Like-kind exchanges of real property.

IRC section 1031 permits the tax-free exchange of like-kind property. If the transferor receives "boot" (such as cash) in addition to the like-kind property, the boot is currently taxable. The application of these rules to the exchange of real property that was burdened by a supply contract was recently considered by the Tax Court.

On June 25, 1993, Peabody Natural Resources Co. transferred a gold mine in exchange for a coal mine. The coal mine was burdened by two contracts mandating that it supply a fixed minimum amount of coal. The contracts could be extended for five-year periods. Peabody reported the transaction as a tax-free exchange under section 1031. The IRS concluded that because the contracts were boot the exchange was taxable.

Result. For the taxpayer. The first question before the Tax Court was the nature of the supply contracts. After reviewing New Mexico law, the court concluded they were contracts for the sale of goods and an interest in real property.

Peabody argued that, since all real property is like-kind to all other real property, the transaction was tax-free. The court rejected this argument, noting that in prior cases the courts have held that real property, especially when leases or other contracts are involved, is not always like-kind to other real estate.

Since the exchanged properties were not automatically like-kind, the Tax Court had to reconcile two prior cases. One held that an overriding royalty interest was part of a like-kind exchange, the other that a carved-out oil payment was not part of a like-kind exchange. The court explained its rationale for the different outcomes as follows: In one case an overriding royalty would last until the mineral deposit was exhausted, while in the other situation a carved-out royalty ended after a stated time of production.

The explanation would seem to imply the Peabody supply contracts, which would terminate before the coal was exhausted, were not like-kind to other real property. However, the Tax Court determined the contracts were part of the bundle of rights the taxpayer received in exchange for the gold mine. As a consequence the contracts affected the grade or quality of the real property (rather than a difference in class). Based on this finding, the court ruled the exchange was tax-free under section 1031.

This decision appears to permit the tax-free exchange of real property burdened by supply contracts, as long as the contracts are considered real property interests under state law.

* Peabody Natural Resources Co. v. Commissioner, 126 TC no. 14.

Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.