Chapter 30: Like-kind exchanges.
In general, when a taxpayer transfers property in exchange for cash or other property, the taxpayer must recognize gain or loss on the transfer. (1) However, there are several areas of the tax law that permit (or require) non-recognition of gains or losses in certain circumstances.
One of the more well-known non-recognition provisions of the tax law is for like-kind exchanges. When a taxpayer transfers property to another party and, in exchange, receives property that is similar to what was given up, the taxpayer is essentially in the same economic position that he or she was in prior to the exchange. It is viewed as a continuation of the same investment. For that reason, the tax law requires that no gain or loss be recognized on property exchanged for other property that is of "like-kind."
As a result of the non-recognition of the gain or loss, the taxpayer's basis in the new property carries the basis of the transferred property, with certain adjustments. Therefore, the unreported gain or loss is not extinguished or forgotten but merely deferred into the future until the property received in the exchange is finally sold in a taxable transaction. The holding period of like-kind property relinquished in the exchange generally carries over (tacks on) to the holding period of the property that was received.
Transactions involving like-kind property may also include property not of a like-kind. The taxpayer not only receives the similar property but something else "to boot". This so-called "boot" may force the recognition of some or all of the otherwise deferred gain or loss.
Like-kind exchanges only apply to property held for productive use in a trade or business or for investment. Such exchanges are most commonly seen in transfers of real estate, automobiles, and business equipment (machines, computers, furniture, etc.).
As a result of the popularity of the non-recognition rule for like-kind exchanges, different techniques have emerged over the years to allow more taxpayers to participate in a variety of exchanges and meet the like-kind exchange requirements, such as:
* Multiparty exchanges--Like-kind exchanges involving more than two parties to the exchange;
* Deferred (forward) exchanges--Like-kind exchanges involving the relinquishment of property prior to the receipt of replacement property; and
* Reverse exchanges--Like-kind exchanges involving the purchase of replacement property prior to the sale of the relinquished property.
Realizing that it is sometimes impossible to complete a like-kind exchange of properties at the exact same time, the like-kind exchange rules contain specific time periods during which like-kind property must be identified and obtained by the taxpayer.
GENERAL RULE FOR LIKE-KIND EXCHANGES
IRC Section 1031 sets forth the rules for like-kind exchanges of property. The general rule, contained in IRC Section 1031(a), carries a number of requirements, each of which must be defined and followed in order to ensure the applicability of the non-recognition provision. IRC Section 1031(a)(1) states:
"No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if the property is exchanged for property of like kind which is to be held either for productive use in a trade or business or for investment." (2)
This general rule requiring non-recognition is mandatory, not elective. Therefore, taxpayers with losses built in to the property that will be exchanged would be wise to use the rules in reverse--that is, to ensure that the provisions of this tax law are not met.
Example: Stephanie Pressman owns an acre of land in the Philadelphia suburbs that she has held for investment purposes. She originally purchased the land for $50,000 and it is now worth $200,000. Jennifer Lansing owns an investment in five acres of land in rural West Virginia. Jennifer paid $250,000 for the land and it has a fair market value of $200,000. Stephanie and Jennifer agree to exchange their holdings. Stephanie's realized gain of $150,000 is deferred as part of the like-kind exchange, as is Jennifer's realized loss of $50,000. Stephanie will take the West Virginia property with a basis of $50,000 and Jennifer will receive the Philadelphia suburb property with a basis of $250,000. Jennifer could have recognized the $50,000 loss by ensuring that she did not meet the provisions of IRC section 1031.
The like-kind exchange provisions do not apply to certain types of property. Qualifying property does not include:
1. stock in trade or other property held primarily for sale, (3)
2. stocks, bonds or notes, (4)
3. other securities or evidences of indebtedness or interest, (5)
4. interests in a partnership (6) (unless the partnership has a valid election under IRC section 761(a) in effect to be excluded from the application of the partnership rules of Subchapter K), (7)
5. certificates of trust or beneficial interests, or (8)
6. choses in action (9) (choses in action are defined by the Supreme Court as the "infinite variety of contracts, covenants, and promises, which confer on one party a right to recover a personal chattel or a sum of money from another.") (10)
Each party involved in an exchange does not need to treat the transaction as a like-kind exchange. One party could be required to treat the transaction as a like-kind exchange while another falls outside the rules for mandatory application. (11)
Example: Car Lot, Inc. is a dealer in passenger automobiles. Sebro, Inc. is a service business that is looking for a new car for its sole owner, John Sebro. Sebro purchases a new car from Car Lot, Inc. for $30,000. In exchange, Sebro trades-in a five-year old car that has an adjusted basis on Sebro's books of $5,000. Car Lot gives Sebro $8,000 on the trade and credits that amount against the $30,000 purchase price. Sebro pays $22,000 cash for the car. Since Car Lot is a dealer in passenger automobiles, the property is not qualifying property under IRC section 1031(a)(2) (A). However, Sebro is trading business property for business property and since the business has met the like-kind exchange rules, it is required to apply the like-kind exchange provisions and defer recognition of gain.
Property received will also not be considered as property of a like-kind if it is not identified on or before the day which is 45 days after the date on which the taxpayer transfers the property relinquished in the exchange. (12) Furthermore, the replacement property must be received by the earlier of:
* the day which is 180 days after the date on which the taxpayer transferred the property relinquished in the exchange, or (13)
* the due date (including extensions) for the transferor's tax return for the taxable year in which the transfer of the relinquished property occurs. (14)
The regulations provide that the identification and replacement periods end at midnight of the 45th and 180th days following the relinquishment of the property, respectively. (15)
Example: On December 30, 2008, Highway Realty Partnership, a calendar year partnership, transfers an apartment building to Suburban Properties with the anticipation of having the transfer be treated as a like-kind exchange. In order to comply with the like-kind exchange time requirements, Highway Realty must identify the replacement property no later than midnight on February 14, 2009. The replacement property must be received no later than April 15, 2009, the due date of Highway Realty Partnership's tax return, unless the taxpayer requests an extension of time to file their 2008 tax return. In that case, Highway Realty has until midnight on June 29, 2009, to acquire the replacement property.
So, what exactly is like-kind property? In general, property of a like-kind refers to the nature or character of the property and not to its grade or quality. (16) For example, a used car and a new car are like-kind property.
For the purposes of determining whether the like-kind requirement is satisfied, property can be categorized in three ways:
1. depreciable tangible personal property
2. other personal property
3. real property
Depreciable Tangible Personal Property--Tangible personal property subject to depreciation is considered of a like-kind if the property in question is either of a like class or a like kind. (17) The regulations provide a safe harbor test for determining if property is of a like class. The test involves reviewing if the exchanged properties are in the same "General Asset Class" or the same "Product Class."
The General Asset Classes are defined in Revenue Procedure 87-56 (18) and contain a number of common properties that are used by businesses. The regulations provide that exchanged assets within one of the asset classes 00.11 through 00.28 and 00.4 of Rev. Proc. 87-56 are treated as like-kind property. (19) The following is a list of the General Asset Classes:
* Office furniture, fixtures, and equipment (asset class 00.11);
* Information systems (computers and peripheral equipment) (asset class 00.12);
* Data handling equipment, except computers (asset class 00.13);
* 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);
* Automobiles, taxis (asset class 00.22);
* Buses (asset class 00.23);
* Light general purpose trucks (asset class 00.241);
* Heavy general purpose trucks (asset class 00.242);
* Railroad cars and locomotives, except those owned by railroad transportation companies (asset class 00.25);
* Tractor units for use over-the-road (asset class 00.26);
* Trailers and trailer-mounted containers (asset class 00.27);
* Vessels, barges, tugs, and similar water-transportation equipment, except those used in marine construction (asset class 00.28); and
* Industrial steam and electric generation and/ or distribution systems (asset class 00.4). (20)
Exchanged property may alternatively be considered of a like-kind if it is in the same Product Class. The Product Class is a four-digit numerical code (the "SIC Code") contained within Division D of the Standard Industrial Classification Manual (the "SIC Manual"). If a property is listed in more than one product class, the property is treated as being listed in any one of those product classes. Note that four digit codes ending in "9" (miscellaneous categories) are not considered a product class for purposes of IRC section 1031. (21)
A property may not be classified within more than one General Asset Class or one Product Class. The General Asset Class safe harbor is applied first. If a property is classified within a General Asset Class, it may not also be classified within a Product Class. (22)
Example: Barnum, Inc. trades-in a used BMW passenger car for a brand new Ford pick-up truck. The BMW is considered to be in General Asset Class 00.22 (automobiles) while the Ford is classified as General Asset Class 00.241 (light general purpose trucks). Since the two vehicles are classified within a General Asset Class, they may not also be classified within a Product Class. (23)
Other Personal Property--Since most properties that are exchanged are defined as depreciable tangible personal property or real estate, this is the least used of the three categories. Property that falls into this category includes primarily:
* intangibles, such as patents or copyrights; and
* collectibles, such as stamps, gems, antiques or coins.
No like classes are provided for intangible personal property. The determination of whether intangible personal property is of a like-kind to other intangible personal property depends on the nature or character of the rights involved and also on the nature or character of the underlying property to which the intangible personal property relates. (24) The goodwill or going concern value of one business is not intangible personal property of a like-kind to the goodwill or going concern value of another business. (25)
Example: Bruce Mailer exchanges the copyright on one novel for the copyright on another novel. These properties are of a like-kind. However, exchanging a copyright on a novel for a copyright on a song is not an exchange of properties of a like-kind. (26)
Real Estate--Real estate is generally considered to be property of a like-kind with any other real estate property.
The regulations even provide an example of a like-kind exchange of real property in the city with a ranch or farm. (27) Also, unimproved real estate is of a like-kind with improved real estate. (28)
Example: Philadelphia Realty Partnership would like to exchange a suburban strip mall complex for an apartment building in the city. Since both properties qualify as real estate, they will be treated as properties of a like-kind.
A leasehold interest represents a lesser ownership than a fee interest in real estate. However, if the lease will exist for a sufficiently long enough period of time, it may be considered to be like-kind property with a fee simple interest. In order to meet the safe-harbor, the lease must last for at least 30 years (including all potential options to extend the term of the lease) to be considered as qualifying like-kind property. (29) A leasehold interest of less than 30 years may only be exchanged for another leasehold interest that extends less than 30 years.
An important point to consider is how international properties are treated under the like-kind exchange rules. Unfortunately for many taxpayers, real estate located in the United States is not considered to be property of a like-kind with property located outside the United States. (30)
Property Held for Productive Use in Trade or Business or for Investment
"Held for productive use in a trade or business or for investment" is not defined in the Code or in the regulations. However, in the past, the IRS has applied the definition of "property used in the trade or business" under IRC section 1231(b) for purposes of the like-kind exchange rules. The taxpayer shoulders the burden of proving the property is held for use in a trade or business or for investment. The determination is made at the time of the exchange.
The inclusion of the words "held for" within the general rule for like-kind exchanges implies that there is a time element that may need to be satisfied in order for the like-kind exchange rules to apply. Although there is no holding period outlined in the law, it is clear that property acquired solely for the purpose of executing an exchange is not "held for productive use in a trade or business or for investment." (31)
Example: Phyllis owns a parcel of land (held for investment) that she contracts to sell to Joan. Phyllis agreed that if Joan could find suitable property of a like-kind, Phyllis would exchange her property for Joan's. Joan finds a property that Phyllis agrees to exchange for her land. Phyllis will recognize like-kind exchange treatment on the transaction, but Joan will not. Joan's acquisition of the property was done solely for the purpose of executing an exchange.
RECEIPT OF BOOT
IRC section 1031 only applies to the like-kind property received in an exchange for other like-kind property. If the taxpayer, in addition to receiving like-kind property, receives money or other dissimilar property in the exchange ("boot", i.e., the taxpayer received the like-kind property and cash 'to boot'), gain will be recognized to the extent of (a) any money received plus (b) the fair market value of the boot received in the exchange. (32) However, in a classic "heads I win--tails you lose" ploy, the Code provides that if the transaction results in a loss to the taxpayer and boot is received in the exchange, the loss is not recognized. (33)
Like-kind exchanges rarely involve only property of a like-kind. The values of the exchanged properties will most likely not be identical, causing one party to "make-up" the difference by paying some cash, assuming some liabilities, or providing some other form of non-qualifying property (i.e., property that is not of a like-kind).
Example: Highpoint, Inc. and Crosstown, Inc. each own a piece of machinery (of a like-kind) used in their respective businesses. Highpoint's machine has an adjusted basis of $50,000 and a fair market value of $90,000. Crosstown's machine has an adjusted basis of $40,000 and a fair market value of $80,000. Highpoint agrees to accept Crosstown's machine plus $10,000 cash in exchange for their machine. Highpoint realizes a gain of $40,000 on the exchange ($80,000 value of Crosstown's machine plus $10,000 cash less the $50,000 adjusted basis of the relinquished machine). Highpoint must recognize $10,000 of the $40,000 realized gain because they received $10,000 of cash (boot). Crosstown realizes a gain of $40,000, but recognizes no gain--the gain is deferred since they met the like-kind exchange requirements and did not receive any non-qualifying property to boot.
When a liability is assumed (or property is taken subject to a liability) in an exchange, the liability is treated as boot received by the original debtor. (34) This is because, in the IRS view, the assumption of the original debtor's liability is equivalent to the new owner providing the original owner cash in the exchange to pay off the loan while simultaneously financing this cash by establishing a loan against the property received. This "implied cash transfer" is treated as boot received by the original debtor/owner.
Example: Longpoint Apartments owns a building with an adjusted basis of $500,000 that is valued at $1,700,000. The property currently has a mortgage of $1,000,000, leaving the owner with a net equity of $700,000. Longpoint exchanges the property with Shortfall Apartments, which owns an unencumbered building with a value of $700,000. The amount realized by Longpoint in the exchange is $1,700,000 ($700,000 value of property received plus $1,000,000 of liabilities assumed by Shortfall). The gain realized by Longpoint is $1,200,000 ($1,700,000 amount realized less $500,000 adjusted basis), of which the boot of $1,000,000 must be recognized as gain in the year of the transfer.
If an exchange involves the reciprocal assumption of liabilities, the amount of debt relief may be offset by the amount of liabilities assumed. (35) The amount of debt relief may also be offset by other forms of boot transferred in the exchange (e.g. cash). (36) However, other boot received may not offset boot given in the exchange. (37) Furthermore, it is notable that when the taxpayer receives boot, he/she cannot reduce the amount treated as boot in acknowledgment of any liabilities that were assumed, even though he/she would have received no boot if the cash were simply used to pay down the liability before the transfer. (38)
Example: LKE, Inc. transfers property subject to a $500,000 mortgage in exchange for property subject to a $400,000 mortgage. Since the liability transferred exceeds the liability assumed, the LKE would be in receipt of $100,000 of boot.
Example: Same facts as above except that LKE also transfers $100,000 of cash in the exchange. LKE's debt relief is completely offset by the liability assumed plus the cash transferred. Therefore, no boot is received in the transfer and will not be required to report any gain.
Example: The other party to the transfer in the above example, ONO, Inc., has relinquished property subject to a $400,000 mortgage and received property subject to a $500,000 mortgage plus $100,000 of cash. ONO can fully offset the $400,000 of debt relief with the $500,000 of liabilities assumed. However, the $100,000 of cash received will still be treated as boot and may force ONO to recognize gain up to this amount on the exchange. Note that this treatment could be avoided by having LKE take the $100,000 of cash and pay down that amount of the liability immediately prior to the transfer. LKE and ONO would then each be assuming $400,000 of liabilities and no boot would be transferred to/ from either party.
The basis of properties acquired in a like-kind exchange is identical to the basis of the property exchanged with the following adjustments:
* Decreased by the amount of money received,
* Increased by the amount of gain recognized on the like-kind property,
* Increased by the amount of boot transferred (money paid or the basis of the property transferred if other non-qualifying property besides cash was transferred),
* Increased by the amount of gain recognized on non-qualifying property transferred, and
* Decreased by the amount of loss recognized on non-qualifying property transferred. (39)
Example: Using the facts included in the Highpoint/Crosstown example, Highpoint's basis in the new machine is $50,000 ($50,000 adjusted basis of relinquished property, reduced by $10,000 cash received, increased by $10,000 gain recognized). Therefore, if Highpoint sells the machine tomorrow for its $80,000 fair market value, the remaining $30,000 of deferred gain would be recognized.
A loss may be recognized in a like-kind exchange where the property transferred in the exchange includes property that is not like-kind. (40)
Example: Again using the previous example, instead of using cash in the transaction Crosstown gives up a car with a fair market value of $10,000 and an adjusted basis of $30,000. Crosstown will recognize the $20,000 on the transfer of the car since it is not like-kind property. Crosstown's basis in the machinery will now be $50,000 ($40,000 adjusted basis in relinquished property, increased by the $30,000 basis of boot transferred, decreased by the $20,000 of loss recognized on non-qualifying boot transferred). Note that, for the purposes of the machinery, this is equivalent to the result if Crosstown simply transferred cash to achieve a basis of $50,000 ($40,000 adjusted basis in relinquished property, increased by $10,000 of boot transferred). However, in this situation Crosstown has been able to recognize the heretofore unrealized loss on the car as a part of the exchange.
If a taxpayer receives both like-kind property and property that is not like-kind, the basis is allocated first to the non-like-kind property to the extent of its fair market value, and then to the property that is of a like-kind, to the extent of the aggregate basis--the adjusted basis of the relinquished property, decreased by any money received or liabilities assumed, and increased (decreased) by any gain (loss) recognized on the exchange. (41)
Example: Continuing our Highpoint/Crosstown example, if Highpoint receives the car instead of cash, Highpoint will still realize a $40,000 gain on the exchange. Of this amount, $10,000 will be recognized as gain due to the receipt of the car as property not of a like-kind. The aggregate basis of the machine and the car is $60,000 ($50,000 adjusted basis of relinquished property, reduced by $0 cash received, increased by $10,000 gain recognized). The basis is then allocated first to the car, up to its fair market value of $10,000. The remaining $50,000 of basis is allocated to the machine, the like-kind property received in the exchange.
Expenses related to an exchange, such as brokerage fees and commissions, are treated the following way:
1. deducted from the amount of gain or loss realized in the like-kind exchange;
2. offset against cash payments (boot) received; and
3. included in the basis of the property received. (42)
EXCHANGES BETWEEN RELATED PERSONS
The like-kind exchange rules provide a limitation on the application of the non-recognition provision in the situation where the parties to an exchange are related. The intention of Congress was to discourage such exchanges where the intent was to reduce or avoid gain recognition on subsequent sales, and to restrict "basis shifting." (43)
Under section 1031(f), if a taxpayer exchanges property with a related person in a transaction to which section 1031 originally applies and within two years of the date of the exchange, the taxpayer or the related party dispose of the property acquired in the exchange, the original gain or loss deferred from the original exchange must be recognized. (44) The gain or loss recognized is taken into account as of the date of the disposition of the property. (45)
Example: William Barson owns an apartment building with an adjusted basis of $300,000. His sister, Flora also owns an apartment building that was left to her by her late uncle. Her adjusted basis in the apartment building is $1,900,000. Both properties are valued at $2,000,000. Flora decides that she does not want to own and manage the property. William thinks that Flora's property has much more upside potential than his but if he were to sell his property, he would realize a $1,700,000 gain. The two decide to exchange properties. One year later, Flora realizes she can't take the stress of being a landlord anymore and sells her property for $2,000,000 and recognizes her $100,000 gain ($2,000,000 proceeds less $1,900,000 basis). By selling the property within two years of the exchange, she automatically triggers the gain to her brother, William, by application of IRC section 1031(f). As a result, William will recognize the gain of $1,700,000 that was originally deferred under the like-kind exchange rules.
Of primary importance in the application of these related-party rules is the question of who is considered to be a related person. For purposes of this rule, a related person is defined in the same way as it is under IRC section 267(b) and IRC section 707(b)(1). (46) The most common application of the related person rule is where members of a family are involved in a transaction. (47) Members of a family include brothers, sisters (whether by the whole or half blood), spouse, ancestors (parents and grandparents) and lineal descendants (children and grandchildren). (48) However, nieces, nephews, aunts, uncles, in-laws, step-parents, step-children and step-grandchildren are not considered members of a family for this purpose.
Example: If William was Flora's nephew, the related party rules would not apply. Flora would recognize the gain on the sale of her property but would not trigger the gain recognition on William's property.
In addition, related parties under sections 267(b) and 707(b)(1) also include:
* A corporation and an individual that owns, directly or indirectly, by or for himself/herself, more than 50% of the value of the outstanding stock;
* Two corporations which are members of the same controlled group;
* A grantor and a fiduciary of any trust;
* A fiduciary of a trust and a fiduciary of another trust, if the same person is a grantor of both trusts;
* A fiduciary of a trust and a beneficiary of such trust;
* A fiduciary of a trust and a beneficiary of another trust, if the same person is a grantor of both trusts;
* A corporation and a fiduciary, if more than 50% of the value of the outstanding stock is owned, directly or indirectly, by or for the trust or by or for a person who is a grantor of the trust;
* A personal and an organization to which section 501 applies and which is controlled directly or indirectly by such person or by members of the family of such individual;
* A corporation and a partnership if the same persons own more than 50% in value of the outstanding stock of the corporation, and more than 50% of the capital interest, or the profits interest, in the partnership;
* A partnership and a person owning more than 50% of the capital interest, or the profits interest, in such partnership;
* Two partnerships in which the same person owns, directly or indirectly, more than 50% of the capital interests or profit interests;
* An S corporation and another S corporation if the same persons own more than 50% in value of the outstanding stock of each corporation;
* An S corporation and a C corporation, if the same persons own more than 50% in value of the outstanding stock of each corporation; and
* Except in the case of a sale or exchange in satisfaction of a pecuniary bequest, an executor of an estate and a beneficiary of such estate;
Like-kind exchanges frequently will involve more than two parties. Three and four parties to an exchange are not an uncommon occurrence.
Example: Lisa owns a building that Matt would like to purchase for cash. Lisa intends to use the proceeds to purchase another building and would prefer to structure the transaction as a like-kind exchange. Nate owns a building that Lisa would like to acquire. A like-kind exchange can be accomplished for Lisa in the following manner:
1. Matt purchases Nate's property for cash
2. Matt and Lisa exchange their buildings in a transaction that qualifies as a like-kind exchange for Lisa. Note that Matt would not receive like-kind exchange treatment on the transaction with Lisa since the property was acquired solely for the purpose of the exchange.
Although ultimately, in the final step, this transaction was structured as a basic like-kind exchange, if multiparty exchange structures like this were not permitted, the like-kind exchange rules would have much less applicability. The transferor of a property would be forced to not only find a person who would like to receive the property but also have property of a like-kind that the transferor wants in return.
FORWARD (DEFERRED) EXCHANGES
A forward (or deferred) exchange is one in which the taxpayer transfers the property now and receives replacement property at a later date. Section 1031 may still apply to such a transaction provided:
1. replacement property is identified within 45 days of the transfer of the relinquished property ("the identification period"), and
2. replacement property is received by the earlier of the due date of the tax return (including extensions) for the year of the transfer or within 180 days of the transfer of the relinquished property ("the replacement period").
There are no extensions (aside from the tax return due date exception) available to these time constraints. If the replacement property is either identified or received after the applicable respective time periods, the like-kind rules will not apply and gain or loss must be recognized on the transaction. (49)
Replacement property must be identified as such in either:
1. a written agreement covering the exchange that is signed by all parties before the end of the identification period; or
2. a written document signed by the taxpayer and hand delivered, mailed, telecopied, or otherwise sent before the end of the identification period to:
* a person involved in the exchange (such as an intermediary, escrow agent or title company) other than the taxpayer, a related party, or the agent of the taxpayer; or to
* the person obligated to transfer the replacement property to the taxpayer (regardless of whether that person is a related party or an agent of the taxpayer). (50)
More than one property may be identified as replacement property. However, the maximum number of properties that may be identified is (1) three properties of any fair market value or (2) any number of properties as long as the aggregate fair market value of the properties does not exceed 200 percent of the fair market value of the relinquished properties as of the date of the transfer. (51)
If more than the allowable number of properties is identified (i.e., neither of the prior paragraph requirements are satisfied), then no replacement properties will be treated as identified unless the replacement property is (1) acquired before the end of the identification period or (2) identified before the end of the identification period and obtained before the end of the replacement period, the value of such property being at least 95 percent of the aggregate fair market value of all identified properties. (52)
The identification of a property as replacement property may be revoked before the end of the identification period in a written amendment to the original agreement delivered, mailed, telecopied or otherwise sent to all parties to the agreement, or in an additional written document of revocation delivered, mailed, telecopied, or otherwise sent to the person to whom the original identification was sent. (53)
Replacement property will meet the time limitations if it is received before the end of the replacement period and is substantially similar to the identified property. (54)
Due to the complexities of transferring property before replacement property is identified, forward exchanges (as well as reverse exchanges, which will be discussed later) often involve more than two parties in the exchange. Taxpayers will frequently rely on "intermediaries" to ensure like-kind exchange treatment.
An intermediary will typically arrange to sell the taxpayer's property and purchase replacement property to exchange with the taxpayer. This arrangement will be treated as a like-kind exchange if the intermediary is a "qualified intermediary (55) and the taxpayer is not in constructive receipt of the proceeds on the sale of the relinquished property.
It is important in a deferred exchange that the taxpayer not be in constructive receipt of the proceeds of the sale during the process (i.e., after the sale but before the subsequent purchase). (56) A taxpayer is in constructive receipt of money or other property at the time that he/ she receives the economic benefit from it, such as when it is credited to the taxpayer's account, set apart for the taxpayer, or otherwise made available so that the taxpayer may draw upon it at any time or may draw upon it at any time if notice of intention to draw is given. (57) The taxpayer avoids the constructive receipt rules as long as substantial restrictions must be placed on the taxpayer's control of the receipt of the funds or property, and continues to not be in constructive receipt unless and until the restrictions lapse, expire or are waived. (58)
Usually, an escrow account will be established to hold the proceeds from the sale of the relinquished property to meet the prior paragraph requirements for avoiding constructive receipt. If the escrow account is a "qualified escrow account," the taxpayer will not be in constructive receipt of the proceeds. A qualified escrow account is an escrow account wherein:
1. The escrow holder is not the taxpayer, a related party, or an agent of the taxpayer, and
2. The escrow agreement expressly limits the taxpayer's rights to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash equivalent held in the escrow account. (59)
A qualified trust may be used in place of a qualified escrow account provided the trust agreement expressly limits the taxpayer's rights to receive, pledge, borrow or otherwise obtain the benefits of the cash or cash equivalent held by the trustee, and the trustee is not the taxpayer, a related party, or an agent of the taxpayer. (60)
A qualified intermediary (QI) is not considered to be an agent of the taxpayer. (61) A QI is a person who:
1. is not the taxpayer, a related party, or already an agent of the taxpayer; and
2. enters into a written agreement with the taxpayer (the "exchange agreement") and, as required by the exchange agreement, acquires the relinquished property from the taxpayer, transfers the relinquished property, acquires the replacement property and transfers the replacement property to the taxpayer. (62)
Example: Albert Trammell wants to sell his office building. The adjusted basis of the building is $600,000 and it is worth $1,100,000. Lee Sheffield wants to buy Albert's office building. Linda Gomez wants to sell her apartment complex for $900,000. QI, Inc. is a qualified intermediary who is not a disqualified person (a related party or an agent of the taxpayer). The following steps fulfill the requirements necessary to ensure that Albert Trammell receives like-kind exchange treatment on the transaction:
Step 1--On April 1, Albert enters into an agreement to sell his office building to Lee for $1,100,000. The closing is set for May 5. (Note: Lee does not care to or want to participate in a like-kind exchange).
Step 2--On April 29, Albert enters into an exchange agreement with QI, Inc. The exchange agreement expressly limits his rights to receive, pledge, borrow or otherwise obtain the benefits of money or other property held by QI in a qualified escrow account. In the exchange agreement, Albert assigns to QI all of his rights in the agreement with Lee. Albert notifies Lee of the assignment to QI.
Step 3--On May 5, Albert executes and delivers to Lee a deed conveying the office building to him. In return, Lee pays $1,100,000 to QI, Inc., which is placed into the qualified escrow account.
Step 4--On June 10, Albert identifies Linda's apartment building as replacement property and delivers to QI, Inc. a written document that states the identification.
Step 5--On July 17, Albert enters into an agreement with Linda to purchase the apartment building from Linda for $900,000. Albert then assigns his rights to QI and notifies Linda of the assignment in writing.
Step 6--On August 21, QI pays $900,000 from the qualified escrow account to Linda who then transfers the deed conveying the apartment building to Albert. QI disburses the remaining $200,000 to Albert.
Result--Albert receives like-kind exchange treatment on the transfer of his office building to Lee in exchange for Linda's apartment building. His realized gain on the transfer is $500,000 ($1,100,000 amount realized less $600,000 ad justed basis). Since Albert received $200,000 of cash (boot), he will recognize $200,000 of the realized gain. His basis in the apartment building will be $600,000 (thus deferring the remaining $300,000 of gain while acquiring the replacement building worth $900,000).
Forward or deferred exchanges refer to a transaction where a taxpayer relinquishes a property and subsequently identifies and receives replacement property. A reverse exchange, on the other hand, occurs in 'reverse' order--the replacement property is obtained before the relinquished property is transferred. Unfortunately, the regulations do not specifically cover this type of transaction.
Revenue Procedure 2000-37 added certain safe harbor procedures for reverse exchanges. In particular, a taxpayer who wishes to use a reverse exchange can employ an intermediary (similar to a qualified intermediary) in the form of an "exchange accommodation titleholder" (EAT). The EAT will not be treated as the taxpayer's agent.
In general, for a like-kind exchange to be effective, the taxpayer may not receive the replacement property before the relinquished property is transferred. However, if properly structured, an EAT, and not the taxpayer, will be considered the owner of the replacement property. The transfer of title by the EAT to the taxpayer will then be postponed until after the taxpayer transfers the relinquished property, completing the exchange.
The IRS will treat an EAT as the beneficial owner of the relinquished and replacement property if the property is held in a "Qualified Exchange Accommodation Arrangement" (QEAA). Property is held in a QEAA when each of the following five requirements are met:
Ownership Requirement--The EAT must possess qualified indicia of ownership of the transferred property during the time it is held by the EAT. The EAT must be a person other than the taxpayer or a disqualified person (a related party or an agent of the taxpayer). The EAT must be subject to federal income tax or be a partnership or S corporation owned more than 90 percent by persons subject to income tax. (63)
Qualified indicia of ownership must be held by the EAT at all times from acquisition until ultimate transfer. Qualified indicia of ownership are either (1) legal title; (2) beneficial ownership under applicable principles of commercial law (e.g. a contract for deed); or (3) ownership of an interest in an entity that is disregarded as separate from its owner for federal income tax purposes, if the entity is the property's legal or beneficial owner. (64)
Intent Requirement--At the time the ownership is transferred to the EAT, the taxpayer must have a bona fide intent that the transferred property be held by the EAT as either replacement or relinquished property in an exchange that is intended to qualify for non-recognition of gain or loss under section 1031. (65)
QEAA Requirement--The taxpayer must enter into a written qualified exchange accommodation agreement with the EAT within five days following the transfer of property to the EAT. The terms of the agreement must specify that the EAT is holding the property for the benefit of the taxpayer in order to facilitate an exchange under section 1031 and Revenue Procedure 2000-37, that the EAT will be treated as the beneficial owner of the property for all federal income purposes, and that the income tax attributes of the property will be reported on the income tax returns of the taxpayer and the EAT as appropriate. (66)
Identification of Relinquished Property Requirement--Within the 45 days following the transfer of qualified indicia of ownership of replacement property to the EAT, the taxpayer must identify relinquished property in a manner similar to the identification requirement under the rules for deferred exchanges. (67)
Time of Transfer Requirement--There are two separate 180-day time limits for the completion of the exchange. The first is that the length of time any one piece of property may be held in a QEAA by an EAT is 180 days regardless of whether it is the relinquished or replacement property. (68) Therefore, the longest time period that any relinquished or replacement property can be owned by the EAT is 180 days.
The second time limit is a 180-day "combined time period" that the EAT may hold both replacement and relinquished property. (69)
Example: Oceanside, Inc. enters into a reverse exchange by relinquishing property to an EAT. The EAT holds qualified indicia of ownership for 30 days during which time Oceanside identifies a like-kind replacement property and has the EAT obtain the property. The EAT transfers the replacement property to Oceanside (ostensibly completing the exchange for Oceanside), and now holds only the relinquished property. The EAT may continue to hold such property for up to 150 days before the relinquished property must be transferred to a new owner.
QUESTIONS AND ANSWERS
Question--How are like-kind exchanges reported for tax purposes?
Answer--Taxpayers involved in a like-kind exchange must complete and file Form 8824 in the year of the exchange.
Question--If a taxpayer acquires a property in a like-kind exchange and subsequently dies, is the deferred gain required to be recognized in the year of death?
Answer--No. The deferred gain would escape income tax just as if the taxpayer had held the relinquished property at the time of his death. Further, the property held at death would be entitled to a step-up in basis to its fair market value as of the date of the taxpayer's death (this is applicable until December 31st, 2009--after this date, consequences may be different depending upon the ultimate resolution of estate tax repeal legislation).
Question--If a taxpayer acquires a property in a like-kind exchange and subsequently uses the property as a personal residence, can the gain exclusion rules of Section 121 be used to effectively remove the deferred gain from taxation?
Answer--Yes, but with special rules. Ordinarily, a taxpayer must use and occupy a property as a personal residence for two of the last five years in order to avail themselves of the Section 121 gain exclusion rules. However, a property that was acquired by a taxpayer who did not recognize gain under the like-kind exchange rules must hold the property for five years (in addition to meeting all of the other requirements of Section 121) in order to qualify for the gain exclusion on the sale of a personal residence. (70)
Question--When should the like-kind exchange rules be avoided?
Answer--Taxpayers may want to avoid the mandatory application of the like-kind exchange rules under the following circumstances:
* The property has an unrealized loss that would benefit the taxpayer by realizing the loss (this is normally the case with automobiles used in a trade or business).
* The taxpayer has losses in the current year (or carryovers into the current year) that can be utilized to absorb the gain on the sale of the property.
* The gain is passive under Section469 and would be offset by current and suspended passive activity losses.
* The taxpayer anticipates that their personal tax rate will increase in future years and the payment of the tax on the gain in the current year would be more beneficial than if the gain were deferred.
Question--How might a taxpayer avoid the application of the like-kind exchange rules?
Answer--A desire to avoid the like-kind exchange rules often occurs with automobiles that are subject to luxury auto limitations. The luxury auto limitations slow down depreciation to a point that the actual value of the car may be declining more rapidly than the taxpayer can claim depreciation. As a result, a taxpayer who wants to purchase a new car would be wise to sell the used car to a third party and recognize the loss instead of trading in the used car in a transaction with the dealer of the new car.
There are many requirements for a like-kind exchange to occur. Willfully failing any of the requirements will create the opportunity to recognize gain or loss on the transaction.
Question--Do states follow the like-kind exchange rules?
Answer--Taxpayers need to review their individual state tax laws to determine if their state allows for the non-recognition of gain and loss on transactions involving like-kind property. While many do, some only classify transactions involving like-kind property in their state as a valid non-recognition event. For example, real estate in one state transferred for real estate in a neighboring state will generally qualify for like-kind treatment for federal purposes but may fail the state requirement since the new property is in a different state.
See Figures 30.1 and 30.2 for worksheets for single asset like-kind exchanges.
[FIGURE 30.1 OMITTED]
[FIGURE 30.2 OMITTED]
(1.) IRC Sec. 1001.
(2.) IRC Sec. 1031(a)(1).
(3.) IRC Sec. 1031(a)(2)(A).
(4.) IRC Sec. 1031(a)(2)(B).
(5.) IRC Sec. 1031(a)(2)(C).
(6.) IRC Sec. 1031(a)(2)(D).
(7.) IRC Sec. 1031(a)(2) flush language.
(8.) IRC Sec. 1031(a)(2)(E).
(9.) IRC Sec. 1031(a)(2)(F).
(10.) Sheldon v. Sill, 49 S.Ct. 441.
(11.) Rev. Rul. 75-292, 1975-2 CB 333.
(12.) IRC Sec. 1031(a)(3)(A).
(13.) IRC Sec. 1031(a)(3)(B)(i).
(14.) IRC Sec. 1031(a)(3)(B)(ii).
(15.) Treas. Reg. 1.1031(a)-2(b)(1).
(16.) 1987-2 CB 674.
(17.) Treas. Reg. 1.1031(a)-2(b)(2).
(18.) Treas. Reg. 1.1031(a)-2(b)(2)(i) through (xiii).
(19.) Treas. Reg. 1.1031(a)-2(b)(3).
(20.) Treas. Reg. 1.1031(a)-2(b)(1).
(21.) See Private Letter Ruling 200241013.
(22.) Treas. Reg. 1.1031(a)-2(c)(1).
(23.) Treas. Reg. 1.1031(a)-2(c)(2).
(24.) Treas. Reg. 1.1031(a)-2(c)(3) Examples (1) and (2).
(25.) Treas. Reg. 1.1031(a)-1(c).
(26.) Treas. Reg. 1.1031(a)-1(b).
(27.) Treas. Reg. [section]1.1031(a)-1(c).
(28.) IRC Sec. 1031(h)(1).
(29.) Rev. Rul. 75-291, 1975-2 C.B. 332.
(30.) IRC Sec. 1031(b).
(31.) IRC Sec. 1031(c).
(32.) Treas. Reg. 1.1031(d)-2.
(33.) Treas. Reg. 1.1031(b)-1(c).
(34.) Treas. Reg. 1.1031(d)-2.
(35.) Treas. Reg. 1.1031(d)-2.
(36.) Treas. Reg. 1.031(d)-2 Example (2)(b).
(37.) IRC Sec. 1031(d).
(38.) Treas. Reg. 1.1031(d)-1(e).
(39.) IRC Sec. 1031(d).
(40.) Rev. Rul. 72-456, 1972-2 CB 468.
(41.) Senate Committee Print and Conference Committee Report to P.L. 101-239.
(42.) IRC Sec. 1031(f)(1).
(44.) IRC Sec. 1031(f)(3).
(45.) IRC Sec. 267(b)(1).
(46.) IRC Sec. 267(c)(4).
(47.) IRC Sec. 1031(a)(3).
(48.) Treas. Reg. 1.1031(k)-1(c).
(49.) Treas. Reg. 1.1031(k)-1(c)(4)(i).
(50.) Treas. Reg. 1.1031(k)-1(c)(4)(ii).
(51.) Treas. Reg. 1.1031(k)-1(c)(6).
(52.) Treas. Reg. 1.1031(k)-1(d).
(53.) Treas. Reg. 1.1031(k)-1(g)(4).
(54.) Treas. Reg. 1.1031(k)-1(f)(1).
(55.) Treas. Reg. 1.1031(k)-1(f)(2).
(57.) Treas. Reg. 1.1031(k)-1(g)(3)(ii).
(58.) Treas. Reg. 1.1031(k)-1(g)(3)(iii).
(59.) Treas. Reg. 1.1031(k)-1(g)(4)(i).
(60.) Treas. Reg. 1.1031(k)-1(g)(4)(iii).
(61.) Rev. Proc. 2000-37 [section]4.02(1).
(63.) Rev. Proc. 2000-37 [section]4.02(2).
(64.) Rev. Proc. 2000-37 [section]4.02(3).
(65.) Rev. Proc. 2000-37 [section]4.02(4).
(66.) Rev. Proc. 2000-37 [section]4.02(5).
(67.) Rev. Proc. 2000-37 [section]4.02(6).
(68.) IRC Sec. 121(d)(10).
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|Publication:||Tools & Techniques of Income Tax Planning, 3rd ed.|
|Date:||Jan 1, 2009|
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