* The property transferred and the property received must be held for productive use in a trade o business or for investment.
* The taxpayer must meet the specified timing requirements.
If these four requirements are not met, gain or loss on the exchange must be recognized. If the taxpayer prefers to have a gain recognized-for example, to obtain a stepped-up basis, to offset a loss, or to recognize a loss already realized-the transaction must be intentionally structured to fall outside of the requirements of Section 1031 because the like-kind rules are mandatory, not elective.
To qualify for non recognition treatment as a Section 1031 exchange, an actual exchange of property must take place. In Halpern v. U. S.,3 the court ruled that the exchange requirement was not met when a cash sale of property was immediately followed by a cash purchase of like-kind property. An exchange of this type is treated as a sale if an analysis of the transaction indicates that the substance rather than the form of the transaction indicates a sale. It is important, therefore, that all documents used at the closing are exchange documents and not the purchase and sale agreements commonly associated with real estate transactions.
In a like-kind exchange, the property being acquired must be similar in nature and character to the property being relinquished and must be located in the United States. The IRS is quite liberal in its interpretation of like-kind properties and views almost all real estate as similar in nature or character. Thus, virtually all real property is like-kind property and can usually qualify under the like-kind exchange rules. Whether the real estate is improved, unimproved, productive, or nonproductive is not relevant; any mixture of office buildings, apartment buildings, factory buildings, shopping centers, stores, hotels, motels, farms, ranches, and parking lots is permitted.
If non qualifying property is included in the transaction, Section 1031 benefits may be partially or totally unavailable. For example, a taxpayer cannot exchange property for services, including brokerage fees or production services. The exchange of land for a building to be constructed on presently owned property is not a qualified exchange. In Bloomington Coca Cola Co. v. Commissioner,4 the Bloomington Coca-Cola Bottling Company transferred property to a contractor in exchange for the construction of a building on some other land owned by Coca-Cola. The court ruled that this was not a like-kind exchange because the company received building services and materials rather than qualifying real property.
The exchange of land for a building to be constructed on a site not presently owned, however, is a qualified exchange. In J.H. Baird Publishing Co. v. Commissioner,5 the taxpayer "sold" property to a contractor, hired the contractor to build a building, and subsequently "traded" a second piece of property back to the same contractor. This trade was deemed a like-kind exchange and was tax free under Section 1031 because the two trades were viewed as parts of one transaction. The J.H. Baird case shows that a taxpayer can exchange existing property for property to be constructed (a building) on the taxpayer's own property and receive like-kind exchange treatment.
Business or Investment Use Requirement
The courts have held that property constituting the taxpayer's principal residence does not qualify as investment property, even when the taxpayer argues that the residence is being held for appreciation. Certain vacation homes also do not qualify for like-kind exchange treatment. A vacation home not held for investment is not a qualified-use property because it is being used for personal reasons and not for business or investment purposes.
In Revenue Ruling 57-244,6 the IRS addressed the issue of taxpayers who purchase property for the construction of a residence, abandon that purpose for clearly established reasons, and then hold the property for investment purposes. A subsequent exchange in this case is held to qualify under Section 1031. Converting a personal residence into a rental unit would also change the use category of the property, thereby making it qualify for a like-kind exchange. The burden of proving conversion is on the taxpayer, and the success of this tactic depends on such considerations as how long the property is rented before the exchange, the documentation of rental efforts, and the substance of the transaction.
Property received in a like-kind exchange and immediately resold can create a problem for the taxpayer. Although there is no specified length of time that a property must be held before sale or liquidation, the purpose the taxpayer establishes for acquiring the property is important. Property acquired in an exchange for the purpose of immediate resale is not held for business or investment purposes. This is especially true when the taxpayer has entered into a binding contract before the exchange to sell the property after the exchange. In Regal' s Realty Co. v. Commissioner,7 the court considered a transaction in which a taxpayer exchanged property for a commercial building and one month later initiated a plan of liquidation under which it would sell the building. The court ruled that the commercial building was not held for business or investment purposes but was held for trading or resale. The exchange, therefore, did not qualify as a like-kind exchange under Section 1031.
During the 1970s, aggressive taxpayers and tax practitioners began structuring like-kind exchanges of real estate in which the replacement property was not received simultaneously with the relinquishment of the taxpayer's exchange property. In Starker v. U.S.,8 the court addressed the issue of the applicability of Section 1031 when the exchange of properties did not occur simultaneously. In the Starker case, property was relinquished in exchange for property that was to be identified and conveyed within the following five years. The IRS argued that Section 1031 did not apply because the exchange was not simultaneous and that what was received in exchange for the property was merely a contract, not property of like kind. The Ninth Circuit Court disagreed and concluded that Section 1031 did not require that the exchange occur simultaneously and that contract rights were sufficient as long as like-kind property was ultimately received. The term Starker exchange, referring to exchanges that are not simultaneous, is now a term commonly used in the discussion of like-kind exchanges.
The Tax Reform Act of 19849 subsequently enacted time limits governing the identification and receipt of property received in an exchange. According to that law, the properties need not be exchanged simultaneously to be eligible for nonr ecognition treatment under Section 1031, but the exchange must meet two separate timing requirements. If either requirement is not met, the property received in the exchange will not be considered like kind.
The first timing requirement is that the property to be received in the exchange must be specifically identified within 45 days of closing on the relinquished property. To prove that identification has occurred, the taxpayer must designate the property in writing and must have proof that this writing was received within the time period. Property is appropriately identified only if it is specifically designated as replacement property and specifically described by reference to a legal description, a street address, or a distinguishable name.
The second timing requirement is that the identified replacement property must be received before the end of the exchange period. The exchange period begins on the date the property is transferred and ends on the date that is the earlier of 180 days after the date of the transfer or the due date of the relinquishing party's income tax return for the taxable year. This timing requirement must be strictly observed. In Christensen v. Commissioner,10 replacement property was received within 180 days of the transfer of the relinquished property but after the due date of the tax return of the party relinquishing the property. The court held that the exchange did not qualify for non recognition of gain or loss. The party argued that the due date of the return should be determined by including the time of an automatic extension for filing a tax return because the statute allows for the inclusion of extensions. The court, however, pointed out that the party had neither requested nor been granted an extension for filing a tax return, which placed the actual due date of the return prior to the time that the replacement property was received. The relinquishing party could have avoided the result in Christensen by simply requesting an automatic extension of the due date for the income tax return. It should be noted that replacement property can qualify as like-kind property even if it is not in existence or if it is being produced at the time it is identified.
Receiving "Boot" in a Like-Kind Exchange
Section 1031 (a) of the Internal Revenue Code provides for the non recognition of gain or loss solely on the exchange of property of like kind. If non-like-kind property or money is included as part of the transaction, there must be recognition of at least a portion of any gain. The non-like-kind property included in the transaction is commonly called "boot." When boot is received, gain to the recipient of the property must be recognized to the extent of the boot received.
Special rules apply in the case of an exchange involving like-kind and non-like-kind property. A taxpayer might, for example, exchange or receive an apartment building or restaurant that contains furniture, fixtures, equipment, or other assets. The IRS has taken the position that when an exchange of assets comprises an integrated economic unit, it is an exchange of multiple assets and not an exchange of one economic unit. In this situation, the properties transferred and the properties received are separated into exchange groups by matching properties of like kind or like class to the extent possible. After the matching process is completed, it may be determined that non-like-kind assets remain; a taxpayer might have to recognize gain on such assets.
Consideration that is received in the form of an assumption of a liability or of a liability attached to property transferred is considered as other property or money and is therefore boot. In Garcia vs. Commissioner,11 the tax court noted that where liabilities are relieved and assumed on both sides of an exchange, they are netted against each other in determining whether and to what extent taxable boot has been received.
Dealers in Real Estate
Dealers in real estate cannot use the like-kind exchange provisions regarding non recognition of gain or loss on exchange of real property because they hold real property as inventory, not for productive use in the business or for investment. The facts and circumstances of each situation must be analyzed to determine if a person is a dealer in property or an investor in property No specific factors are controlling in deciding the dealer versus investor issue. The IRS looks at all the facts and circumstances and considers factors such as the
* Reason and purpose for which the property was acquired and/or relinquished,
* Length of time the property was held,
* Number and frequency of sales,
* Continuity of sales-related activity over a period of time,
* Amount of the gain obtained on the sale in relation to the gains obtained by other dealers or investors, and
* Extent to which the taxpayer or his or her agents engaged in sales activities by developing or improving the property, soliciting customers, or advertising.
* Structuring Like-Kind Exchanges to Defer Gain
In structuring a like-kind exchange, a taxpayer should identify that objective as early as possible-at a minimum, before the closing date of the sale of the property. It is important to observe the two time requirements: identify the replacement property in no more than 45 days and take title of that property by the 180th day after the date of transfer of the relinquished property.
One of the difficulties in setting up a like-kind exchange is finding two parties who have suitable property they want to exchange. When the buyer of the relinquished property does not have suitable replacement property, one option is to have the buyer purchase replacement property so the exchange can then occur. This option creates problems, however, because a buyer is often unwilling to go through the inconvenience of purchasing like-kind property to accommodate the seller, and a transaction in which the taxpayer sells property to one party and buys suitable replacement property from another does not qualify as a like-kind exchange. One solution to this problem is using a qualified intermediary to complete the exchange. The regulations under Section 1031 allow a taxpayer to
* Enter into a real estate exchange agreement with a qualified intermediary,
* Assign his or her rights to an underlying real estate sales contract to the qualified intermediary,
* Provide notice of assignment to the buyer,
* Sell the relinquished property to a third party in a normal real estate closing with a qualified escrow agent receiving the funds, and
* Reinvest the proceeds in other real estate by assigning the underlying purchase contract to the qualified intermediary and notifying the seller.
It is important to remember that when a taxpayer sells the relinquished property and later acquires replacement property, the sale proceeds must be kept out of the taxpayer's control. Generally, the taxpayer should not have the right to receive, pledge, borrow, or obtain benefit from the sale proceeds. The IRS requires that gain in a like-kind transaction be recognized to the extent of boot received. If the boot is kept out of the taxpayer's control, the taxpayer may avoid the actual or constructive receipt of boot; a qualified escrow account can be used to accomplish this objective.
For a number of years, taxpayers attempted to defer gain by using a technique called reverse like-kind exchanges. In this type of transaction, a taxpayer typically knows what property he or she wants to acquire, but the seller does not want to participate in an exchange. The transaction can be structured so that an intermediary acquires and holds the new property until the taxpayer finds a buyer for his or her property. In essence, the taxpayer in these transactions is purchasing new property before the sale of the old property. In 1991, however, the IRS issued regulations12 stating that these transactions did not qualify for like-kind treatment because there was not a simultaneous exchange. The regulations stated that the deferred exchange rules under Section 1031 do not apply to these reverse exchanges.
After the 1991 regulations were issued, taxpayers still engaged in a wide variety of transactions, including so-called "parking transactions," to facilitate reverse like-kind exchanges. Parking transactions typically are designed to temporarily move the desired replacement property to a qualified intermediary until the taxpayer arranges for the transfer of the relinquished property to the ultimate transferee in a simultaneous or deferred exchange. Once such a transfer is arranged, the taxpayer transfers the relinquished property to the qualified intermediary in exchange for the replacement property. The qualified intermediary then transfers the relinquished property to the ultimate transferee. In a parking arrangement, taxpayers attempt to arrange the transaction so that the qualified intermediary has sufficient benefits and burdens relating to the property to be treated as the owner for federal income tax purposes.
Many taxpayers disagreed with the 1991 IRS position and continued to use reverse exchanges and treat them as like-kind exchanges. In 1998, the IRS issued Private Letter Ruling 9814019.13 The case that precipitated this ruling involved a reverse-exchange transaction between two parties in which the conveyance of a new easement to the taxpayer was to be followed by relinquishment of the old easement to another company. The IRS reversed its prior position in this ruling and permitted a two-party reverse exchange under the like-kind exchange rules.
In 2000, the IRS further clarified its position by issuing Revenue Procedure 2000-37,14 which provides a safe harbor under which the IRS will not challenge the qualification of property as either replacement property or relinquished property for purposes of Section 1031 if the property is held in a "qualified exchange accommodation arrangement." In this type of arrangement the taxpayer is allowed only 45 days between the time the property being exchanged is identified and the time the intermediary takes legal title to the new property. Under Revenue Procedure 2000-37 the maximum time allowed for the sale of the property being exchanged is the earlier of 180 days or the due date of the relinquishing property owner's tax return for that year determined with regard to extensions. This procedure suggests that the IRS believes it is in the best interest of sound tax policy to provide a taxpayer with a workable means of qualifying a transaction under Section 1031 if the taxpayer has a genuine intent to accomplish a like-kind exchange at the time that it arranges for the acquisition of the replacement property and actually accomplishes the exchange within a short time after the acquisition. This procedure essentially guarantees that the IRS will accept a reverse like-kind exchange if it is structured properly.
A further development in this area of tax law occurred in the 2000 case of DeCleene v. Commissioner,15 in which a taxpayer tried to accomplish a like-kind exchange without using an intermediary. The taxpayer acquired the Lawrence property in 1992. Approximately one year later the taxpayer transferred the Lawrence property to Western Lime and Cement Company in exchange for a note. Three months later the taxpayer reacquired the Lawrence property in exchange for a new property called the McDonald property. The court held that Western Lime and Cement Company did not acquire any of the benefits and burdens of ownership of the Lawrence property, and therefore the Lawrence property was never transferred. Consequently, the only way in which the transaction could qualify for non recognition under Section 1031 would be if the acquisition of the Lawrence property in 1992 were treated as part of an integrated plan to exchange it for the McDonald property. However, the taxpayer had not taken any steps to document intent to enter into such an exchange.
In this case the court pointed out that because the taxpayer purchased the Lawrence property without the participation of an intermediary or exchange facilitator, the intent to eventually conclude an exchange was not made clear. The court ruled that the transaction was a taxable sale and not a tax-free exchange. The DeCleene ruling highlights the need to use an intermediary and to document the exchange carefully.
Using a Limited Liability Company in a Like-Kind Exchange
Under Section 1031(a)(2)(D), the exchange of an interest in a partnership is not eligible for non recognition treatment in a like-kind exchange. Since most limited liability companies elect to be treated as partnerships for federal tax purposes, non recognition treatment is not available for a like-kind exchange involving such a limited liability company. Under Internal Revenue Code Section 401,16 however, a one-owner limited liability company can have the limited liability entity disregarded for tax purposes by electing to reflect the limited liability company transactions on his or her individual tax return.
Until 2001, the IRS had not directly addressed the question of whether the exchange of real property for an interest in a single-member limited liability company that holds other real estate was eligible for non recognition treatment under the like-kind exchange provisions. The IRS finally resolved the question in Private Letter Ruling 200118023,17 which states that an exchange of property for an interest in a single-member limited liability company that holds like-kind property is eligible for non recognition treatment. This is true as long as the limited liability company has elected not to be treated as a partnership and is therefore a disregarded business entity for federal tax purposes. If this is the case, the acquisition of an interest in a limited liability company that holds like-kind property is treated as the acquisition of qualifying like-kind replacement property. It is important to emphasize again, however, that the exchange is not eligible for like-kind treatment if the limited company has elected to be treated as a partnership.
Like-kind exchanges are a popular method of deferring taxes on the disposition of business or investment property. While these real estate exchanges offer excellent tax advantages, the discussion here illustrates the importance of structuring the exchanges in accordance with IRS regulations in order to realize tax deferment.