State law property classifications do not control 'like kind' determination.

• Author: Schachat, Robert D.

In Chief Counsel Advice (CCA) 201238027, the IRS concluded that state law property classification does not control whether exchanged properties are considered of "like kind" for purposes of Sec. 1031. Rather, federal income tax law controls and requires consideration of all facts and circumstances, including state law and federal tax law classifications, as appropriate.

Facts and Analysis

For an exchange of properties to qualify for deferral treatment under the like-kind exchange rules of Sec. 1031, the properties must be of like kind. Regs. Sec. 1.1031(a)-1(b) states that the words "like kind" refer to the nature or character of the property and not to its grade or quality, and that one kind or class of property may not be exchanged for property of a different kind or class. The regulation also notes that the fact that any real estate involved is improved or unimproved is not material, for that fact relates only to the grade or quality of the property and not to its kind or class.

CCA 201238027 offers four examples to illustrate whether state law characterizations of property as real or personal affect whether the property is of like kind. Example 1 involves an exchange of a natural gas pipeline in State 1 (constructed along a right of way on real property) that is classified as personal property in State 1 for a State 2 natural gas pipeline that is classified as real property in State 2.

While in some cases courts have looked to state law classifications of property as real or personal in determining whether exchange property is of like kind, the IRS explained, the courts have relied on more than just state law classifications in their analysis. The IRS pointed out that other cases demonstrate that the like-kind determination is a question of federal law rather than state law, and that relying solely on state property classifications can lead to absurd results. Thus, state law property classifications do not determine whether property is of like kind; rather, the determination is a federal one that considers all facts and circumstances.

Accordingly, the IRS concluded in Example 1 that the state law characterization of the pipelines does not override the basic nature and character of the property involved. The pipelines are of the same nature and character and, thus, are of like kind for purposes...