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Like-kind exchanges; a look at the proposed changes.

Like-Kind Exchanges A Look at the Proposed Changes

Many business have relied on IRC Section 1031 to defer gain on exchanges of business or investment property. Under these rules, no gain or loss is recognized if business or investment property is exchanged for other business or investment property of the same class. Proposed regulations, however, contain a new, more restrictive definition of what constitutes property of the same class. Liabilities are handled differently, the provisions for deferred exchanges are modified and new rules are provided for determining gain recognized and basis on new property pursuant to an exchange of multiple properties, including exchanges of entire businesses.

Like-kind Property

Defined

Under current law, like-kind property is given a very broad definition. Real property must be exchanged for real property and personal property must be exchanged for personal property.(1) Note that personal property is generally considered to be all property except land or buildings. This is a broad legal definition. Property that a taxpayer uses for his or her own personal use does not qualify for like-kind exchange treatment. Accordingly, a factory may be exchanged for a farm and a computer may be exchanged for a truck, so long as the property is either used for business or income producing purposes. Under the proposed regulations, depreciable personal property used in a business will be considered to be like-kind if it is either within the same general business asset class or within the same product class.(2)

Property within a general business asset class consists of depreciable property described in one of the asset classes of Rev. Proc. 87-56 as modified.(3) The most common of the asset classes are: * Office furniture, fixtures and

equipment, * Information systems (computers

and peripheral equipment), * Data handling equipment,

except computers, * Automobiles and taxis, * Light general purpose trucks,

and * Heavy general purpose trucks.

Property may be considered like-kind if it is within the same product class, which consists of tangible, depreciable personal property that is listed in a product code.(4) The product code is a five-digit number under a coding system of the U.S. Department of Commerce.(5) Therefore, an excavator and a power crane are in the same product class because they have the same product code. However, an excavator and a mixer are not considered to be like-kind property because they are not in the same general business asset class or the same product class. (Excavators have a product code of 3531E and mixers have a product code of 3531F.)(6) Property not listed in a product class or listed in a miscellaneous category are considered to be like-kind based on all the facts and circumstances.(7) Inventory and other property primarily held for sale do not qualify for like-kind exchange treatment even if they are in the same general business asset class or in the same product class.(8)

Example: Taxpayer exchanges a truck with a fair market value of $1,100 and a computer with a fair market value of $800 for a truck with a fair market value of $800 and a computer with a fair market value of $1,000. The taxpayer also receives $100 cash. Since the properties exchanged are in two different asset classes, gain will be recognized on the excess value of the computer received for the truck ($1,000 - $800) plus $100 cash for a total recognized gain of $300. Under the current regulations, gain would only be recognized on the $100 cash received.

An exchange of intangible personal property, nondepreciable personal property or property held for investment does not qualify for a like-kind exchange unless the properties are of a like kind. No classes are provided for this type property. Whether intangible personal property is of a like kind to other intangible personal property depends not only on the type of right involved but also on the type of underlying property to which the intangible personal property relates. Therefore, an exchange of a copyright on a novel for a copyright on another novel will be treated as an exchange of like-kind property, while an exchange of a copyright on a novel for a copyright on a song will not.(9) In addition, an exchange of goodwill or going concern of dissimilar businesses will not qualify as a like-kind exchange, and an exchange of goodwill or going concern of similar businesses will qualify as a like-kind exchange only in very rare and unusual circumstances.(10)

Treatment of Deferred

Exchanges

A deferred exchanged occurs when property, used in a taxpayer's trade or business or for the production of income, is relinquished pursuant to an agreement and the like-kind property is received at a later date. As Section 1031 currently provides, this type of transaction qualifies as a like-kind exchange only if the property to be received is identified or received within a specified time period.

However, the proposed regulations contain additional provisions that limit the application of Section 1031 in a deferred exchange situation. According to the proposed regulations, even if property is received or identified within the required time period, the transaction will be treated as a taxable sale if it is an exchange of property for money rather than an exchange of property of property. Accordingly, a transfer of property for cash followed by a purchase of "like-kind" property will not qualify as a tax-free exchange even if the property is identified or received within the required time period. Furthermore, the transaction does not qualify as a like-kind exchange if the taxpayer actually or constructively receives cash or other non-qualifying property before the like-kind property is received.

Replacement property is identified within the required time period if it is identified within 45 days beginning on the date that the taxpayer transfers the relinquished property. If the property is not identified within 45 days, it may still qualify for like-kind treatment if it is received on the earlier of: 1. 180 days beginning on the

date the taxpayer transfers the

relinquished property; or 2. The due date (including extensions)

for the taxpayer's

return for the taxable year in

which the transfer of the relinquished

property occurs.(11)

If, as part of the same exchange, the taxpayer transfers more than one item of property, the time begins to run from the date of the earliest transfer. If the date for identifying or receiving property falls on a Saturday, Sunday or a legal holiday, the date will not be extended to the next business day.(12)

Example: The Eagle Corporation is a calendar year taxpayer that enters into an agreement with the Robin Corporation for an exchange of property. Under the terms of the agreement, Eagle must transfer its property on November 17, 1990. The identification period ends on January 1, 1991, despite the fact that this is New Year's Day. The exchange period ends on March 15, 1991, the due date for the tax return, because it is earlier than May 16, 1991 (180 days from the transfer). However, if Eagle is granted a six-month automatic extension, the exchange period ends on May 16, 1991, because it is earlier than the date for filing the extended return.

There is no problem in identifying replacement property if the property is received within the 45-day limit.(13) If replacement property is not received within 45 days, it may be identified only if it is designated as replacement property in a written document signed by the taxpayer and sent to anyone other than the taxpayer or a related party within 45 days. A related party is someone who is described in Sections 267(b) or 707(b).(14) A related party may also be an agent of the taxpayer such as an employee, attorney or broker. If the agent is one who performs services for the taxpayer only with respect to exchanges of property intended to qualify for like-kind treatment, the agent will not be treated as a related party. In addition, financial institutions are not considered to be related parties if they only perform routine financial services for the taxpayer.(15) The written document must describe the replacement property unambiguously. Real property is unambiguously described by legal description or street address. Personal property is unambiguously described if the description is specific enough to identify the particular type of property. Therefore, a truck is unambiguously described by specific make, model and year.(16)

The taxpayer may identify more than one piece of property as replacement property regardless of the number of properties relinquished. This allows the taxpayer the flexibility of identifying alternate properties if the first choice becomes unavailable. However, there are limits to the number of properties that may be identified. The taxpayer may always identify three properties irrespective of the fair market values (three-property rule). The taxpayer may identify more than three properties so long as the aggregate fair market values of the properties identified (valued at the end of the replacement period) do not exceed 200% of the aggregate fair market values of the property relinquished (valued at the time of the transfer).(17) If the taxpayer identifies more than the allowed number of properties as replacement property, the taxpayer may be treated as not identifying any replacement property, meaning the exchange will fail to qualify as like-kind. This will not happen with respect to any property actually received by the taxpayer within the identification period. If the 200% limit is exceeded, the taxpayer will not lose like-kind exchange treatment if the replacement property is identified before the end of the identification period and received before the end of the exchange period. However, the taxpayer must receive 95% of the aggregate fair market value of all replacement identified before the end of the exchange period.(18)

Example: The Eagle Corporation transfers a tract of land with a fair market value of $100,000. Before the end of the identification period, Eagle receives a tract of land as replacement property with a fair market value of $50,000. Eagle may either identify two other pieces of property as replacement or more than two other pieces of property so long as their aggregate fair market values do not exceed $150,000 [200% of (100,000)-$50,000].

When applying the limits on the number of properties that may be identified, property that is incidental to a larger piece of property is disregarded. Therefore, if a truck is identified as replacement property and the truck contains a tool kit and a spare tire, the spare tire and the tool kit will not be counted as separate property when applying the three-property limit. In order for a piece of property to be considered to be incidental, it must be standard commercial practice for the property to be transferred with the larger item of property and the aggregate values of the incidental items cannot exceed 15% of the aggregate fair market value of the larger item.(19) The taxpayer may revoke the identification of replacement property by sending a signed, written statement of revocation to all parties before the end of the identification period.(20)

The requirements relating to the receipt of identified property are met if the identified property is received before the end of the exchange period and the replacement property is substantially the same as the property identified.(21) Sometimes a deferred exchange will occur and the replacement property is not in existence or is being produced. This is permissible and the exchange will not fail to qualify as a like-kind exchange so long as the property is completed by the end of the replacement period. When the replacement property is not in existence, small changes in production will not be considered. However, if substantial changes are made, the property will not be considered to be the same property as the property identified.(22)

If the taxpayer actually or constructively receives money or other property in the full amount of the consideration for the relinquished property before the taxpayer actually receives the like-kind replacement property, the transaction will be treated as a taxable sale rather than a tax-free exchange.(23) The general rules of actual and constructive receipt will apply in determining whether or not a taxpayer has made a taxable sale. Therefore, if the taxpayer has the unrestricted right to demand cash or other non-qualifying property in lieu of the like-kind property, the transaction will be treated as a sale.

There are four safe harbors that will allow the taxpayer to be in actual or constructive receipt of cash without violating the provisions of Section 1031.(24) The person who is obligated to furnish the replacement property may be required to guarantee this obligation by a mortgage, deed of trust or other security agreement that is not cash or a cash equivalent. The obligation may also be secured by certain standby letters of credit or a guarantee of a third party. The obligation to transfer replacement property may be secured by cash or a cash equivalent if it is held in a qualified escrow account or a qualified trust. An escrow or trust account is qualified if the escrow holder is not the taxpayer or a related party and the taxpayer's rights to benefit from the amount held in escrow are limited. The taxpayer may use a qualified intermediary to affect the exchange, or the taxpayer may be entitled to interest or other "growth factor" provided that the taxpayer's right to receive such interest is limited. The taxpayer is considered to be entitled to interest or other "growth factor" if the taxpayer's right to receive money or property (including like-kind property) depends upon the lapse of time between the transfer of relinquished property and the receipt of replacement property.(25)

In determining the gain recognized and the basis of like-kind property received, the rules contained in the current regulations will govern.(26)

Exchange of Multiple

Properties

When properties from more than one exchange group are transferred, the computation of the gain recognized and the basis of the like-kind property received becomes more complicated. The properties transferred and the properties received must be separated into their proper exchange groups. An exchange group consists of the properties transferred and received that are of a like kind or class. Each exchange group must consist of at least one property transferred and at least one property received. A residual group consists of money or other property that is not subject to the like-kind rules of Section 1031 such as stocks, bonds and property primarily held for sale. The residual group also contains property that is not of a like kind or class as the property for which it is transferred. The amount of money allocated to the residual group is equal to the difference between the aggregate fair market value of the properties transferred in all exchange groups and the aggregate fair market value of all properties received. In general, the residual group will consist of either money or property transferred in an exchange or money or property received in an exchange, but not both. An exchange group surplus occurs when the aggregate fair market values of all the properties received exceed the aggregate fair market values of the properties transferred. An exchange group deficiency occurs when the aggregate fair market values of the properties transferred exceed the aggregate fair market values of the properties received.

The amount of gain or loss realized with respect to each exchange group and residual group is the difference between the aggregate fair market value of the properties transferred in that exchange group or residual group and the properties' aggregate adjusted basis. Gain is recognized to the extent of the smaller of the gain realized or the amount of the exchange group deficiency. Losses are not recognized. The amount of gain or loss recognized in the residual group is equal to the gain or loss realized since this property does not qualify for like-kind exchange treatment.

Example: Frank exchanges a computer and an automobile for a printer and an automobile. The computer relinquished has a fair market value of $1,000 and an adjusted basis of $375. The automobile relinquished has a fair market value of $4,000 and an adjusted basis of $3,500. He receives a printer worth $800, an automobile worth $2,950, corporate stock worth $750 and cash of $500. All properties will be used in Frank's business or for the production of income. 1. The first exchange group

consists of the computer and

the printer. Frank has a $200

exchange deficiency because

the fair market value of the

computer exceeds the fair

market value of the printer

($1,000 - $800). 2. The second exchange group

consists of the two automobiles

with an exchange deficiency

of $1,050 because the

fair market value of the automobile

relinquished exceeds

the fair market value of the

automobile received ($4,000

- $2,950). 3. The residual group is $1,250

(the excess of the fair market

values of the properties relinquished

over the fair market

values of the properties received.

The residual group

corresponds to the stock and

the cash received. 4. Frank recognizes a $200 gain

with respect to the first exchange

group because the

exchange deficiency is less than

the gain realized ($1,000 - $375). 5. Frank recognizes a gain of

$500 on the second exchange

group because the gain realized

($4,000 - $3,500) is less

than the $1,050 exchange

deficiency. 6. Since none of the property

transferred by Frank was in

the residual group, he recognizes

no gain on this property. 7. Frank's basis in the printer is

$375 which is equal to his

basis in the computer less the

amount of the exchange deficiency,

plus gain recognized

($375 - $200 + $200). Frank's

basis in the replacement automobile

is $2,950 ($3,500 - $1,050

+ $500).

Treatment of Liabilities

If liabilities assumed by the taxpayer exceed the liabilities that the taxpayer transfers, the excess is allocated among the exchange groups in proportion to the fair market value of the properties received. On the other hand, if the liabilities that the taxpayer transfers exceed the liabilities that the taxpayer assumes, the excess is treated as part of the residual group and handled accordingly.(27) This is a departure from the current regulations that allow the benefits received from the transfer of liabilities to be offset by the receipt of property subject to a liability.(28)

Example: Barbara exchanges a computer, an automobile and a heavy duty truck for Charlie's computer, automobile and heavy duty truck. Barbara's computer has a fair market value of $1,500 and an adjusted basis of $800. Her automobile has a fair market value of $2,500 and an adjusted basis of $900 and is subject to a $500 liability. Her truck has a fair market value of $2,000 and an adjusted basis of $700. Charlie's computer has a fair market value of $1,600 and an adjusted basis of $1,100. His automobile has a fair market value of $3,100 and an adjusted basis of $2,100 and is subject to a liability of $750. His truck has a fair market value of $1,400 and an adjusted basis of $600 and is subject to a $250 liability. He also gives Barbara $400 in cash. 1. The first exchange group

consists of the computers, the

second consists of the automobiles

and the third exchange

group consists of the trucks. 2. The liabilities that Barbara

assumes ($1,000) exceed the

liabilities that Barbara transfers

($500), resulting in an

excess of $500. This excess is

allocated among the three

exchange groups that Barbara

receives in proportion to their

relative fair market values:

$131 to the first exchange

group ($500 x $1,600/

$6,100); $254 to the second

exchange group ($500 x

$3,100/$6,100); $115 to the

third exchange group ($500

x $1,400/$6,100). With the

allocation of the liabilities,

there is an exchange deficiency

of $31 with respect to the

first exchange group ($1,500

+ $131 - $1,600), a $346

exchange surplus with respect

to the second exchange group

($2,500 + $254 - $3,100)

and an exchange deficiency

of $715 with respect to the

third exchange group ($2,000

+ $115 - $1,400). (Note that

an increase in an exchange

group deficiency because of

excess liabilities may increase

the gain recognized since this

deficiency is one of the factors

used in determining recognized

gain.) 3. The difference between the

aggregate fair market value

of the property Barbara receives,

less excess liabilities,

is $5,600 ($1,600 + $3,100

+ $1,400 - $500). The aggregate

fair market value of

the property Barbara transfers

is $6,000 ($1,500 +

$2,500 + $2,000), creating

an excess of $400. This constitutes

the residual group

corresponding to the $400 cash

Barbara receives. 4. Barbara recognizes a $31 gain

on the exchange of the first

group because the exchange

deficiency is less than the gain

realized ($1,500 - $800). She

recognizes no gain with respect

to the second exchange

group because the exchange

deficiency is less than the gain

realized ($2,500 - $900). She

recognizes a $715 gain on the

exchange of the third group

because the $715 exchange

deficiency is less than the gain

realized (2,000 - $700). Since

none of the property that

Barbara transferred was allocated

to the residual group,

she recognizes neither gain

nor loss with respect to this

property. 5. Barbara's basis in the property

she receives is computed

by taking the basis of the

property she transfers, decreased

by an exchange group

deficiency, increased by an

exchange group surplus, increased

by excess liabilities

assumed and increased by gain

recognized.

Barbara's basis in her new computer is $931 ($800 - $31 + $131 + $31). Her basis in her new automobile is $1,500 ($900 + $346 + $254). Her basis in her new truck is $815 ($700-$715 + $115 + $715). 1. Charlie's first exchange group

has an exchange deficiency of

$100 ($1,600 - $1,500). His

second exchange group has a

deficiency of $600 ($3,100 - $2,500)

and his third exchange

group has a surplus of $600

($1,400 - $2,000). 2. The aggregate fair market

value of the property Charlie

transfers exceeds the aggregate

fair market value of the

property received by $100

($6,100 - $6,000). Since

Charlie's liabilities transferred

exceed his liabilities assumed,

Charlie is treated as receiving

$500 in cash. The $400

that Charlie pays Barbara and

$400 of the excess liabilities

transferred cancel each other

out and are not within any of

the exchange groups or the

residual group. This leaves

$100 of the excess liabilities

in the residual group. 3. Charlie recognizes a gain of

$100 with respect to the first

exchange group because the

exchange deficiency of $100

is less than the gain realized

($1,600 - $1,100). With

respect to the second exchange

group, Charlie recognizes a

gain of $600, the exchange

group deficiency, because it

is less than the gain realized

($3,100-$2,100). Since there

is not exchange deficiency with

respect to the third exchange

group, Charlie recognizes no

gain. None of the property

transferred by Charlie was

allocated to the residual group,

so Charlie recognizes no gain

with respect to this group. 4. Charlie has a basis of $1,100

in his new computer ($1,100

- $100 + $100). Charlie has

as basis of $2,100 in the new

automobile ($2,100 - $600 +

$600). He has an adjusted

basis of $1,200 in the truck

($600 + $600 + $0).

Conclusion

When the proposed regulations are adopted, they will be effective retroactively for all transfers of property made after July 2, 1990, unless there was a binding written contract in effect on May 16, 1990, and at all times thereafter. However, the regulations will almost certainly be subject to court challenges on the grounds that the Treasury Department exceeded its authority. Regulations are issued to interpret laws, not to enact them. Admittedly, the law does not define like-kind property. This was done by judicial interpretation as early as 1941. If the Treasury Department determined that like-kind property was given a definition that was too broad, it should not have acquiesced to the definition for almost 50 years. The radical departure from the accepted definition is tantamount to legislation, not interpretation. If Congress decides that a change is in order, let them amend Section 1031.

M. Jill Lockwood Martin, CPA, is professor of accounting at Georgia Southern University in Statesboro, Georgia. Her interests include the taxation of partnerships, estates and trusts and S corporations. She is the author of Partnership Taxation Handbook published by Prentice-Hall.

Footnotes

(1) Commissioner v. Crichton, 122 F2 181 [CA-5] 1941.

(2) Proposed Reg. 1.1031(a)-2(b)1.

(3) Rev. Proc. 87-56, 1987-2 C.B. 674.

(4) Proposed Reg. 1.1031(a)-2(b)(3).

(5) See U.S. Department of Commerce, Bureau of the Census, 1987 Census of Manufacturers and Census of Mineral Industries, 1989 Reference Series: Numerical List of Manufactured and Mineral Products (Issued February 1989).

(6) Ibid.

(7) Proposed Reg. 1.1031(a)-2(b)(4).

(8) IRC Section 1031(a)(2).

(9) Proposed Reg. 1.1031(a)-2(c).

(10) Proposed Reg. 1.1031(a)-2(c)(2).

(11) Proposed Reg. 1.1031(a)-3(b)

(12) Proposed Reg. 1.1031(a)-3(b)(2)(iii).

(13) Proposed Reg. 1.1031(a)-3(c).

(14) Substitute "10%" for "50%" each place it appears.

(15) Proposed Reg. 1.1031(a)-3(k).

(16) Proposed Reg. 1.1031(a)-3(c)(3).

(17) Proposed Reg. 1.1031(a)-3(b)(c)(4).

(18) Proposed Reg. 1.1031(a)-3(c)(4)(ii).

(19) Proposed Reg. 1.1031(a)-3(c)(5).

(20) Proposed Reg. 1.1031(a)-3(c)(6).

(21) Proposed Reg. 1.1031(a)-3(d).

(22) Proposed Reg. 1.1031(a)-3(e).

(23) Proposed Reg. 1.1031(a)-3(f).

(24) Proposed Reg. 1.1031(a)-3(g).

(25) Proposed Reg. 1.1031(a)-3(h).

(26) Proposed Reg. 1.1031(a)-3(j).

(27) Proposed Reg. 1.1031(f)-1(b)(2)(ii).

(28) Reg. 1.1031(b)-1(c).
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Author:Martin, M. Jill Lockwood
Publication:The National Public Accountant
Date:Dec 1, 1990
Words:4355
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