Monday, June 5, 2017
Generally, an exchange of property for other property is treated as a sale. However, no gain or loss is recognized if property held for productive use in a trade or business or for investment is exchanged for property of a like-kind to be held either for productive use in a business or for investment. I.R.C. §1031. The new property is treated as a continuation of the original property. That means that neither gain nor loss is recognized until (if ever) the replacement property is sold. Gain, however, is recognized to the extent of any boot or unlike property received in the exchange.
Like-kind exchanges are very popular in agriculture. Whether the transaction involves a trade of real estate or equipment, ag producers find tax-deferred exchanges to be a useful tax planning tool. Today’s post looks at just a few of the aspects of like-kind exchanges.
What is “Like-Kind”?
Personal property. With respect to the trade of tangible personal property, such as farm machinery, the Treasury Regulations determine if property is like-kind by reference to being within the same product class. Also, property is of a like-kind to property that is of the same nature or character. Like-kind property does not necessarily have to be of the same grade or quality. In addition, for intangible assets, the determination of like-kind must be made on an asset-by-asset basis. Thus, a like-kind trade can involve a bull for a bull, a combine for a combine, but not a combine for a sports car or a farm or ranch for publicly traded stock.
Real estate. With respect to real estate, a much broader definition of like-kind applies. Virtually any real estate used for business or investment can be exchanged for any other real estate if the exchanger continues to use the replacement property for business or investment. Thus, agricultural real estate may be traded for residential real estate. However, if bare farmland is traded for farmland with depreciable structures on it, tax issues can arise. Many farm depreciable buildings and structures are “I.R.C. §1245 property.” For example, commodity storage facilities and single-purpose agricultural structures are I.R.C. §1245 property, as are irrigation systems, drainage tile, and other improvements to farm real estate. If property with an I.R.C. §1245 depreciation recapture attribute is disposed of in an I.R.C. §1031 exchange, the I.R.C. §1245 depreciation recapture must be recognized to the extent that the replacement property has insufficient I.R.C. §1245 property. IRS Form 8824 provides a location for reporting the I.R.C. §1245 depreciation recapture if non-I.R.C. §1245 property is received in exchange.
A leasehold interest can be exchanged for fee interests if the leasehold interest has at least 30 years to run at the time the exchange is entered into. Treas. Reg. §1.1031(a)-1(c). Case law also indicates that, at the time the transaction is entered into, the lease must have at least 30 years remaining. See, e.g., VIP Industries Inc. & Subsidiaries v. Comm’r, T.C. Memo. 2013-357.
Water rights that are limited in duration are not considered like-kind to a fee interest in land, (Wiechens v. United States, 228 F. Supp. 2d 1080 (D. Ariz. 2002)), but if the water rights are limited only as to annual use the IRS has ruled that they are of sufficient like-kind to a fee interest in land to qualify the transaction for like-kind exchange treatment. Priv. Ltr. Rul. 200404044 (Oct. 23, 2003).
The “Holding” Requirement
The statute is silent about how long the relinquished and replacement properties must be held. Thus, the key is the taxpayer’s intent in holding the exchange properties. However, the IRS has ruled that if the taxpayer acquires the relinquished property immediately before the exchange, or disposes of the replacement property immediately after the exchange, the holding requirement of I.R.C. §1031(a) is not met. See, e.g., Rev. Rul. 75-291, 1975-2 C.B. 332; Rev. Rul. 77-297, 1977-2 C.B. 304; Rev. Rul. 84-121, 1984-2 C.B. 168.
The courts tend to consider whether the relinquished property was held for investment or for use in a business, and whether the replacement property was held for investment or for use in a business. See, e.g., Bolker v. Comr., 760 F.2d 1039 (9th Cir. 1985). Clearly, acquiring property in an exchange which is then immediately fixed-up and sold, does not meet the test of having been held for investment or for use in a trade or business. Similarly, based on the facts of the case, IRS may argue that the transaction really involved the intent to make a gift and that the property was not held for investment or for use in a trade or business. See, e.g., Wagensen v. Comr., 74 T.C. 653 (1980); Click v. Comr., 78 T.C. 225 (1982). In any event, the taxpayer bears the burden to prove the requisite intent. See, e.g., Land Dynamics v. Comr., T.C. Memo. 1978-259.
For exchanges between related parties, if property that was part of the exchange is disposed of within two years of the last transfer that was part of the exchange, the tax deferral is eliminated. In addition, I.R.C. §1031(f)(4) provides that the like-kind exchange rules do not apply to any exchange that is part of a transaction or series of transactions structured to avoid the related party prohibition. The IRS has ruled that taxpayer who transfers relinquished property to a qualified intermediary in an I.R.C. §1031 exchange for replacement property formerly owned by a related party does not qualify for non-recognition treatment. Rev. Rul. 2002-83, IRB No. 2002-49 (intermediary used to circumvent the related party prohibition). The IRS has also disallowed tax-deferred treatment where a taxpayer attempted several related party exchanges, moving low basis property in exchange for the high basis property of a related party, before the sale of the low basis property. Priv. Ltr. Rul. 200126007 (Mar. 22, 2001). However, the IRS has allowed tax-deferred treatment where the related party exchange preceded the sale to a third party by more than the two-year statutory minimum. Field Service Advice 200137003 (Sept. 17, 2001).
What About Debt?
The IRS has prescribed rules that govern the handling of debt in a like-kind exchange. Treas. Reg. §1.1031(d)-(2). Gain recognized on a like-kind exchange with debt is the greater of the excess value of the relinquished property over the value of the acquired property, or the excess of the equity in the relinquished property over the equity in the acquired property (this excess equal to the cash received in the exchange). Thus, if the value of the acquired property equals or exceeds the value of the relinquished property and the equity in the acquired property equals or exceeds the equity in the relinquished property, no gain is recognized on the exchange.
These are just a few of the points concerning like-kind exchanges that seem to generate a lot of questions. These transactions are popular in agriculture. But, anytime a tax-deferred exchange is desired, competent tax and legal advice is a must.