes.

Regs. Sec. 1.1031(k)-(1)(e) indicates that partially constructed improvements to the replacement property qualify as being like-kind to real estate to the extent classified as real estate under state law on the date of receipt. Thus, in a deferred exchange, a client may acquire replacement property to be improved during the 180-day deferral period (or due date of the client's return, if sooner). Under Kegs. Sec. 1.1031(k)-1(e)(3)(iii), improvements not completed before the end of the deferred-exchange period will still be deemed substantially the same as the replacement property identified by the client within the 45-day identification period, if: (1) the improved replacement property would have been considered substantially the same property as identified by the client, had it been completed when received by the client; and (2) when the replacement property is received, the partially completed improvements constitute real property under applicable state law.

If the replacement property improvements are constructed after the client receives the replacement property in a completed forward exchange, they Hill not qualify under Sec. 1031. (17) Thus, when a client finds that it has to use the relinquished property's exchange proceeds to construct improvements on the replacement property after the exchange-deferral period, it should restructure the exchange to become a reverse exchange (discussed below), rather than a conventional forward exchange.

Reverse Tax-Free Exchanges

To construct improvements on the replacement property that will qualify for a like-kind exchange, clients often have them constructed by an independent party, and then, at a later date, exchange into the replacement property. For example, a client may do a "reverse tax-free exchange" by first having an independent party (not classified as the client's agent for tax purposes) acquire replacement property land and later construct improvements thereon. When the improvements are constructed and become part of the replacement property, that property (including the newly constructed improvements) is then exchanged for the relinquished property.

"Parking" arrangements under Rev. Proc. 2000-37: One form of a reverse exchange--referred to as a "parking arrangement"--occurs when the replacement property is first acquired or "parked" with a third party, referred to as an exchange accommodation titleholder (EAT). Kev. Proc. 2000-37 (18) provides a safe harbor for parking arrangements when the replacement property is acquired by the EAT before the disposition of the relinquished property. In Rev. Proc. 2004-51, (19) the IRS stated that Kev. Proc. 2000-37 Hill not apply if the taxpayer owned the replacement property before the exchange. It is not clear what would happen if the taxpayer owned the replacement property and disposed of it in an unrelated transaction before the exchange.

Rev. Proc. 2000-37 permits an EAT to borrow money from the exchanging party and for the latter to guarantee the EAT's construction...