For many years, taxpayers have been able to defer recognition of gain on the disposition of assets by engaging in Sec. 1031 like-kind exchanges. Consequently, many questions and issues surrounding these transactions have been addressed, but many cases and rulings continue to arise each year. For example, in the past two years, several rulings and a case have discussed the restriction on related-party sales in Sec. 1031(f). Although the courts continue to apply the rules strictly, Treasury may have created a reasonable exception.
Several rulings have examined transactions to determine whether the taxpayer should be treated as having received boot. This is especially complex when a transaction involves liabilities. In addition, cases and rulings have discussed what properties qualify as like-kind and when a qualified intermediary (QI) should be treated as an agent. This article analyzes these cases and rulings and identifies questions that still need to be answered.
Like-Kind Exchanges Generally
Sec. 1031 provides that no gain or loss is recognized if property used in a trade or business or held for investment is exchanged for like-kind property. 1 The law excludes exchanges of inventory, stocks, bonds, interests in partnerships, and choses in action from nonrecognition treatment. 2 The property that the taxpayer transfers is usually referred to as relinquished property, and the property received is referred to as replacement property. Deferred transactions may qualify as like-kind exchanges if they are completed by the earlier of the due date of the tax return for the tax year in which the transfer of the relinquished property occurs or 180 days after such transfer. 3
If the taxpayer receives cash or other property in addition to the like-kind property, then gain, but not loss, is recognized equal to the lesser of the boot received or the gain realized. The basis of the qualified property received is equal to the basis of the property transferred, increased by gain recognized and decreased by loss recognized. 4
To prevent some abusive transactions, Sec. 1031(f) provides that if the exchange occurs between related parties, then the gain or loss is recognized if either party disposes of the exchanged property within two years. There are exceptions for dispositions following the taxpayer's death, involuntary conversions, and transactions whose principal purpose was not tax avoidance.
Property Types and Uses
Regs. Sec. 1.1031(a)-1(b) states that to be of like kind, the exchanged properties must be of the same nature or character. The grade or quality is not relevant. Therefore, the exchange of improved real estate for unimproved real estate can qualify as like-kind, but a like-kind exchange generally involves either personal properties or real properties.
In Chief Counsel Advice (CCA) 201238027, the IRS examined the relevance of state-law classification of property as either real or personal. The CCA contains several examples. The first is an exchange of a gas pipeline classified as personal property by a state for another gas pipeline classified as real property by another state. In another example, both a steam turbine and the building it is attached to as a fixture are classified by the state in which they are located as real property. They are exchanged for raw land classified as real property by another state.
The CCA mentions that the Supreme Court has held that state law dictates the classification of property as either real or personal. 5 Therefore, if a state defines the exchanged properties as real, the exchange will qualify as like-kind in most situations. However, the CCA points out that in Fleming , 6 the Tax Court, affirmed by the Supreme Court, concluded that an exchange of real property for carved-out oil payment rights that state law classified as real property did not qualify under Sec. 1031 because the payment rights were not of the same nature or character as the real property.
In Clemente, Inc. , 7 the Tax Court applied similar reasoning to deny like-kind exchange of real property with limited gravel extraction rights. Therefore, the CCA concluded that an exchange of the turbine for raw land would not qualify as like-kind since they are of different nature and character. Conversely, the gas pipelines would be treated as like-kind real property despite their differing state classifications, because they are of the same nature and character.
The CCA noted that not all case law has distinguished between real property and extraction rights in the same way as Fleming , however. For example, in Crichton , 8 the Fifth Circuit held that an overriding royalty interest in minerals was of like kind with a city lot.
In Koch 9 (not cited in the CCA), the Tax Court explained that the different conclusions reached in these two cases were based on duration. The overriding royalty in Crichton continued until the minerals were exhausted, while a carved-out oil payment right, as in Fleming , usually terminates when a specified quantity of oil or minerals is removed.
The CCA supplements these prior cases by indirectly concluding that "nature or character" includes the structure and use of the property in addition to duration. Taxpayers will need to examine exchanged properties' structure and use, in addition to duration, in deciding whether they are of like kind. The fact that both properties are real property under state law does not guarantee a nontaxable exchange.
The CCA conclusion regarding the gas pipelines is a significant expansion of the cited cases and rulings, which dealt with similarly defined properties. This example involves properties with different classifications. The fact that the properties are not both real or personal does not mean that an exchange cannot qualify under Sec. 1031, as long as they are of similar nature and character.
Regs. Sec. 1.1031(a)-2(c)(2) states that goodwill or going-concern value of a business is not of like kind with goodwill or going-concern value of a different business. In these transactions, the goodwill transferred is treated as sold, and the goodwill received is treated as boot. In Deseret Management Corp ., 10 the Court of Federal Claims applied this rule to the exchange of a radio station for another radio station. The taxpayer was able to prove, however, that any goodwill transferred in the exchange had minimal value. Therefore, no gain was recognized.
The nature and character of two properties must be similar for a like-kind exchange, but that fact alone is not sufficient. The properties must also be used in a trade or business or held for investment. A personal residence will not qualify as either. However, if the property received in the exchange is initially held for investment or to be leased and is then converted into a personal residence, can the exchange still qualify as nontaxable? The Tax Court considered this question in Yates 11 and Reesink . 12
Investment property received in an exchange can be converted into a residence and the exchange still qualify under Sec. 1031, depending on whether the taxpayer intended to acquire the property as an investment at the time of the exchange—a matter that is a question of fact. In Yates , the taxpayers moved into the property as their residence four days after acquiring it. The only evidence the taxpayers presented of an investment intent was that they asked the seller to obtain permission for them to use the property as a bed-and-breakfast establishment. Given the lack of proof of business intent and an almost immediate personal use, the court ruled that the property did not qualify for a like-kind exchange. 13
In Reesink , on the other hand, the taxpayers were able to prove a primary investment motive, even though they converted the property into their personal residence shortly after acquisition. The taxpayers proved that they distributed fliers listing the acquired property as available for rent and did not move into the property as their residence for eight months. In addition, the taxpayers did not decide to sell their original residence until six months after the exchange. These facts, plus testimony that the taxpayers had planned to stay in their original residence until their sons (the oldest being only 14) graduated from high school, were sufficient to convince the Tax Court that they intended to acquire the property as an investment at the time of the exchange.
The Tax Court in VIP's Industries Inc. 14 held for the IRS regarding an exchange of a long-term lease on real property for real property fee interests but left two interesting questions unanswered. The lessee corporate taxpayer leased real property for 33 years. It built and operated a motel on the leased property. When the lease had 21 years and four months remaining, the taxpayer used a QI to sell the leasehold interest and acquire fee interests in two real properties. The taxpayer treated the transactions as a like-kind exchange; the IRS disagreed.
Regs. Sec. 1.1031(a)-1(c) provides as an example of a like-kind exchange the exchange of a leasehold of real property with a remaining term of 30 years or more for a fee interest in real property. In Peabody Natural Resources Co ., 15 the Tax Court referred to the regulation as providing a safe harbor. On the other hand, in Capri, Inc ., 16 the Tax Court stated that the regulation requires the leasehold term to be at least 30 years. Therefore, the Tax Court's opinions leave open whether the leasehold can be shorter than 30 years. Does the regulation provide a safe harbor rather than a requirement?
Rather than address this issue, the Tax Court referred to its decision in May Department Stores Co ., 17 in which it held that a 20-year leasehold was not equivalent to a fee interest. It held that the leasehold interest in VIP's Industries was closer in nature to that in May Department Stores Co. than to the one described in Regs. Sec. 1.1031(a)-1(c) and therefore was not equivalent to the fee interest. Given that the court's decision was on grounds other than the lease's length, taxpayers likely will be unable to successfully argue that leaseholds of less than 30 years (including extensions) are equivalent to fee interests. The reason for this conclusion is the Supreme Court's 2011 holding in Mayo Foundation 18 that regulations will be enforced unless they contradict the Code or are arbitrary and capricious. Therefore, the IRS interpretation of the regulation that a leasehold must be at least 30 years to be equal to real property is likely to be enforced in future cases.
The second unanswered question in VIP's Industries was the taxpayer's alternate argument that the motel leasehold improvement was of like kind to the fee interest. The taxpayer cited Davis , 19 which held that improvements on real property and fee interests are of like kind under the involuntary conversion provisions of Sec. 1033. The IRS opposes Davis and cited Rev. Rul. 67-255, in which it ruled that improvements and real property are not of like kind. 20 Again, the court did not address this question. Instead, it found that since the leasehold was not of like kind with the fee interests, then neither was the improvement.
Taxpayers likely will be unable to argue successfully that improvements and fee interests are of like kind for purposes of Sec. 1031. Although both Secs. 1031 and 1033 use the phrase "like kind," courts have not treated them as identical. Therefore, the Davis case will not carry as much authority as it would if it were a Sec. 1031 case. More important, courts in Crichton and other cases have concluded that a real property classification does not determine whether the properties are of like kind, as previously discussed. Instead, the nature and character of the properties dictate the outcome. This precedent will likely lead courts in future cases to rule in favor of the IRS's approach to this issue.
Taxpayers who intend to engage in exchange transactions, especially those that engage in series of ongoing exchanges of tangible personal property (referred to as LKE programs), typically use QIs to qualify the exchange transactions under Sec. 1031. QIs must meet the rules in Regs. Sec. 1.1031(k)-1(g)(4), including that they cannot be disqualified persons. Disqualified persons are defined in Regs. Sec. 1.1031(k)-1(k) as including agents of the taxpayer. Agents are those who perform services for the taxpayer, including acting as "the taxpayer's employee, attorney, accountant, investment banker or broker, or real estate agent or broker within the 2-year period ending on the date of the transfer of the first of the relinquished properties." 21
Recently, the IRS issued two private letter rulings examining whether the QI performed prohibited services. In Letter Ruling 201308020, the QI provided the taxpayer with software that allowed it to match the properties in an LKE program, submit 45-day identifications, and compute depreciation and gains and losses. The IRS determined that the software assisted the LKE program, and since the QI did not perform any accounting services and did not sell the software to other persons, the services did not make the QI a disqualified person.
In Letter Ruling 201332010, the taxpayer used an exchange accommodation titleholder (EAT) and a QI to buy and sell vehicles that it rented to unrelated third parties. In addition to the purchases and sales, the EAT acquired titles to the vehicles, registered them in different states, and obtained sales tax permits. The IRS concluded that these services did not result in the EAT's being a disqualified person.
Both rulings demonstrate how a QI may perform tasks that facilitate the exchange without being deemed to have performed prohibited services. These rulings should allow a QI to engage in the exchanges and all reasonable related activities that aid the taxpayer in meeting the Sec. 1031 requirements without the taxpayer's having to hire additional, unrelated parties to join the transactions.
If the taxpayer receives boot—cash or property that does not qualify as like-kind—the taxpayer is required to recognize gain. The receipt can be either actual or constructive. Regs. Sec. 1.103(k)-1(f) contains the rules regarding whether the taxpayer receives boot in a deferred exchange by receiving cash before receiving the replacement property. If the amount of the boot received equals the consideration received for the relinquished property, the transaction is a sale and not a like-kind exchange.
The taxpayer is treated as having actual receipt of boot if it receives the cash or property or its economic benefit. 22 The taxpayer is treated as having constructive receipt of cash or property if the cash or property is credited to the taxpayer's account, set apart for the taxpayer, or made available for the taxpayer to draw. 23 In addition, actual or constructive receipt of the boot by an agent of the taxpayer is treated as receipt by the taxpayer.
Given those definitions, the conclusion in Field Attorney Advice (FAA) 20124801F that the taxpayer did not engage in a like-kind exchange even though it used a QI was not surprising. In this FAA, the funds from the disposition of the relinquished property were placed in an account that the taxpayer could control by using them to acquire property or pay for other items. The fact that the acquired property could qualify as replacement property was immaterial. The QI must control the funds and use them to acquire the replacement property, which is transferred to the taxpayer. The taxpayer cannot have access, control, or benefit of the funds from the relinquished property for the transaction to qualify under Sec. 1031.
To make sure the taxpayer is not treated as having constructive receipt of cash, the agreement with the QI should state that the cash will not be transferred or made available to the taxpayer. At a minimum, the agreement should meet the regulations' safe harbor "that the taxpayer has no rights . . . to receive, pledge, borrow, or otherwise obtain the benefits of money or other property before the end of the exchange period." 24 Including this provision in the agreement may be beneficial.
For example, in Morton , 25 the taxpayer had an agreement barring receipt of cash. Unfortunately, however, the funds were deposited into the taxpayer's account rather than the QI's account. As soon as this was discovered, the taxpayer transferred the funds to the QI. The IRS argued that the taxpayer received boot. The court held that the accidental violation of the agreement should not be treated as a receipt of boot. Nevertheless, this decision should encourage taxpayers to carefully establish and maintain their relationship with a QI.
Liabilities can affect the amount of boot under Regs. Sec. 1.1031(d)-2. The transfer of property subject to a liability or the assumption of a liability by the transferee will result in the transferor's being deemed to have received boot equal to the amount of the liabilities. If both the relinquished property and the replacement property are subject to liabilities and/or the transferee and transferor both assume liabilities, the amount of the boot deemed received is equal to the excess of the liabilities transferred over the liabilities received. If the taxpayer transfers both cash and liabilities, then the cash reduces the amount of boot deemed received. However, if the taxpayer receives cash and assumes a liability, the total amount of cash received is treated as boot.
The IRS recently examined the impact of liabilities on a Sec. 1031 transaction in Letter Ruling 201302009 and CCA 201325011. In Letter Ruling 201302009, the taxpayer owned property used in a business. The taxpayer borrowed money, using the property as security for a nonrecourse loan. The taxpayer wanted to transfer the property. Unfortunately, the value of the property was less than the amount of the nonrecourse loan. If the taxpayer transferred the property to the creditor, the taxpayer would be required to recognize gain based on a Sec. 1001 deemed sale. The gain would be the excess of the relieved nonrecourse debt over the basis of the property. As previously mentioned, the taxpayer cannot reduce the amount of cash treated as boot by assuming a liability. Instead of transferring the property to the creditor, the taxpayer in the letter ruling entered into an agreement with a QI. The taxpayer transferred the property and the debt to the QI, which then transferred it to the creditor. The QI acquired replacement property equal to the value of the nonrecourse debt either by borrowing funds or receiving cash from the taxpayer. The QI then transferred the acquired property to the taxpayer.
The ruling concluded that the transaction qualified under Sec. 1031, even though the transferred liability exceeded the value of the property. Although the ruling does not state the amount of cash or debt incurred to acquire the new property, the sum of the cash and new debt must equal or exceed the debt secured by the relinquished property. If it does, then the transaction meets the rules of Regs. Sec. 1.1031(d)-2 that eliminate the deemed receipt of boot because of a transferred liability, provided the transferor assumes debt equal to or greater than the transferred debt or transfers cash equal to the excess of the liability transferred over the debt assumed.
In the ruling, the IRS did not discuss an interesting question. It found that the debt transferred as part of this Sec. 1031 exchange had been incurred to refinance debt existing before the exchange. If the debt that was refinanced was incurred to acquire the transferred property, the refinancing would probably not be an issue. However, if the refinanced debt was unrelated to the property and the refinancing occurred shortly before the transaction, the debt could be considered boot, without regard to the debt incurred on the replacement property. It would have been helpful if the IRS had discussed the loan's timing and complete use and whether debt assumed with the replacement property would nullify the other types of debt mentioned.
The IRS may have addressed part or all of these unanswered questions in CCA 201325011. In this CCA, the taxpayer engaged in equipment rental and had an LKE program with a QI that sold the relinquished property and purchased the replacement property. The taxpayer had a line of credit that had been used to purchase relinquished property but also for unrelated expenses. The relinquished property secured the line of credit. When the QI sold the property, the funds were required to be used to pay down the line of credit. The taxpayer then borrowed funds to purchase the replacement property. The CCA addressed whether the required line of credit payment should be treated as receipt of boot.
The fact that the repaid debt had been incurred for purposes other than purchasing the relinquished property was immaterial, the IRS ruled. The regulations treat the elimination of debt as boot only to the extent that the eliminated debt exceeds assumed debt. Therefore, as long as the debt assumed with the replacement property equals or exceeds the eliminated debt, no boot is received. In addition, the fact that the old debt was paid and new debt assumed is also immaterial. The CCA cites Barker , 26 in which the Tax Court held that the use of sale proceeds to pay off debt on relinquished property was not treated as boot as long as the debt assumed with the replacement property equaled or exceeded the debt paid off.
The CCA allows Sec. 1031 transactions to pay off business debt not incurred to acquire the relinquished property, as long as the relinquished property secures the debt. It does not discuss the impact of payment of business debt not secured by the property, which may not be treated as a no-boot exchange. In addition, the CCA states, "The full value of the rental property secures the entire outstanding balances on the lines of credit." This leaves open the effect of a line of credit exceeding the value of the relinquished property and if the relinquished property only partially secures the debt. Partial security should not be an issue; debt in excess of the relinquished property should also not be an issue, based on Letter Ruling 201302009. However, if the debt is not incurred in the business, it may well cause gain recognition.
In 1989, Congress enacted Sec. 1031(f) to prevent related-party basis-shifting transactions. 27
Example: T owns property A with a fair market value (FMV) of $100 and a basis of $20. S , T' s related party, owns property B , which is of like kind to property A , with an FMV of $100 and a basis of $90. If T sells property A , T will recognize gain of $80. If, instead, T and S engage in a Sec. 1031 like-kind exchange and then S sells property A , S will recognize a gain of $10 because of the basis shift resulting from the like-kind exchange.
Sec. 1031(f) is designed to prevent transactions illustrated by the example. It provides that if related parties, defined by Secs. 267(b) and 707(b), engage in a like-kind exchange, and if either property is sold within two years of the exchange, both related parties must recognize the realized gain that the exchange generated.
Sec. 1031(f)(2) exempts certain non-tax-avoidance dispositions within two years of the exchange from the gain recognition requirement of Sec. 1031(f)(1): those following the death of either related party, an involuntary conversion (as defined in Sec. 1033) of either property, and cases in which the exchange and disposition do not have tax avoidance as one of their principal purposes. Sec. 1031(f)(4), on the other hand, denies like-kind treatment to a transaction or series of transactions designed to avoid Sec. 1031(f). The IRS and the courts are constantly examining transactions involving these related-party rules.
A taxpayer in a like-kind exchange does not have to own 100% of the replacement property. An undivided partial interest in the replacement property is permitted, as long as the acquisition price of the undivided interest equals or exceeds the disposition price of the relinquished property. In Letter Ruling 201242003, the IRS applied this rule to related parties. The taxpayer and a related party each owned separate real properties. They joined together to employ a QI to assist them with a reverse like-kind exchange (described above). The QI acquired the replacement property. After the acquisition, but within 180 days, the taxpayer and related party had the QI dispose of their separately owned properties, each one worth less than the replacement property. After the disposition of the relinquished properties, the QI transferred the replacement property to the taxpayer and related party with undivided ownership. Since the taxpayer and related party each acquired an interest in property at a higher cost than that of the disposed property, Sec. 1031 applied. The fact that the ownership of the replacement property was undivided partial interests was immaterial. The fact that the owners of the replacement property interests were related was also immaterial. The transactions were not for tax avoidance or basis shifting.
The IRS considered similar related-party transactions in Letter Rulings 201216007 and 201220012. The taxpayer and a related party each owned separate properties.In Letter Ruling 201216007, the taxpayer wanted to engage in a reverse like-kind exchange. It employed a QI to acquire replacement property A from an unrelated party. The taxpayer then transferred the relinquished property to the QI for it to be disposed of to an unrelated party. In both rulings, the disposition price of the relinquished property exceeded the acquisition price of the replacement property. In Letter Ruling 201216007, within 45 days, the taxpayer identified replacement property B for the QI to acquire. Replacement property B was owned by a disregarded entity owned by a related party. In both rulings, the QI acquired replacement property by acquiring the disregarded entity from the related party and transferred one or both replacement properties to the taxpayer.
In Letter Ruling 201216007, the related party engaged the QI to acquire replacement property to replace replacement property B , which it would treat as relinquished property. In both cases, the property that the related party identified had a value equal to or greater than 95% of the value of its relinquished property. The QI obtained the identified property and transferred it to the related party. The question in the rulings was whether Sec. 1031(f) denied Sec. 1031 treatment to the taxpayer and related party.
The rulings address a couple of questions that are not associated with the related-party question. First, the rulings treat the acquisition of a disregarded entity as the acquisition of the property owned by the entity. If the property is of like kind, then the acquisition of the disregarded entity can qualify under Sec. 1031. It is important to remember that the taxpayer must acquire 100% of the disregarded entity. If the taxpayer acquires less than 100%, the disregarded entity will be converted into a partnership, and the acquisition of an interest in a partnership will not qualify under Sec. 1031.
The second question in the rulings is whether a combination reverse/forward exchange can qualify under Sec. 1031. In Letter Ruling 201216007, the taxpayer had the QI obtain replacement property first, and then it had the QI dispose of the relinquished property. Since the relinquished property had greater value than the original replacement property, the taxpayer had the QI obtain a second replacement property. The ruling concluded that this is acceptable. The ruling does not mention that the IRS has previously ruled that a combination reverse/forward exchange was acceptable (CCA 200836024). The difference between this CCA and the more recent rulings is that the parties in the CCA were unrelated. The fact that the parties are related should not affect the conclusion.
Letter Rulings 201216007 and 201220012 also mention that both steps must meet the required timing. In other words, the properties must be identified within 45 days of the other exchange and acquired within 180 days. Thus, the taxpayer needed to identify the property it was going to relinquish within 45 days of the QI's acquisition of the initial replacement property, and the taxpayer had to identify the second replacement property within 45 days of the QI's disposition of the relinquished property. Since the taxpayer met these requirements and the actual acquisition was within 180 days, the reverse/forward combined exchanges qualified under Sec. 1031.
The analysis of the application of Sec. 1031(f) in these rulings points out known, as well as new, material. First, Sec. 1031(f) covers exchanges between related parties. Since the rulings involve a QI, the transactions do not involve a direct exchange between related taxpayers. The result is that Sec. 1031(f) does not directly apply. Treasury reached this conclusion in prior letter rulings. 28 Instead, Sec. 1031(f)(4), which denies Sec. 1031 treatment to transactions designed to avoid Sec. 1031(f), can cause the taxpayer to recognize gain.
In several prior letter rulings, the IRS considered the application of Sec. 1031(f)(4) to related-party transactions that involved QIs. In Letter Rulings 200712013 and 200728008, the taxpayer had a QI acquire replacement property from an unrelated third party in a reverse acquisition transaction. It then had the QI sell its relinquished property to a related party. The related party sold the relinquished property within two years of acquisition. Treasury ruled that Sec. 1031(a) applied because the tax avoidance rule of Sec. 1031(f)(4) did not cause Sec. 1031(f) to apply. The reasoning behind the rulings was that since the related party did not own like-kind property before it acquired the relinquished property, there was no basis shift. What they do not discuss is that the result creates the ability to extend the date by which the taxpayer must dispose of the relinquished property in a reverse exchange by selling it to a related party, who can then sell it anytime in the future.
In CCA 201013038, Treasury applied Sec. 1031(f) to a related-party exchange involving a QI by limiting the application of the Sec. 1031(f)(2) business-purpose exception. In the CCA, the taxpayer leased equipment. A related party sold like-kind equipment. The taxpayer used a QI to sell its relinquished property and acquire replacement property from its related party. (Since the related party owned like-kind property, the conclusions in Letter Rulings 200712013 and 200728008 are inapposite.) The taxpayer stated that it had the QI purchase the replacement property from its related party rather than an unrelated party for business reasons.
The CCA quotes the Senate Finance Committee's report providing examples of valid business purposes for Sec. 1031(f)(2):
(i) a transaction involving an exchange of undivided interests in different properties that results in each [related] taxpayer holding either the entire interest in a single property or a larger undivided interest in any of such properties; (ii) dispositions of property in nonrecognition transactions; and (iii) transactions that do not involve the shifting of basis between properties. 29
The CCA states that Treasury will limit the application of Sec. 1031(f)(2)'s business-purpose exception to transactions such as those in the examples in the Senate report. Since the current taxpayer did not meet these examples, its business purpose was insufficient to prevent the application of Sec. 1031(f)(4) and the taxation of the exchange.
In IRS Letter Rulings 201216007 and 201222012, the taxpayer used a QI to dispose of the relinquished property. It then had the QI obtain two replacement properties, one from a related party. The related party then used the QI to obtain replacement property from an unrelated party in a transaction that qualified under Sec. 1031. The rulings concluded that Sec. 1031(f)(4) did not apply since the related party engaged in a nontaxable exchange, meeting an example in the Senate report. The rulings noted that both related parties must keep the acquired properties for at least two years.
The rulings' conclusions that the exchanges were nontaxable appears to be correct and consistent with prior Treasury statements, but with a slight variation. The like-kind exchange that the related party would engage in might involve replacement property equal to only 95% of the relinquished property. In Rev. Rul. 2002-83, Treasury stated that Sec. 1031(a) will not apply if "the related party receives cash or other non-like-kind property for the replacement property." This can be interpreted as preventing the related party from receiving any boot. If this is a correct interpretation, and if the related party in the letter rulings received property worth only 95% of the replacement property it relinquished, then it would have received some cash or non-like-kind property, causing taxation of the related-party transaction.
By ruling that the transaction in the letter rulings qualifies under Sec. 1031(a), Treasury may have established a de minimis rule. In general, this is a reasonable approach to applying the example the Senate report gave, especially since the revenue ruling states that the 45- and 180-day requirements must be met, as well as that the acquired property must be retained for two years. However, if the value of the property is extremely high, then a 5% de minimis rule could permit the receipt of substantial boot. Hopefully, future rulings will establish a maximum amount of cash that will qualify. 30
Recently, the District Court for the District of North Dakota reviewed a related-party Sec. 1031 transaction in North Central Rental & Leasing . 31 The court held the transaction was taxable.
For valid business reasons, Butler Machinery Co. created North Central Rental and Leasing, a subsidiary, to engage in equipment rental and leasing. Butler acquired equipment from Caterpillar Inc., which allowed customers such as Butler to pay for purchased equipment over 180 days. Caterpillar encouraged its customers such as Butler to dispose of their rental equipment in Sec. 1031 LKE programs. Caterpillar assured Butler that the 180-day deferred payment program would not be affected if Butler purchased the equipment and transferred it to North Central as replacement property.
North Central and Butler arranged an LKE program with a QI. During the tax years under examination, they engaged in 398 Sec. 1031 exchanges. North Central provided, and the court used, the following representative transaction to determine the tax outcome: North Central transferred to the QI the relinquished property with a basis of $129,373. The QI sold it to an unrelated party for $756,500. Butler purchased replacement property from Caterpillar for $761,065. Butler transferred the replacement property to the QI, which transferred it to North Central. The QI transferred the $756,500 32 it received from the sale of the relinquished property to Butler. North Central transferred $4,565 to Butler to equalize the amount Butler received with the purchase price of the replacement property. Butler did not have to pay Caterpillar for the replacement property for 180 days. Therefore, it was entitled to use the cash it received from the QI and North Central to pay any liabilities or business expenses during the 180 days before the due date for payment to Caterpillar.
The taxpayer argued that Sec. 1031(f) did not apply to these transactions. The court rejected this argument, noting that even if it did not directly apply, 33 Sec. 1031(f)(4) states that Sec. 1031(f) applies to a transaction or series of transactions designed to avoid the application of Sec. 1031(f). Therefore, Sec. 1031(f) can be indirectly applied. In making this evaluation, the court reasoned that the true substance of the transaction and not its form should determine the outcome and that the taxpayer engaged in a series of transactions requiring the application of the step-transaction doctrine.
The court primarily ruled that the transactions were motivated by tax avoidance, for two reasons: First, the net effect was a basis shift. If one ignores the role of the QI, North Central exchanged property with a basis of $129,373 with a related party for property with a basis for $761,065, and this higher basis avoided recognizing any gain. If North Central had simply sold the property, or if its related party had sold the property after an exchange, the realized gain would have been recognized under Secs. 1031(a) and (f)(1).
The court's second reason is more effective. Butler had unrestricted use of the cash received from the sale of the relinquished property for 180 days because the replacement property's purchase price was deferred. The court considered this situation to be similar to the one in Coleman , 34 in whichthe taxpayer assumed a $35,000 liability and received $14,000 cash. The taxpayer argued that they should be netted. The Eighth Circuit held that the cash should be treated as boot received, since the cash was not restricted to payment of the liability assumed. Applying this rule to the current case would treat the taxpayer as having sold, not exchanged, property.
The court in North Central stated, "[I]t is significant whether 'the cash was earmarked' for payment to Caterpillar, since '[r]eceipt of money which is unfettered or unrestrained signifies a sale of the property.' " 35 These cases raise the question whether a restriction on the cash would have resulted in a tax-free exchange. The court in North Central did not cite Regs. Sec. 1.1031(d)-2, Example (2)(c), which says, "[C]onsideration received in the form of cash or other property is not offset by consideration given in the form of an assumption of liabilities or a receipt of property subject to a liability." This regulation appears to treat cash received as boot without regard to any restriction imposed on it, unless the taxpayer can prove that the restriction should be treated as eliminating the receipt of the cash.Until litigation decides it, the impact of restrictions on cash received remains unclear.
The taxpayer in North Central did not argue under Sec. 1031(f)(2) that tax avoidance was not a primary motive, the court noted, adding that even if it had, this argument would have been rejected.
Viewed independently and with the facts stated, the decision appears correct. However, when it is compared with CCA 201325011 discussed above, the result is not so certain. As previously discussed, this CCA allowed the QI to pay nonacquisition debt incurred by the taxpayer in its business with part of the proceeds from the disposition of the relinquished property. Is there really a difference between the QI's paying liabilities incurred by the taxpayer in its ordinary course of business and giving cash to the taxpayer to pay off business debt? In both the CCA and North Central , payments to the supplier of the replacement property occurred after the cash received from the sale of the relinquished property was used in the taxpayer's business.
The facts in the case and the CCA have three differences: First, the debt paid by the QI in the CCA was debt of the taxpayer. In North Central , the cash was used by the related party (probably to pay debts). Given that the taxpayer was wholly owned by related parties, is it significant that the debt was incurred by different entities? In the CCA, the repaid debt was secured by the relinquished property, while in North Central , the debt was independent. Is the security factor important? Would a creditor refuse to add more property as security? If the debt were already secured by other property whose value exceeded the debt, would adding security have true economic substance?
Third, in the CCA, the QI was required to pay the debt. In North Central , the cash distributed to the related party could be used to cover any business expenditure. The district court emphasized that the cash was not restricted to repayment of the debt to Caterpillar. However, the CCA allowed nonpurchase debt to be repaid. What would the outcome have been if the QI had been required to pay debt incurred by Butler rather than simply transfer the cash to it? Would the reasoning of the CCA have resulted in the court's holding that the transaction was not motivated by tax avoidance? It would appear that either the CCA or the court decision should be changed. It is reasonable to expect that these and additional questions related to liabilities within Sec. 1031 exchanges will be considered in future cases and rulings.
Sec. 1031 has been the subject of multiple cases and rulings, some favorable to taxpayers. For example, the taxpayer can use Sec. 1031 to avoid recognizing gain on the disposition of property with a value less than its related nonrecourse debt. Related parties can engage in a series of transactions without recognizing gain, provided that no related party receives boot in excess of 5%. Business debt can be paid with funds received from relinquished property. However, the courts continue to apply Sec. 1031(f)(4) to mandate recognition of gain on certain related-party transactions.
In February 2013, the IRS issued Notice 2013-13, requesting comments on dual-use construction and agricultural equipment. It has been suggested that the dual-use issue merits broader consideration than the limited manner in which the notice approaches it. If it is, numerous taxpayers will know whether they can engage in Sec. 1031 exchanges. Nonetheless, taxpayers and their advisers can expect a significant number of decisions on Sec. 1031 questions during the next few years.
4 Secs. 1031(b) and (c).
5 Morgan , 309 U.S. 424 (1940).
6 Fleming , 24 T.C. 818 (1955), rev'd, 241 F.2d 71 (5th Cir. 1957), rev'd sub nom. P.G. Lake, Inc. , 356 U.S. 260 (1958).
7 Clemente, Inc. , T.C. Memo. 1985-367.
8 Crichton , 122 F.2d 181 (5th Cir. 1941).
9 Koch , 71 T.C. 54 (1978).
10 Deseret Management Corp. , 112 Fed. Cl. 438 (2013).
11 Yates , T.C. Memo. 2013-28, aff'd, No. 13-1833 (4th Cir. 11/21/13).
12 Reesink , T.C. Memo. 2012-118.
13 See also Goolsby , T.C. Memo. 2010-64.
14 VIP's Industries Inc. , T.C. Memo. 2013-157.
15 Peabody Natural Resources Co. ,126 T.C. 261 (2006).
16 Capri, Inc. , 65 T.C. 162 (1975).
17 May Department Stores Co. , 16 T.C. 547 (1951).
18 Mayo Foundation for Medical Education and Research , 131 S. Ct. 704 (2011).
19 Davis , 411 F. Supp. 964 (D. Haw. 1976).
20 Crichton , 122 F.2d 181 (5th Cir. 1941).
21 Regs. Sec. 1.1031(k)-1(k)(2).
22 Regs. Sec. 1.1031(k)-1(f)(2).
25 Morton , 98 Fed. Cl. 596 (2011).
26 Barker , 74 T.C. 555 (1980).
27 Omnibus Budget Reconciliation Act of 1989, P.L. 101-239, §7601.
28 See, e.g., IRS Letter Ruling 200728008.
29 H.R. Rep't No. 247, 101st Cong., 1st Sess. (1989), at 1341; S. Print. No. 56 at 152.
30 IRS Letter Ruling 201048025 reflects a de minimis rule based on a percentage of the realized gain received. Unfortunately, the redacted ruling says only "x%" of the realized gain would not cause the transaction to be deemed undertaken to avoid Sec. 1031(f). Therefore, the true de minimis amount is unknown.
31 North Central Rental & Leasing, LLC , No. 3:10-cv-00066 (D. N.D. 9/3/13).
32 The opinion states this amount as $756,065 but does not explain the resulting mathematical discrepancy.
33 See Ocmulgee Fields, Inc. , 613 F.3d 1360 (11th Cir. 2010).
34 Coleman , 180 F.2d 758 (8th Cir. 1950).
35 North Central Rental & Leasing, LLC , slip op. at 14, quoting Swaim , 651 F.2d 1066, 1070 (1981).