Do the mulitple-property like-kind exchange regs. thwart Sec. 1031's intent?

• Author: Parr, Jason J.
• Position: IRS regulations, Internal Revenue Code section 1031

While Sec. 1031 allows gain non-recognition on an exchange of like-kind properties, Regs. Sec. 131(j)-1's goal appears to be maximization of gain recognition when multiple like-kind properties are exchanged. This article examines this paradox and the questions it raises for practitioners, such as the application of the depreciation recapture rules.

While Sec. 1031 provides the basic framework for income taxation of like-kind exchanges, Regs. Sec. 1.1031(j)-1 offers guidance on the tax treatment of like-kind exchanges of multiple properties. Congress's gain-minimizing intent in establishing Sec. 1031 appears to be mitigated by Treasury's zest to maximize taxable gain in Regs. Sec. 1.1031(j)-1. This article offers a brief background of Sec. 1031 and an in-depth consideration of the complex tax treatment established in Regs. Sec. 1.1031(j)-1.

Current Developments

The Taxpayer Relief Act of 1997 (TRA '97) did not include an IRS proposal(1) to narrow the like-kind standard from "property held for productive use in a trade or business or for investment" to property "similar or related in service or use." However, taxpayers using like-kind exchanges were not completely unaffected by the new law; the TRA '97 limited like-kind exchanges of foreign and domestic properties.(2) This law change and increased IRS revenue demands heighten the need for taxpayers to correctly interpret and comply with the complex regulations governing like-kind exchanges of multiple properties.

Background

Initially, Sec. 1031 seems straightforward: one property is exchanged for another, no gain or loss is recognized and the transferred property takes the basis and holding period of the relinquished property. But nonrecognition treatment occurs only if the relinquished and replacement properties are both held for productive use in a trade or business or for investment. Complexity is added when an exchange involves multiple properties.

Regs. Sec. 1.1031(j)-1, enacted in 1991(3) to address exchanges of multiple properties, has been considered by relatively few courts. In contrast to Sec. 1031, the regulation evidences treasury's intent to maximize taxable gain.

Multiple Property Exchange Elements

Exchange Groups

Regs. Sec. 1.1031(a)-1(b) states that Sec. 1031 applies only to an exchange of one kind or class of property for property of a like kind or class. In multiple-property exchanges, the matching of like-kind or like-class properties is accomplished through the use of exchange groups, as described in Regs. Sec. 1.1031(j)-1(b)(2)(i).

Relinquished and replacement properties are divided into exchange groups and a residual group. Each exchange group consists of the properties transferred and received in the exchange, all of which are of a like kind or like class; each group must contain at least one property transferred and one property received in the exchange. All properties in the same General Asset Class or Product Class (as defined in Regs. Sec. 1.1031(a)-2(b)) are in the same exchange group. Money and other property (defined by Sec. 1031 (a)(2)) not eligible for Sec. 1031 treatment cannot be included in an exchange group; such property belongs to the residual group.

Types of General Asset Classes: Regs. Sec. 1.1031(a)-2(b) (2) provides the 13 General Asset Classes originally set forth in Rev. Proc. 87-56(4):

1. Office furniture, fixtures and equipment (asset class 00.11).

2. Information systems (computers and peripheral equipment) (asset class 00.12).

3. Data handling equipment, except computers (asset class 00.13).

4. Airplanes (airframes and engines), except those used in commercial or contract carrying of passengers or freight, and all helicopters (airframes and engines) (asset class 00.21).

5. Automobiles and taxis...