SECTION 1031
USE OF LIKE KIND EXHANGES
IN REAL ESTATE TRANSACTIONS

Kevin M. Rowe

Alston & Bird LLP (New York, NY)

I. Introduction

In general, gain or loss realized gain upon the transfer of property is recognized and subject to tax.’ The amount of gain or loss realized upon the transfer of property is equal to the cash plus the fair market value of any property received in the transaction, minus the Taxpayer’s basis in the transferred property.

The Code contains many exceptions to the general rule that realized gain is recognized and subject to tax, including Section 1031. Other exceptions to the general rule requiring gain recognition include:

(i) transfer of property to a corporation in exchange for stock in the transferee

corporation by. persons in control of the transferee corporation

immediately after the transaction; 2

(ii) distribution by a corporation of stock in a controlled corporation to

shareholders in tax-free spin off; 3

(iii) exchange of stock of one corporation for stock of another corporation pursuant to a plan of reorganization;

(iv) exchange of property by a corporation party to a reorganization for stock of another corporation party that is a party to a reorganizations

(v) distribution of property by a subsidiary corporation to its parent in

complete liquidation; 6

(vi) transfer of property to a partnership in exchange for an interest in the partnership ;7

(vii) distribution of property by a partnership to a partner;

(viii) receipt of consideration following involuntary conversion of property if consideration is reinvested in similar property within specified time period;9

I.R.C. § 1001. ‘` I.R.C. § 351. 3 I.R.C. § 355. 4 I.R.C. §§ 354 and 368. ‘ I.R.C. §§ 361 and 368. 6 I.R.C. § 332. I.R.C. § 721. a I.R.C. § 731.

 

(ix) exchange of common stock for common stock in the same corporation or

the exchange of preferred stock for preferred stock in the same

corporation;’

(x) reacquisition of real property by seller of real property from buyer in

satisfaction of acquisition indebtedness; lI

(xi) transfer of property from an individual to a spouse or former spouse pursuant to a divorce;’ 2

(xii) transfer of property by an officer or employee of the executive branch of the federal government pursuant to a certificate of divestiture issued by the President or the Director of the Office of Government Ethics;’ 3

(xiii) sale of publicly traded securities followed by reinvestment in “specialized small business investment company” (limited to $50,000 of gain for individuals); 14

(xiv) sale of qualified small business stock followed by reinvestment of proceeds in other qualified small business stock;’ 5 and

(xv) transfers of certain stock pursuant to order of SEC that effectuates the Public Utility Holding Company Act of 1935.16 17

These provisions are diverse and no single policy explains all of them. The regulations under Section 1001 of the Code provide the following general explanation of many exceptions to the rules requiring gain recognition on the disposition of property::

These sections describe certain specific exchanges of property in which, at the time of the exchange, particular differences exist between the property parted with and the property acquired, but such differences are more formal than substantial. As to these, the Code provides that such differences shall not be deemed controlling, and gain or loss shall not be recognized at the

9 LR.C. § 1033. `° LR.C. § 1036. ” LR.C. § 1038. ‘Z LR.C. § 1041. 1′ LR.C. § 1043. ’4 LR.C. §’ 1044. ‘S LR.C. § 1045. ’6 LR.C. § 1081. ’7 Some provisions deny recognition of losses but not gains, including LR.C. § 267 (losses realized in transactions between related parties); LR.C. § 269 (losses arising from corporate transaction involving change of control where tax avoidance is principal purpose); LR.C. § 1091 (losses attributable to wash sales of securities); and LR.C. § 1092 (losses attributable to straddle transactions).

18 Treas. Reg. § 1.1002-1(c).

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time of the exchange. The underlying assumption of these exceptions is that the new property is substantially a continuation of the old investment still unliquidated; and in the case of reorganizations, the new enterprise, the new corporate structure and the new property are substantially continuations of the old still unliquidated.

It is safe to say that while this accurately describes some of the nonrecognition provisions, it does not represent a comprehensive or final explanation of all of these rules.

11. The Basic Rule of Section 1031

The general rule found in Section 1031 (a) states that’”no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment for property of like kind which is held for productive use in a trade or business or for investment,” Gain realized on the exchange is recognized (and subject to income tax) to the extent of the amount of cash and the fair market value of the non-likekind property received in the exchange.

This outline will first review each of the elements of the general rule of Section 1031 and then highlight common issues and problems in the Section 1031 area.

Throughout this Outline the person transferring property will be referred to as the “Taxpayer,” the transferred property will be referred to as the “Relinquished Property” and the property received in exchange will be referred to as the “Replacement Property.”

111. Exchange

A Section 1031 transaction requires the transfer of qualifying properly in exchange for other qualifying property. A transfer of property by the Taxpayer for cash followed, however quickly, by the reinvestment of the cash by the Taxpayer in qualifying property is not an exchange.

The IRS for many years took the position that the simultaneous exchange of qualifying properties was necessary under Section 1031. This position was rejected in Starker v. U.S., i9and later codified in 1984 with the enactment of Section 1031(a)(3) (which contains the 45-day identification period and the 180-day exchange period discussed below). Similarly, the IRS has, historically, been uncomfortable with transactions in which (i) the Taxpayer directs the buyer of the Relinquished Property to acquire or to improve the Replacement Property; z° and (ii) the buyer of the Relinquished

” 602 F.2d 1341 (9″ Cir. 1979). 2° J.K Baird Publishing Co. v. Comm’r, 39 T.C. 608 (1963), acq. 1963-2 C.B. 4 (exchange qualifies as Section 1031 exchange because Taxpayer did not constructively receive cash from the buyer of the Relinquished Property and the buyer did not act as the Taxpayer’s agent in acquiring and improving the Replacement Property).

 

Property agrees to construct improvements on Replacement Property that is already owned by the Taxpayer.

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Section 1031 is not elective and it precludes recognition of realized losses as well as realized gain. The IRS has denied loss recognition to the Taxpayer on the ground that the Taxpayer engaged in a Section 1031 exchange. However, this outcome can be avoided with minimal effort by stating in the relevant documents that the Taxpayer does not intend to engage in an exchange, or by having the Taxpayer receive cash consideration from the buyer of the Relinquished Property without restriction.

IV. Property

 

A. General. The general rule holds that all property, tangible or intangible, 22 may be transferred or received in a Section 1031 transaction (subject of course to the requirement that the property be of like kind). The following types of property are ineligible for Section 1031:23

(i) stock in trade or other property held primarily for sale;

(ii) stocks, bonds or notes;

(iii) other securities or evidences of indebtedness;

(iv) interests in a partnership;

(v) certificates of trust or beneficial interests; or

(vi) choses in action.

B. Stock in Trade or Other Property held Primarily Sale. This category is defined as property included in inventory as well as property the Taxpayer holds primarily for sale in the ordinary course of business and it is applied at the time of the exchange. Identifying property included in inventory is fairly straightforward; but identifying property held primarily for sale in the ordinary course is a more complicated and can generate highly subjective inquiries as to the Taxpayer’s motivation for holding property. Disputes under this rule overlap in many ways with the requirement (discussed below) that the Taxpayer hold the Relinquished Property for productive use in a trade or business or for investment and to hold the Replacement Property for the same purposes.

C. Stocks, Bond, Notes, Securities and Certificates of Interests in Trusts. This category is self-explanatory; although it is worth noting that Section 1031, as originally enacted, did not exclude stocks from exchange treatment.

” Bloomington Coca Cola Bottling Co. v. Comm’r, 189 F.2d 14 (7 `s Cir. 1951) (Taxpayer sold Relinquished Property for cash in a taxable transaction because it already owned the “Replacement property”). z2 Section 1.1031 (a)-2(c) of the Treasury Regulations provides that intangible property may be transferred in a Section 1031 exchange. 21 I.R.C. § 1031(a)(2).

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D. Partnership Interests. This exclusion was enacted in 1984 and it came after many cases in which Taxpayers successfully argued in court that partnership interests could were eligible for the benefits of Section 1031 because a partnership interest was property not listed in the exclusions in Section 1031.24 In 1984, Section 1031 was amended to add partnership interests to the list of property ineligible for a Section 1031 exchange. 25 The regulations now provide that Section 1031 does not apply to any exchange of partnership interests “whether the interests exchanged are general or limited partnership interests or are interests in the same partnership or in different partnerships. “26

The IRS has ruled that for purposes of Section 1031 a single member limited liability company will be disregarded as an entity separate from its owner consistent with the general treatment of such entities under federal income tax law. 27

Two issues relating to partnership interests under Section 1031 are worth further examination. The first issue concerns the interaction between Sections 1031 and 761 of the Code. Regulations issued under Section 761 of the Code permit certain types of partnerships to elect to be excluded from the rules of subchapter K. If a partnership makes this election, an interest in the partnership is treated, for federal income tax purposes including Section 1031, as an undivided proportionate interest in all assets held by the partnership and not as an interests in an entity. A partner in a partnership that has elected out of subchapter K under Section 761 of the Code can transfer his undivided interest in partnership property in a Section 1031 transaction. The Section 761 election has limited utility because it is only available to partnerships engaged in investment activity, formed for the joint production, extraction, or use of property but not for purposes of selling services or products so procured or extracted, or availed of by dealers for the purpose of underwriting or selling a particular issue of securities.

The second issue concerns whether an undivided fractional interest in real property (such as an interest as a tenant-in-common) is classified as an interest in a partnership for federal income tax purposes (and thereby ineligible for transfer in a Section 1031 exchange). This problem often arises when the Taxpayer wishes to pool his or her investment in the Relinquished Property in Replacement Property that is significantly more expensive than the Relinquished Property.

For federal income tax purposes, a partnership includes a syndicate, group, pool, or joint venture that is not a corporation, trust or an estate through or by means of which any business, financial operation or venture is carried on whether or not there is a partnership or limited liability company existing under state law. 28 The de facto

24 Gulfstream Land and Dev. Corp. v. Comm’r, 71 T.C. 587 (1979) (partnership interest qualifies for Section 1031 exchange). zs I.R.C. § 1031(a)(2)(D). 26 Treas. Reg. § 1.1031(a)-I(a)(1). It should be noted that subchapter K, the rules governing partnerships, contains a lot of flexible rules that enable partnerships to merge or acquire other partnerships without recognition of gain as long transaction does not involve cash consideration. 27 LTR 9807013 (November 13, 1997). 21 I.R.C. §§ 761 (a) and 7701(a)(2).

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partnership doctrine holds that a joint undertakings is a partnership for federal income tax purposes even though it is not formed as a partnership or limited liability company under state law and it is described in regulations as follows: 29

A joint venture or other contractual arrangement may create a separate entity for federal tax purposes if the participants carry on a trade, business, financial operation or venture and divide the profits therefrom. For example, a separate entity exists for federal tax purposes if co-owners of an apartment building lease space and in addition provide services to the occupants either directly or through an agent. Nevertheless, a joint undertaking merely to share expenses does not create a separate entity for federal tax purposes. For example, if two or more persons jointly construct a ditch merely to drain surface water from their properties, they have not created a separate entity for federal income tax purposes. Similarly, mere co-ownership of property that is maintained, kept in repair, and rented or leased does not constitute a separate entity for federal tax purposes. For example, if an individual owner, or tenant-in-common, of farm property leases it to a farmer for a cash rental or a share of the crops, they do not necessarily create a separate entity for federal tax purposes.

The most detailed IRS guidance on the application of the de facto partnership doctrine to tenants in common is Revenue Ruling 75-3743° in which the IRS held that ownership of an apartment building by co-tenants did not constitute a partnership for federal income tax purposes. The agreement between the co-tenants provided that (i) the parties had no intention to create a partnership, (ii) each co-tenant could sell his cotenancy interest at any time, (iii) the co-tenants retained co-tenancy partition rights, and (iv) each co-tenant retained the right to borrow against his or her co-tenancy interest. The co-tenants hired an unrelated company to manage all aspects of the building, including the provision of basic utilities, unattended parking and normal repairs and cleaning. The management company charged the tenants in the apartment building separately for parking with an attendant and for gas and electric service and the co-tenants did not share in profits derived in this activity. In finding no partnership, the Service reasoned that the co-tenants were joined together solely to hold the property and not to share profits from an enterprise using the property (other than the passive investment return). The Service reasoned that the services provided by the management company were “customarily” provided by a real estate manager to passive investors in rental real property. Although other services furnished by the management company to the tenants were not customary real estate managers managing passive investments, the co-tenants did not share in the profits attributable to these services.

`9 Treas. Reg. § 301.7701-1(a)(2). ‘° 1975-2- C.B. 261.

 

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The IRS has cited Revenue Ruling 75-374 in several private letter rulings holding that co-tenancy arrangements were not partnerships under Section 1031.31 On October 11, 2000, the IRS stated in Revenue Procedure 2000-4632 that it intended to study whether certain arrangements in which taxpayers hold undivided fractional interests in real property constitute a separate entity for federal income tax purposes that may not be exchanged in tax-free section 1031 exchange. This suggests that the IRS is uncomfortable with the extent of taxpayer activity in this area; but understands that the range of possible responses are limited. Absent a specific ruling on this issue, the best advice is stay as close as possible to the principles enunciated in Revenue Ruling 75-374.

The following provisions are generally considered necessary to avoid classification of an undivided fractional interest as a partnership: (i) express statement that the parties do not intend to create a partnership for federal income tax purposes (including agreement of co-tenants not to file partnership tax returns and not to hold themselves out as partners); (ii) no restriction on the right of each co-tenant to sell, finance or otherwise create a lien on his or her interest; and (iii) no delegation of authority to a third party, such as the manager of the property, to encumber the property. In addition, the following provisions generally will not, standing alone, cause partnership classification: (w) a management agreement with a third party to manage the property (including bookkeeping obligations and the maintenance of a single bank account); (x) division of income derived from the property in accordance with the proportionate interests of the co-tenants in the property; (y) requirement that co-tenants fund expenses associated with the property held in co-tenancy; and (z) right of first refusal in the event a co-tenant wishes to dispose of his or her co-tenancy interest.

Provisions in the co-tenancy agreement that are likely to result in the arrangement being classified as a partnership for federal income tax purposes include: (i) waiver by co-tenants of rights to sell or encumber co-tenancy interest; (ii) delegation by all cotenants of substantial powers to a third party (including right to encumber property held in the co-tenancy; (iii) third party sharing in profits from the property; and (iv) filing of partnership return or taking other actions resulting in co-tenants holding themselves out as partners. In summary, while it is possible to establish a co-tenancy agreement without having the arrangement classified as a partnership, the rules in this area are evolving and practitioners must be very careful.

E. Choses in Action. A “chose in action” is not defined in the regulations under Section 1031 or in the pertinent legislative history. The common definition of the term is a right to receive from another person property or money that is not reduced into possession but is recoverable through a legal process. This term does not include common types of intangible property such as trade names, patents and copyrights. 33 The

’1 P.L.R. 200019014 (February 10, 2000) (tenants in common did not create de facto partnership where agent performed only customary management functions); P.L.R. 199907029 (September, 1998) (although the management company performed only customary services on behalf of co-tenants de facto partnership found where the co-tenants held themselves out as a partnership, including filing partnership income tax returns). 12 2000-44I.R.B.1.

P.L.R. 8453034 (September 28, 1984).

 

 

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IRS has also ruled that contracts for the services of a professional baseball player are not choses in action and can be exchanged in a Section 1031 exchange. 34

 

V. Purpose for Holding the Relinquished Property and the Replacement Property.

A. General Rules. At the time of the Section 1031 exchange, the Taxpayer must hold the Relinquished Property for productive use in a trade or business or for investment. In addition, the Taxpayer must hold the Replacement Property for the same purposes for a period of time following the exchange. The Relinquished Property and the Replacement Property be like-kind, Section 1031 may apply to an exchange of property held for use in a trade or business for property held for investment as well as an exchange of property held for investment for property held for use in a trade or business (subject to the requirement that the properties be of like kind).35

Whether the Taxpayer holds the Relinquished Property for productive use in a trade or business or for investment immediately prior to the exchange is determined based on all facts and circumstances. Property acquired for the purpose of completing an exchange is generally not considered to be held for the requisite purpose. 36 A facts and circumstances also test applies to determine whether the Taxpayer holds the Replacement Property for the requisite purposes (it applies without regard to the transferor’s purpose 37 for holding such property).

Two common issues in this area are (i) whether a Taxpayer holds the Relinquished Property for investment purposes or for making sales to customers in the ordinary course of business, and (ii) whether a Taxpayer has the requisite intention of holding either the Relinquished Property or the Replacement Property when he or she receives the Relinquished Property from a related person (such as a corporation or a partnership) shortly before the exchange, or shortly after the exchange he or she transfers the Replacement Property to a related person.

B. Property Held for Investment or for Sale in the Ordinary Course. Perhaps the most common fact pattern here involves the real estate developer who “abandons” the intention to subdivide a tract of land and build homes to hold the land for investment purposes (and typically shortly thereafter he or she transfers the property in a Section 1031 transaction) or, with a slight variation, the individual who changes his or purpose

34 Rev. Rut. 67-380, 1967-2 C.B. 291. 35 Treas. Reg. § 1.1031 (a)-1(a). 36 Rev. Rut. 77-297, 1977-2 C.B. 304 (accommodation acquirer of Replacement ineligible for Section 1031 upon transfer of property to the Taxpayer; unclear why his tax basis in such property was not equal to the property’s fair market value at the time of the exchange). ” Id.; Barker v. U.S., 668 F. Supp. 1199 (1987) 87-2 ~USTC 9444 (Taxpayer did not have the requisite intent when he acquired restaurant for the purpose of exchanging it for farmland because he acquired the restaurant solely for use in the exchange); Rev. Rut. 77-297, 1977-2 C.B. (Section 1031 applied to Taxpayer who received specially acquired Replacement Property in exchange for the Relinquished Property but not to the transferor of the Replacement Property because he acquired the property solely for the purpose of completing the exchange).

 

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for holding real property from personal use to investment (and shortly thereafter exchanges the property in a Section 1031 exchange). In a recent case, Neal T. Baker Enterprises, Inc. v. Commissioner, 38 the taxpayer, a real estate development, acquired vacant land to subdivide and to construct and sell homes. Later, the taxpayer claimed it had abandoned its intention to develop the property in order to hold the property for investment purposes. After changing the purpose of holding the property, the taxpayer exchanged the vacant land for other real property in a transaction designed to qualify as a tax-free transaction under Section 1031.

The court held that the taxpayer failed to demonstrate that it had changed its purpose for holding the property and Section 1031 was inapplicable because immediately prior to the exchange, the Relinquished Property was held for development and sale to customers in the ordinary course of business. The court cited the taxpayer’s failure (i) to reduce its general real estate development activities in respect of other properties as well as the property at issue, (ii) to furnish business records in support of its contention that the Relinquished Property was no longer held for development, and (iii) to abandon efforts to gain approval of the subdivision map pertaining to the property at issue. The court concluded that the taxpayer failed to satisfy the burden of proving that when it transferred the land “it was wearing the hat of an investor.”39

In general, there are no definite guidelines for determining a Taxpayer’s purpose for holding property other than that it is an all facts and circumstances test. Many tax advisors believe it takes two years to establish a change in the Taxpayer’s intent for holding property and in any change of circumstances situation the Taxpayer should carefully document the change in circumstances.

 

C. Property Transferred to or from a Related Person. It is unclear whether the Taxpayer will be deemed to hold the Relinquished Property for the requisite purpose if, shortly before the exchange, he or she receives the property as a result of some type of tax-free transaction with a related party, or whether the Taxpayer will be deemed to hold the Replacement Property for the requisite purpose if, shortly after the exchange, he or she transfers the property to a related person in a tax-free transaction. In the past, the IRS has ruled that when a Taxpayer receives property from a corporation (presumably in a tax free distribution) the Taxpayer does not assume the corporation’s purpose for holding the

’8 76 TCM 301 (1998). 39 A similar rule is found under Section 1221 of the Code, which defines the term “capital asset” to exclude, among other things, property held for sale to customers in the ordinary course of business. Many cases have arisen in which taxpayers claim the lower capital gains tax rate for gains recognized on the disposition of real property that was initially acquired for development. These cases also turn on all the facts and circumstances and they may be helpful in disputes under Section 1031. See Biedenharn v. Comm’r, 526 F.2d 409 (5`b Cir. 1976), rev’g on reh’g 509 F.2d 171 (5`” Cir. 1975), cert. denied, 429 U.S. 819 (1976) (property acquired for investment but extensive efforts to sell the property, including subdivision, construction of roads and other infrastructure, transformed purpose for holding property to sales to customers in the ordinary course; consequently gain was ordinary income); Heller Trust v Comm’r, 382 F. 2d 675 (9`h Cir. 1967) (taxpayer entitled to capital gain rate for sale of rental apartment building as separate condominium units under liquidation of investment theory necessitated by taxpayer’s declining health).

 

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property for purposes of Section 1031.4° The Service also ruled that Section 1031 did not apply when the Taxpayer transferred the Replacement Property to a newly formed corporation on the ground that the Taxpayer did not have the requisite intent for holding the Replacement Property. 41

After losing consistently in court on this issue ,4z the Service appears to have reversed the position reflected in these rulings. In a private letter ruling, 43 the IRS ruled, in simplified terms, that the tax-free liquidation of a subsidiary (or a tax-free merger of the subsidiary into a related corporation) would not affect application of Section 1031 to an exchange completed shortly before the liquidation as long as the corporation into which the subsidiary liquidated held the Replacement Property for the requisite purpose. This a very reasonable approach, if applied broadly, would eliminate a lot of needless uncertainty. However, the IRS has yet to issue a broad repudiation of the position in the earlier rulings and until such a ruling is issued, caution should be exercised in this area.

V1. Replacement Property Must be Like-Kind.

A. General Rule. In order to attain nonrecognition of gain or loss under Section 1031 the Relinquished Property and the Replacement Property must be of a “like kind.” The term “like kind” refers to the nature or character of property not the quality or grade of property.44 Property is into three categories for purposes of defining “like kind:” (i) tangible personal property subject to an allowance for depreciation (that is, tangible personal property used in a trade or business); (ii) other personal property including intangible property and personal property held for investment (which is ineligible for depreciation allowances); and (iii) real property.

B. Depreciable Tangible Property. Depreciable tangible personal property is exchanged for like kind property if it is exchanged for other depreciable personal property that is of a “like class” or of a “like kind. 45 Like class means that the two properties are in the same “General Asset Class” or the same “Product Class.” The term “General Asset Class” originates in rules that classify property for purposes of assigning a useful life under the depreciation rules. 46 The General Asset Classes include, among others, the following: (i) office furniture, fixtures and equipment; (ii) information systems (computers and peripheral equipment; (iii) automobiles and taxis; (iv) buses; (v) heavy general purpose trucks; and (vi) railroad cars and locomotives.

°° Rev. Rut. 77-337, 1977-2 C.B. 305. °` Rev. Rul. 75-292, 1975-2 C.B. 333. 12 Bolker v. Comm’r, 81 T.C. 782 (1983), aff’d 760 F.2d 1039 (9~’ Cir. 1985) (taxpayer received property as a result of a corporate liquidation and held property for approximately three months before the exchange; court also reasoned possibly in dicta that Section 1031 should apply as long as the Taxpayer did not cash out of the property); Magneson v. Comm’r, 81 T.C. 767 (1983), aff’d 753 F.2d 1490 (9s` Cir. 1985). 43 LTR 9850001 (August 31, 1998). °4 Treas. Reg. § 1.1031 (a)-1(b). 45 Treas. Reg. § 1.103t(a)-2(b). 46 .fee Rev. Proc. 87-56, 1987-2 C.B. 674.

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The term “Product Class” originates in the Standard Industrial Classification codes set forth in Executive Office of the President, Office of Management and Budget, Standard Industrial Classification Manuel (1987) (“SIC Manuel”). Two properties that are in the same SIC class but different General Asset Classes are not like kind property. If the definition of an Asset Class or a Product Class is modified the modifications will be effective for purposes of determining whether properties are of alike kind under Section 1031, effective for exchanges occurring after the effective date of the modification.

Depreciable properties may still be like kind property even if they are not in the same Asset Class or Product Class if based on all facts and circumstances they are of like kind.47

Section 1031(h)(2) provides that personal property used predominately within the United States and personal property used predominantly outside the United States are not like kind property.

C. Other Personal Property. Whether items of intangible personal property or tangible property not eligible for depreciation (such as collectibles and fine art), are of like kind is generally based on rulings arid case law and the rulings look to all facts and circumstances. Section 1031(e) is an exception to this rule; it provides that livestock of different sexes are not like kind.

Numismatic coins (that is, coins whose value is based on age, history and general aesthetics) are like kind. Similarly, bullion coins (coins whose value is based on weight and metal content) are like kind if they are made of the same metal .48 However, numismatic coins and bullion coins are not like kind .49 Foreign currency of different countries is not like kind property. 50

The regulations provide that whether two items of intangible property are like kind depends on the nature or character of the rights involved and the nature of the underlying property to which the intangible property relates. 51 The regulations also provide that the goodwill or going concern value of one business is not like kind to the goodwill or going concern value of another business. 52 Copyrights for two novels are like kind , but a copyright on a novel and a copyright on a song are not like kind.53 However, the IRS ruled in a technical advise memorandum that an FCC radio license and an FCC television license are like kind property. 54 The Service reasoned that in both cases the underlying property or the essence of television and radio licenses is assignment of a frequency of the electromagnetic spectrum and that any difference between the two licenses were of grade or quality rather than nature or character.

4′ Treas. Reg. § 1.1031 (a)-2(b)(4). 48 Rev. Rul. 82-166, 1982-2 C.B. 190 (gold bullion coin and silver billion coin are not like kind). 49 Rev. Rul. 79-143, 1979-1 C.B. 264; Rev. Rul. 76-214, 1976-1 C.B. 218. so Treas. Reg. § 1.988-2(a)(1)(ii); Rev. Rul. 74-7, 1974-1 C.B. 198. 5′ Treas. Reg. § 1.1031 (a)-2(c)(1). sz Treas. Reg. § 1.1031 (a)-2(c)(2). 13 Treas. Reg. § 1.1031 (a)-2(c)(3). 14 LTR 200035005, May 11, 2000.

 

D. Real Property. As indicated above, the like kind test looks to the nature or character of property not grade or quality. Consequently, any fee simple interest in real property is like kind to any other fee simple interest in real property and it is immaterial whether one parcel of real property is improved and the other is not, or whether one is located in the city and the other in the country. 55

The Service has also adopted a generous policy in respect of exchanges involving partial interests in real property. The regulations state that a fee simple and a lease are like kind if at the time of the exchange the remainder of the term of the lease is at least 30 years. The Service has ruled that a tenancy in common interest and a fee simple are like kind 56 and that stock in cooperative housing corporation and a condominium interest are like kind property on the ground that under state law shares in the cooperative corporation and the condominium interest were classified as real property under applicable state law. 57 The Service has ruled that a conservation easement and a fee simple are like kind property where both are classified as real property under state law. 58

One restriction in this area is Section 1031(h)(1) which provides that real property located in the United States and real property located outside the United States are not property of alike kind.

V11. Tax Consequences of a Section 1031 Transaction.

 

A. General Rules. The general rule in a good Section 1031 exchange is that the Taxpayer does not recognize gain or loss realized in the exchange (that is, the difference between the fair market value of the Replacement Property and the Taxpayer’s basis in the Relinquished Property). 59 The Taxpayer’s basis in the Replacement Property is equal to his or her basis in the Relinquished Property, and the Taxpayer’s holding period for the Relinquished Property is transferred to or “tacked” to his or her holding period for the Replacement Property.

55 Treas. Reg. § 1.1031(a)-I(c). 56 LTR 200019014, February 10, 2000. 5′ LTR 8810034, December 10, 1987 (ruling involved same property and it is not clear whether that was a significant fact in the ruling). 58 LTR 9621012, February 16, 1996. 59 The general rule of Section 1031 providing for non recognition of realized gain is overridden in limited circumstances under the depreciation recapture rules found in Sections 1245 and 1250 of the Code. If the Taxpayer exchanges “Section 1245 recapture property” (personal property subject to depreciation) for property which is not Section 1245 recapture property, realized gain is recognized to the extent of depreciation deductions previously taken with respect to the transferred property. A similar rule applies to transfers of “Section 1250 recapture property” (certain real property subject to accelerated depreciation) except that in this case the realized gain is limited to the aggregate accelerated depreciation taken in respect of the property (accelerated depreciation means the difference between the aggregate depreciation deductions taken over the aggregate depreciation deductions that would have been taken using the straight line method). Since the Tax Reform Act of 1986 largely eliminated accelerated depreciation for Section 1250 property, the rules requiring gain recognition upon the transfer of Section 1250 recapture property have limited application in practice.

If in addition to receiving like kind property, the Taxpayer receives cash or other property that does not qualify as like kind property (“nonqualified property”), then he or she must recognize gain in an amount equal to the lesser of the (i) amount of gain realized in the exchange, or (ii) the sum of the fair market value of the nonqualifying property plus the cash received in the exchange. No loss is recognized in respect of the Relinquished Property even if the Taxpayer receives nonqualifying property in the exchange. The Taxpayer’s holding period for the Relinquished Property is tacked to his or her holding period for the Replacement Property.

When the Taxpayer receives nonqualifying property, his or her basis in the Replacement Property is determined in a two-part process. First, the aggregate basis of the Replacement Property and the nonqualifying property in the Taxpayer’s hands is equal to the Taxpayer’s basis in the Relinquished Property minus the aggregate cash received in the exchange plus the amount of gain recognized by the Taxpayer in the exchange. Next, this aggregate basis is allocated to the nonqualifying property up to its fair market value on the date of the exchange and then the remainder is allocated to the Relinquished Property.

The regulations illustrate the rules for determining the basis of property received in a Section 1031 exchange that includes nonqualifying property with the following example: b° A, who is not a dealer in real estate, in 1954 transfers real estate held for investment which he purchased in 1940 for $10,000 in exchange for other real estate (to be held for investment) which has a fair market value of $9,000, an automobile which has a fair market value of $2,000, and $1,500 in cash. A realizes a gain of $2,500, all of which is recognized under Section 1031(b). The basis of the property received in exchange is the basis of the real estate A transfers ($10,000) decreased by the amount of money received ($1,500) and increased in the amount of gain that was recognized ($2,500), which results in a basis for the property received of $11,000. This basis of $11,000 is allocated between the automobile and the real estate received by A, the basis of the automobile being its fair market value at the date of the exchange, $2,000, and the basis- of the real estate received being the remainder, $9,000.

If the Taxpayer transfers nonqualifying property in addition to the Relinquished Property, he or she will recognize gain or loss realized in respect of the nonqualifying property. The aggregate consideration received in the transaction is allocated between the Replacement Property and the nonqualifying property pro rata on the basis of the fair market value of the respective properties, and the Taxpayer will be taxed on the gain or loss realized on the transfer of the nonqualifying property as if Section 1031 was not in play.

B. Treatment of Mortgages. If the Relinquished Property is subject to a liability or any other liabilities of the Taxpayer are assumed in the Section 1031 exchange than the aggregate amount of such liabilities is treated as cash received in the exchange. 61 Consequently, if the Taxpayer transfers the Relinquished Property subject to a liability,

6″ Treas. Reg. § 1.1031 (d)-1(c). 6` I.R.C. § 1031(d).

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he or she will recognize gain realized on the transaction to the extent of the lesser of the gain realized, or the amount of the liability to which the Relinquished liability is subject.

If both the Relinquished Property and the Replacement Property are subject to liabilities, or if other liabilities of the Taxpayer are assumed or the Taxpayer assumes liabilities of the transferor of the Replacement Property a netting rule applies to determine the amount of cash received by the Taxpayer in the exchange. Under this rule, consideration given in the form of an assumption of a liability is netted against consideration received in the form of an assumption of a liability to determine the net amount of cash the Taxpayer will be deemed to receive in the exchange. 62 The Taxpayer is considered to “give consideration in the form of an assumption of a liability” if he or she incurs debt to pay part of the purchase price of the Replacement Property.” For example, if the Taxpayer exchanges Property A subject to a $100 debt for like kind Property B also subject to a $100 debt, the “cash” given in the form of the assumption of the liability secured by Property B will offset the “cash” received in the form of the assumption of the liability secured by Property A. This result also would apply if the Taxpayer, instead of taking Property B subject to a preexisting liability, incurred debt to fund part of the purchase price for Property B (the remainder of the price would be funded by Property A).

This liability netting rule does not allow the Taxpayer to offset the value of consideration received in the form nonqualifying property (other than cash) by consideration given in the form of the assumption of liabilities. 64 For example, if the Taxpayer transfers Property A in exchange for Property B and $100 of nonqualifying property and Property B is subject to a debt of $100, the Taxpayer cannot net the “cash” given on account of taking Property B subj ect to a $100 liability against the $100 of nonqualifying property received in the exchange.

The IRS takes the position that the amount of nonqualifying property (including cash) received by the Taxpayer is reduced by expenses incurred by the Taxpayer in connection with the exchange, 65 including, arriong other things, brokerage fees, title insurance premiums, and recording fees.

VIII. Related Party Exchanges.

In general, a Taxpayer may engage in a Section 1031 transaction with a related party; however Section 1031 (f) and (g) contain special restrictions designed to preclude abusive transactions involving related parties. The definition of the term related party is discussed below in paragraph K of Section X of this Outline.

62 Treas. Reg. § 1.1031(a)-1(c). 63 In an example of the rigid litigation posture the IRS has often asserted in the Section 1031 area, the IRS initially asserted that a Taxpayer could not offset boot received in the form of an assumed liability by indebtedness incurred to finance the acquisition of the Replacement Property. See P.L.R. 9853028, ***. 64 Treas. Reg. § 1.1031(d)-2. 65 Rev. Rul. 72-456, 1972-2 C.B. 468.

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Section 1031 (f) provides that if a Taxpayer transfers property to a “related party” in a transaction that qualifies as a good Section 1031 exchange (without considering Section 1031 (f) or (g)) and, prior to the second anniversary of the completion of such exchange, either (i) the Taxpayer disposes of the Replacement Property, or (ii) the related person disposes of the Relinquished Property, the Taxpayer must recognize all gain realized on the exchange of the Relinquished Property (other than any portion of such gain that was already recognized on account of the receipt of nonqualifying property in the original exchange). The Taxpayer must recognize the gain described in the preceding sentence in the taxable year in which the second disposition occurs not the taxable year in which the initial exchange of the Relinquished Property occurs. Certain transfers not motivated by tax avoidance, such as an involuntary conversion within the meaning of Section 1033 of the Code or a transfer resulting from the death of the Taxpayer or a related person do not trigger gain recognition.

The following example illustrates the type of tax planning Section 1031 (f) is designed to prevent:

Assume T and S are each a wholly-owned subsidiary of H, and T owns property (“P1″) with a fair market value of $100 and a tax basis of $10 that unrelated B wishes to acquire for $100 cash. Also assume that S owns property (“P2″) with a fair market value of $100 and a tax basis of $100. If T simply sells P 1 to B it would recognize $90 of gain and pay tax of $36 (assuming a 40% rate of tax). At the end of the day, the PTS group of corporations would have $64. On the other hand, if prior to dealing with B, T and S exchange P 1 and P2, and then B purchases P 1 from S for the $100 cash, (i) neither T nor S would recognize gain on the exchange of P l and P2 and S’s $100 basis in P2 would transfer to P l, and (ii) S would realize no gain on the sale of Pl to B because the amount received would not exceed its tax basis in that property and it would incur no income tax. Thus, at the end of the day, with minimal tax planning, the second transaction yields the HTS group $100 cash.

Section 1031 (g) provides additional protection against creative tax planners focusing on the relatively short 2-year lock up period required under Section 1031(f). It requires suspension of the running of the two year period beginning on the date the related party exchange is completed if either the Taxpayer or the related party has substantially diminished his or her risk of loss with respect to the Replacement Property or the Relinquished Property, respectively, by reason of (i) the holding of a put with respect to such property, (ii) the holding of a call by a third party with respect to such property, or (iii) a short sale or other similar transaction.

IX. Multiple Asset Exchanges.

The general rule of Section 1031 requires a property-by-property comparison for computing the gain recognized and the basis of property received in the exchange. Section 1.10310)-1 provides an exception to this rule for exchanges of multiple properties, provided the taxpayer follows the detailed rules in the regulations. The approach of the regulations is to assign items of Relinquished Property and Replacement

38

Property into “exchange groups” and to determine the amount of gain recognized and the basis of the assets received in the exchange on an exchange group basis.

The regulations provide a mufti-step formula for determining the amount of gain, if any, recognized in a multiple property exchange. 66 Loss is never recognized in a multiple property exchange. Briefly, the steps are as follows. First, the Taxpayer must determine the fair market value of each item of property that is to be exchanged or received in the transaction. Next, each item of property in the transaction is assigned to an exchange group, which is defined as a group of property of alike kind or like class, as defined under the general rules defining like kind property. 67 Next, the aggregate liabilities assumed by the Taxpayer in the transaction are offset against the aggregate liabilities of which the Taxpayer is relieved as part of the exchange. If the Taxpayer assumes more liabilities than the liabilities of which he or she is relieved, the excess is allocated among the exchange groups in proportion to the aggregate fair market value of the properties received by the Taxpayer in each exchange group. If the aggregate liabilities of which the Taxpayer was relieved exceed the assumed liabilities, the excess is set aside for potential allocation to the residual group and possible recognition of a portion of the gain realized in the transaction.

The next step is to determine the “exchange group surplus” or the “exchange group deficiency” with respect to each exchange group. An exchange group surplus or an exchange group deficiency is the excess of the aggregate fair market values of the properties received in a particular exchange group minus the aggregate fair market values of transferred property allocated to the exchange group. If the equation generates a positive number there is an exchange group surplus and if a negative number an exchange group deficiency. In either case, if the liabilities assumed by the Taxpayer in the exchange exceed. the liabilities of which the Taxpayer was relieved in the exchange, an allocable part of such excess reduces the exchange group surplus or the exchange group deficiency of each exchange group. The gain recognized with respect to each exchange group is the lesser of the realized gain with respect to that group (that is, aggregate fair market value of property received minus aggregate tax basis of transferred property), or the exchange group deficiency with respect to the group. No gain is recognized with respect to an exchange group that has an exchange group surplus.

The regulations also provide a complex formula for determining tax basis of property received in multiple property exchange. 68 The aggregate basis of the properties received of each exchange group is equal to (i) the aggregate basis of the properties within that exchange group that were transferred in the exchange, (ii) increased by the amount of gain, if any, recognized in respect of that exchange group, (iii) increased or decreased by the exchange group surplus or the- exchange group deficiency, as the case may be, and (iv) increased by the amount, if any, of the excess liabilities assumed by the Taxpayer that are allocated to the exchange group. The resulting aggregate basis is allocated proportionately to each item of property in the exchange group in accordance

6s Treas. Reg. § 1.1031()-1(b). b’ See Section VI of this Outline. 68 Treas. Reg. § 1.1031(j)-1(c)

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with its fair market value. The basis of each item of property in the residual group is its fair market value.

X. Multi-Party and Deferred Exchanges.

A. Introduction. In simple a two party Section 1031 exchange, the Taxpayer finds someone who owns the Replacement Property and wishes to acquire the Relinquished Property and the two simply exchange the properties (and if necessary add other nonqualifying property or cash to equalize values). Such an exchange is completed on a single day and both sides may enjoy the benefits of Section 1031. This model is obviously somewhat impractical; but, hard to believe, until the 1980′s the IRS basically took the position that Section 1031 was limited to the simultaneous exchange of property by two parties. Over the years taxpayers consistently challenged this position on two fronts, by asserting (i) multi-party exchanges, were consistent with Section 1031, and/or (ii) non-simultaneous or deferred exchanges were consistent with Section 1031.

In basic form, a multi-party exchange involve an intermediary (an additional party) who acquires the Replacement Property and transfers it to the Taxpayer in exchange for the Relinquished Property and then transfers the Relinquished Property for cash to a buyer. The acquisition of the Replacement Property is financed in whole or part with the consideration paid by the buyer of the Relinquished Property. Until quite recently, it was ‘common for the IRS to challenge these transactions on the ground that what the Taxpayer had done at the end of the day was tantamount to the sale of the Relinquished. Property for cash followed by a reinvestment of the sale proceeds in the Replacement Property and that such a transaction as not a Section 1031 exchange.69 Eventually, after losing many cases, the IRS issued guidelines for these transactions, first in a Revenue Ruling7°and ultimately in 1991 it issued the detailed regulations we have today setting forth several workable safe harbors for multi-party exchanges.7l

The second issue in this area is whether Section 1031 applies when the transfer of the Relinquished Property and the receipt of the Replacement Property do not occur at the same time. Again, hard to believe, the IRS for many years took the position that a Section 1031 transaction required the simultaneous exchange of qualifying properties. This position was rejected in the famous case of Starker v. U.S. 72 Congress codified the result in Starker in 1984 by providing in new Section 1031(a)(3) that Section 1031 applied to deferred exchanges as long as two basic requirements were met. First, the Taxpayer must identify the Replacement Property before midnight of the 45`” day after the day on which the Relinquished Property was transferred. Note, this period, known as the “identification period,” is the 46 day period beginning on the date of the disposition of the Relinquished Property. It is common to see the identification period erroneously

69 See, Biggs v. Comm’r, 69 T.C. 905 (1978), aff’d, 632 F.2d 1171 (5`h Cir. 1980); Carlton v U.S., 385 F.2d 238 (5′ Cir. 1967); . ‘° Rev. Rul. 77-297, 1977-2 C.B. 304. ’1 Treas. Reg, § 1.1031 (k)-1. 72 602 F.2d 1341 (9″ Cir. 1979).

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described as the 45-day period beginning on the date of the transfer of the Relinquished Property.

The second basic requirement is the Taxpayer must acquire the Replacement Property before the earlier of (i) the 180`h day after the day on which the Taxpayer transferred the Relinquished Property, or (ii) the return due date (determined with regard to extensions) of the Taxpayer’s income tax return for the year in which the exchange occurred. As with the identification period, this period, known as the “exchange period,” is the 181-day period beginning on the date the Relinquished Property was transferred. It is also common to see the exchange period erroneously described as the 180-day period beginning on the day of the date of the transfer of the Relinquished Property. Moreover, people often overlook the two parts of the test and that the exchange period is shorter for exchanges occurring in the last two an one half months of the taxable year, unless an extension is elected for filing the income tax return for the year of the exchange.

B. The Regulations. In 1991, the IRS issued regulations that provide detailed but workable safe harbors for multi-party and deferred exchanges.

C. Identification of Property. The regulations contain a detailed procedure on the identification of Replacement Property in a deferred exchange. 73 The Replacement Property is properly “identified” only if it is designated as such in a written document signed by the Taxpayer and sent before the end of the identification period to either (i) the person obligated to transfer the Replacement Property to the Taxpayer, or (ii) some other person participating in the exchange such as the qualified intermediary (this will be discussed below). Real property is unambiguously described if it is described by its legal description, address or some distinguishable name (such as the Chrysler building). Personal property is identified by a specific description of a particular type of property (model, make and year).

The regulations permit the Taxpayer to identify more than one Replacement Property. The maximum number of Replacement Properties that the Taxpayer may identify is (i) three properties without regard to the aggregate fair market value of the identified properties, or (ii) any number of properties provided that the aggregate fair market value of the identified properties does not exceed 200 percent of the aggregate fair market value of the Relinquished Properties as of the date of the original transfer. 74 If the Replacement Property is to be constructed or substantially improved the fair market value of the property for this purpose is a reasonable estimate of the fair market value on the date the Taxpayer is expected to receive the property. 75 The Taxpayer can revoke the identification of Replacement Property prior to the end of the identification period provided the revocation is made in a written document sent to the person who received the initial identification of the Replacement Property.76 In addition, no identification procedures are necessary if the Taxpayer actually receives the Replacement Property

73 Treas. Reg. § 1.1031 (k)-1(c). ” Treas, Reg. § 1.1031 (k)-1(c)(4)(i). 75 Treas. Reg. § 1.103i(k)-1(c)(4)(ii). 76 Treas. Reg. § 1.1031 (k)-1(c)(6).

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prior to the end of the identification period. Identification procedures are also relaxed for Replacement Property identified before the end of the identification period and received before the end of the exchange period as long the Replacement Property that is received represents at least 95 percent of the aggregate fair market value of all properties that were identifed.77

D. Constructive Receipt In General. The principal issue addressed by the regulations in the safe harbors pertaining to multi-party exchanges is ensuring that the Taxpayer does not actually or constructively receive cash or other consideration from the buyer of the Relinquished Property prior to the receipt of the Replacement Property. If the Taxpayer actually or constructively receives part of the money or other property paid by the transferee of the Relinquished Property before receipt of the Replacement Property, that consideration will generally be treated nonqualifying property causing the Taxpayer to recognize all or part of the gain realized in the exchange. If prior to receipt of the Replacement Property, the Taxpayer actually or constructively receives all the consideration from the transferee than the transaction will be a taxable exchange78

The general rules on constructive receipt apply in determining whether the Taxpayer is in actual or constructive receipt of cash or property. Under these general rules, the Taxpayer is in actual receipt of cash or property at the time he or she actually receives the money or property, or at the time he or she receives the economic benefit of the money or property. The taxpayer is in constructive receipt of money or property at the time the money or property is credited to the taxpayer’s account, set apart for the taxpayer or otherwise made available to the taxpayer. The Taxpayer is not in constructive receipt of money or property if his or her receipt of the property is subject to substantial limitations. The Taxpayer is, however, in constructive receipt of cash or property at the time those restrictions lapse or are waived. In addition, actual or constructive receipt of money or property by an agent of the Taxpayer is actual or constructive receipt by the Taxpayer.79

With that as background, the bulk of the regulations is made of four safe harbors procedures for executing a multi-party exchange. If the Taxpayer falls within the safe harbors, he or she will not be in constructive receipt of cash or property from the acquirer of the Relinquished Property. Each safe harbor is outlined below.

E. Safe Harbor No. 1 – Security or Guarantee Arrangements. The determination whether the Taxpayer has constructively received proceeds from the sale of the Relinquished Property will be made without regard to the following arrangements to secure the obligation of the person who ultimately acquires the Relinquished Property to transfer the Replacement Property to the Taxpayer: (i) a mortgage, deed of trust or other security interest in property; (ii) a standby letter of credit which secures the transferee’s obligation and which is nontransferable and can only be drawn upon if the transferee defaults on his obligation to transfer the Replacement Property to the Taxpayer; and (iii)

” Treas. Reg. § 1.1031 (k)-1(c)(4)(ii). ‘$ Treas. Reg. § 1.1031(k)-1(1)(1). 79 Treas. Reg. § 1.1031 (k)-1(1](2).

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the guarantee of a third party-80 This safe harbor does not apply if the Taxpayer has an unrestricted right to receive property pursuant to the security arrangement.

F. Safe Harbor No. 2 – Qualified Escrow Accounts and Qualified Trusts. The determination of whether the Taxpayer has constructively received proceeds from the sale of the Relinquished Property is made without regard to the fact that the transferee’s obligation to transfer the Replacement Property to the Taxpayer is secured by cash or a cash equivalent that is held in a qualified escrow account or a qualified trust. 81

A qualified escrow account is an escrow account where the escrow holder is not the Taxpayer or a disqualified person (as defined below) and 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 escrow. However, the escrow agreement may provide the Taxpayer with the right to receive, pledge, borrow or obtain the escrow funds if the Taxpayer fails to identify Replacement Property before the end of the identification period (in this situation the transaction would not qualify for Section 1031 and it is not necessary to worry about constructive receipt because the Taxpayer will be fully taxable on any gain realized on the sale of the Replacement Property). The escrow agreement may also give the Taxpayer. the right to receive, pledge, borrow, or otherwise obtain the benefits of the funds held by the escrow after the identification of the Replacement Property if a material and substantial contingency occurs that relates to the deferred exchange, is provided. for in writing and is beyond the control of the Taxpayer and of any disqualified person (other than a person obligated to transfer Replacement Property to the Taxpayer).82

A qualified trust is similar to a qualified escrow. It is a trust in which the trustee is not the Taxpayer or a disqualified person (as defined below except that the relationship between the Taxpayer and the trustee create by the trust is not taken into account) and the trust agreement expressly limits the Taxpayer’s right to receive, pledge, borrow, or otherwise obtain benefits from the cash held in the trust until receipt of the Replacement Property. 83 As with the qualified escrow, the trust agreement may give the Taxpayer the right to receive, pledge, borrow or obtain the escrow funds if the Taxpayer fails to identify Replacement Property before the end of the identification period, and the agreement may also give the Taxpayer the right to receive, pledge, borrow, or otherwise obtain the benefits of the funds held by the escrow after the identification of the Replacement Property if a material and substantial contingency occurs that relates to the deferred exchange and the procedural rules outlined in the preceding paragraph are followed. 84

$° Treas. Reg. § 1.1031(k)-1(g)(2). 81 Treas. Reg. § 1.1031(k)-1(g)(3)(i). gz Treas. Reg. § 1A031(k)-1(g)(3)(ii). 13 Treas. Reg. § I.103I(k)-I(g)(3)(iii)(A), 84 Treas. Reg. § 1.1031 (k)-1(g)(3)(iii)(B1.

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Except as provided above, the Taxpayer may not receive cash or property from a qualified escrow or a qualified trust; however the Taxpayer may receive money or other property from another party to the exchange without jeopardizing the safe harbor. 85

G. Safe Harbor No. 3 – Qualified Intermediary. In the case of an exchange involving a qualified intermediary, the qualified intermediary is not considered the Taxpayer’s agent (and consequently, the Taxpayer is not in constructive receipt of any consideration received and held by the qualified intermediary prior to the day on which the Taxpayer receives the Replacement Property).86 A qualified intermediary is a person who is not the Taxpayer or a related person (as defined below) that enters into a written agreement with the Taxpayer called the “exchange agreement.”8′ The exchange agreement obligates the qualified intermediary to acquire the Relinquished Property from the Taxpayer and transfer the property to the transferee, and to acquire the Replacement Property from the seller of that property and to transfer the Replacement Property to the Taxpayer.

The qualified intermediary does not have to actually take title to either the Relinquished Property or the Replacement Property. 88 The transfers can be accomplished by direct deed from the Taxpayer to the ultimate transferee of the Relinquished Property and/or by direct deed from the seller of the Relinquished Property to the Taxpayer.” The qualified intermediary is treated as having acquired or transferred property under this rule in any of the following situations: (i) it actually acquires and transfers legal title to the property; (ii) it enters into an agreement with a person other than the Taxpayer for the transfer of the Relinquished Property to that person, and the Relinquished Property is transferred to that person; and (iii) it enters into an agreement with the owner of the Replacement Property and pursuant to that agreement the Replacement Property is transferred to the Taxpayer. 90 For this purpose, a qualified intermediary is treated as entering into an agreement if the intermediary is assigned all the rights of a party to that agreement and all parties are notified of the assignment n writing prior to the actual transfer of any property contemplated by the agreement. So the Taxpayer can enter into an agreement with respect to either the Relinquished Property or the Replacement Property and transfer it to the qualified intermediary.91

As with the qualified escrow and qualified trust agreements, the exchange agreement may give the Taxpayer the right to receive, pledge, borrow or obtain the escrow funds if the Taxpayer fails to identify Replacement Property before the end of the identification period, and the agreement may also give the Taxpayer the right to receive, pledge, borrow, or otherwise obtain the benefits of the funds held by the escrow after the identification of the Replacement Property if a material and substantial contingency

85 Treas. Reg. § 1.1031(k)-I(g)(3)(v). gb Treas. Reg. § 1.1031 (k)-1(g)(4)(i). 87 Treas. Reg. § 1.1031 (k)-1(g)(4)(iii). gg Treas. Reg. § 1.1031(k)-I(g)(4)(iv). gg Rev. Rul. 90-34, 1990-1 C.B. 154. 9° Treas. Reg. § 1.1031(k)-I(g)(4)(iv). 9′ Treas. Reg. § 1.1031 (k)-1(g)(6)(v).

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occurs that relates to the deferred exchange and the procedural rules outlined in the preceding paragraph are followed. 92

H. Safe Harbor No. 4 -Interest and Growth Factors. The fourth safe harbor provides that the Taxpayer will not be treated as in actual or constructive receipt of money or other property if the Taxpayer is entitled to receive, prior to receipt of the Replacement Property, any interest or growth factor with respect to the funds held by a qualified escrow; a qualified trust or a qualified. intermediary. 93 To qualify for this safe harbor, the amount of interest or the growth factor must depend on the length of time elapsed between the transfer of the Relinquished Property and the receipt of the Replacement Property and the Taxpayer must treat the amount received as interest and include it in ordinary income. 94 It is intended that this safe harbor will overlap with the other safe harbors. For example, a an exchange agreement with a qualified intermediary may provide an interest or a growth factor consistent with this safe harbor.

I. Definition ofDisqualified Person. A qualified trustee or escrow agent and a qualified intermediary cannot be a “disqualified person.” There three ways a person can be a disqualified person.

A disqualified person is a person that is an agent of the Taxpayer at the time of the transaction. A person who acted as the taxpayer’s employee, attorney, accountant, investment banker, broker, or real estate agent or broker within the two year period ending on the date of the transfer of the Relinquished Property is treated as an agent of the taxpayer at the time of the transaction for purposes of this rule. Performance of services relating to an exchange of property that is intended to qualify for nonrecognition under Section 1031 will not be taken into account under this rule. Similarly, performance of routine financial, title insurance, escrow or mist service by a financial institution for the Taxpayer will not be taken into account.9s

J: Person Related to the 7axp(aver. A person is a disqualified person if the person and the Taxpayer bear a relationship that is described in either Sections 267(b) or 707(b) of the Code (determined by s!ibstituting 10% for 50% in each place it appears).96 The relationships described in those sections are as follows:

(i) members of a family (defined as an individual’s siblings, spouse, ancestor

or lineal descendants);

(ii) an individual and a corporation if the individual owns directly or indirectly

more than 10 percent of the outstanding stock of the corporation;

(iii) two corporations which are members of the same affiliated group of corporations;

92 Treas. Reg. § 1.1031(k)-1(g)(4)(ii). 93 Treas. Reg. § 1.1031(k)-I(g)(5). 9° Treas. Reg. § 1.1031(k)-1(h). 9s Treas. Reg. § 1.1031(k)-1(kl(2l. 9e Treas. Reg. § 1.1031(k)-1(k ).

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(iv) a grantor and a fiduciary of any trust;

(v) a fiduciary of one trust and a fiduciary of a second trust if the same person

is the grantor of both trusts;

(vi) a fiduciary and a beneficiary of the same trust;9′

(vii) a fiduciary of a trust and a beneficiary of a trust if the same person is the grantor of both trusts;

(viii) a fiduciary of a trust and a corporation if the trust or the grantor of the trust owns more than 10 percent of the value of the stock of the corporation;

(ix) a person and a tax exempt organization if the person controls the tax exempt organization (or in the case of an individual if a family member controls the tax exempt organization);

a corporation and a partnership if the same persons own more than 10 percent of the value of the outstanding stock of the corporation and more than 10 percent of the aggregate capital or profits interests in the partnership;

(xi) an S corporation and another S corporation if the same persons own more than 10 percent of the value of the stock of each corporation;

(xii) an S corporation and a regular C corporation if the same persons own more than 10 percent of the value of the stock of each corporation;

(xiii) an executor of an estate and a beneficiary of the estate (except in the case of a pecuniary bequest);

(xiv) a partnership and a person that owns directly or indirectly more than 10 percent of the capital interest or profits interest in the partnership; and

(xv) two partnerships in which the same persons own more than 10 percent of the capital interests and the profits interests.

For purposes of determining whether one of the above relationships exists, the following constructive ownership rules apply:

(i) stock owned, directly or indirectly, by or for a corporation, partnership,

estate or trust is considered as being owned proportionately by or for its

shareholders, partners, or beneficiaries; and

an individual is considered to own stock owned by a member of his family (defined as an individual’s siblings, spouse, ancestor or lineal descendants).

In applying the constructive ownership rules, stock that is treated as owned by the owner of an entity is treated as actually owned by the holder of the interest in the entity for purposes of again applying the constructive ownership rules. Stock that is attributed

9′ This rule is applied without regard to a qualified trust created in connection with the Section 1031 exchange.

 from a family member is not treated as owned by the family member for purposes of again treating another person as the owner under the family attribution rules.

K. A Person Related to an Agent of the Taxpayer. The third category of disqualified persons is a person that has a relationship with an agent of the Taxpayer that is described in the preceding section. 98

XI. Reverse Like Kind Exchanges

A. General Rule. A reverse like kind exchange the Replacement Property is acquired before the transfer of the Relinquished Property. These transactions are also called reverse Starker transactions after the seminal case, Starker v. Commissioner, 99 which held that Section 1031 did not require the Taxpayer to acquire the Relinquished Property and sell the Replacement Property on the same day. In 1984, this ruling was codified with the enactment of Section 1031(a)(3) of the Code which permits deferred exchanges as long as the Replacement Property is identified within the 46 day period beginning on the date of the transfer of the Relinquished Property and acquired within the 181-day period beginning on such date. This statutory change does not address the situation in which the Taxpayer acquires or arranges for a friendly party to acquire the Replacement Property before the disposition of the Relinquished Property.to0 Until the issuance of Revenue Procedure 2000-37,101 it was unclear whether Section 1031 applied if the Taxpayer acquired or arranged for an accommodation party to acquire the Replacement Property prior to the transfer of the Relinquished Property.’ 02 The cases in this area are not very helpful because they involve situations in which the taxpayer acquired property directly without clearly establishing an intention to engage in an exchange. 103

Revenue Procedure 2000-37 establishes a safe harbor for reverse like kind exchanges. In general terms, it states that Section 1031 may apply to such an exchange (subject to the other applicable requirements) as long as the property is acquired by an Exchange Accommodation Title I-colder (an “EATH”) pursuant to a “qualified exchange accommodation agreement” (a “QEAA”).104 The Revenue Procedure does not take a position as to the application of Section 1031 to reverse like kind exchanges that fall outside the safe harbor or occur prior to issuance of the revenue procedure. The requirements of the revenue procedure are outlined in the following paragraphs.

98 Treas. Reg. § 1.1031 (k)-1(k)(4).

~9 602 F.2d 1341 (9″ Cir. 1979).

goo It is not uncommon for a person to locate desirable Replacement Property prior to completion of the

sale of the Relinquished property.

2000-401A.& 308.

102 Since the Code or the regulations did not forbid these kinds of transactions, a typical structure involved

the acquisition of the Replacement Party by an unrelated accommodation party followed by the transfer of

such property to the Taxpayer.

X03 Dibsy v. Comm ‘r, 70 TCM 918 (1995) (court finds no evidence that taxpayer intended acquisition of

commercial property to be part of Section 1031 exchange); Bezdjian v. Comm’r,. 845 F.2d 217 (9a’ Cir.

1988) (no evidence that Section 1031 exchange was intended when property acquired 3 weeks before

transfer of relinquished property).

104 Rev. Proc. 2.000-37, 2000-40 1.R.R. 308.

47

B. The Exchange Accommodation Title Holder. The EATH must not be the Taxpayer or a disqualified person as defined in Section 1.1031 (k)-1(k) of the Treasury Regulations, and the EATH must be subject to federal income tax or if the EATH is a partnership or an S corporation at least 90% of its interests or shares of stock must be held by persons subject to federal income tax. 105

C. Indicia of Ownership. The EATH must possess “qualified indicia of ownership” in respect of the Replacement Property or the Relinquished Property lo6at all times from the date the EATH acquires the property until completion of the exchange. Qualified indicia of ownership means (i) legal title to the property, (ii) other indicia of ownership of property that are treated as beneficial ownership of the property under applicable principles of commercial law, or (iii) interests in a single member limited liability company that is disregarded as an entity separate from its owner for federal income tax purposes and that holds either legal title or other indicia of ownership.

D. Property Acquired as Part of Section 1031 Exchange. At the time the EATH acquires the qualified indicia of ownership, the Taxpayer must that the property held by the EATH will represent either the Replacement Property or the Relinquished Property in transaction qualifying as a Section 1031 exchange.

E. Written Agreement Between Taxpayer and EATH. No later than 5 business days after transfer of the qualified indicia of ownership to the EATH, the taxpayer and the EATH enter into a QEAA that provides, among other things, that (i) the EATH holds the property for the benefit of the Taxpayer in order to facilitate completion of the Section 1031 exchange; (ii) the EATH will be treated as the owner of the property for federal income tax purposes; and (iii) the Taxpayer and the EATH will report the transaction for federal income tax purposes in a manner that is consistent with the EATH being the owner of the property.

F. Time Periods. The Revenue Procedure contains specific time periods for identification of the Replacement Property and completion of the exchange that are basically the same as the time periods applicable in the deferred exchange area. The Revenue Procedure states that no later than 45 days after the transfer of the qualified indicia of ownership of the Replacement Property to the EATH, the Relinquished Property must be identified under the rules set forth in Section 1.1031(k)-1(b) of the Treasury Regulations. The Revenue Procedure also states that no later than 180 days after transfer of qualified indicia of ownership of the Replacement Property to the EATH the property is transferred to the Taxpayer as Replacement Property (or to a person not the Taxpayer as Relinquished Property). It is not clear if these time periods are identical to the identification and exchange periods set forth in Section 1031(a)(3). The language

°5 The definition of term, disqualified person, is discussed in paragraphs I and ,I of Section X of this Outline. 1°6 Although the Revenue Procedure contemplates that the EATH may hold either the Replacement or the Relinquished Property, in the more common fact pattern the EATH acquires the Replacement Property prior to the transfer of the Relinquished Property.

48

of the Revenue Procedure could be read as describing periods that are 1 day shorter than the periods described in Section 1031(a)(3).

G. Special Provisions in EATHAgreement. The real utility of the Revenue Procedure is found in the generous list of “permissible agreements” the Taxpayer and the EATH can enter. These include the following:

(i) the EATH can serve as a qualified intermediary with respect to the

Taxpayer in a deferred exchange (provided the EATH satisfies all other

requirements applicable to a qualified intermediary);

(ii) the Taxpayer or a disqualified person can guarantee some or all of the

EATH’s obligations, including debt obligations incurred to acquire the

property, as well as all costs and expenses;

(iii) the Taxpayer or a disqualified person can lend funds to the EATH;

(iv) the EATH can lease the property to the Taxpayer or a disqualified person;

(v) the Taxpayer or a disqualified person can manage the property, act as a

contractor with respect to improvements of the property, or otherwise

provides services with respect to the EATH;

(vi) the Taxpayer and the EATH can enter into agreements relating to the acquisition of the property including (puts and calls) but only for a period not in excess of 185 day period beginning on the day the EATH acquired title to the property; and

(vii) the Taxpayer and the EATH can agree to assign the risk of loss or the benefits of gain. with respect to the Relinquished Property by making payments upon completion of the exchange.

In summary, Revenue Procedure 2000-37 is significant pro-taxpayer ruling.

X11. Conclusion

It is reasonable to conclude that there is no valid tax policy requiring the degree of complexity found in Section 1031. After recent changes, in particular the constructive receipt safe harbors in the mufti-party exchange regulations and the reverse like kind exchange safe harbors in Revenue Procedure 2000-37, Section 1031 looks like a convoluted elective rollover scheme littered with substantial traps for the unwary arising from outdated riles. In conclusion, a very compelling argument can be made that existing Section 1031 should be replaced with an elective rollover scheme that would permit taxpayers to defer recognition of gain derived from the sale of qualified property to the extent the proceeds derived from the sale are reinvested in other items of qualified property within a specified tune period. ‘°’ Unfortunately, until Congress acts, we are stuck with existing Section 1031 with all its complexity and the final word must be that Section 1031 exchanges should be handled with caution.

107 Proposals like this have been raised in Congress in recent years.

_________________

End

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