Friday, October 26, 2018
The TCJA eliminated tax-deferred like-kind exchanges of personal property for exchanges completed after 2017. However, exchanges of real estate can still qualify for tax-deferred treatment if the exchange involves real estate that is “like-kind.” But, what does that mean?
Real estate tax-deferred trades and what counts as “like-kind” – that’s the focus of today’s post.
Definition of “Real Estate”
Broad definition. Under the former rules governing trades of personal property, such as farm machinery, the Treasury Regulations determined if property was like-kind by reference to being within the same product class. See Treas. Reg. §1.1031-2(b)(2). Also, property was of a like-kind to property that was of the same nature or character. See Temp. Treas. Reg. §1.1031(a)-2T(d). However, like-kind property personal property did not necessarily have to be of the same grade or quality. In addition, for intangible assets, the determination of like-kind had to be made on an asset-by-asset basis. Thus, a like-kind trade could 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.
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 taxpayer continues to use the replacement property for business or investment. The regulations define “like-kind” in terms of reference to the nature or character of the replacement property rather than its grade or quality. Treas. Reg. §1.1031(a)-1(b); see also C.C.M. 201238027
In addition, it doesn’t matter whether the real estate involved in a tax-deferred exchange is improved or unimproved. Treas. Reg. §1.1031(a)-1(b), (c). 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 the exchange.
Unique situations. While the definition of real estate is rather broad, some distinctions are present. For example, 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.
That 30-year rule is important. The IRS has, apparently, taken the position that an exchange of a remainder interest in a tract of real estate for a life estate (where the life expectancy of the life tenant exceeds 30 years) for another tract of real estate can qualify for like-kind exchange treatment. Rev. Rul. 72-601, 1977-2 C.B. 467. Likewise, a remainder interest in real estate can qualify for like-kind exchange treatment when it is exchanged for a remainder interest (or, probably, a reversionary interest) in a different tract of farmland. Rev. Rul. 78-4, 1978-1 C.B. 256. Also, real estate owned in fee simple can qualify for like-kind exchange treatment when traded for real estate subject to 99-year leases. See, e.g. Koch v. Comr., 71 T.C. 54 (1978).
Also, a sale followed by a leaseback involving terms of 30 years or more has been deemed to be like-kind. Rev. Rul. 60-43, 1960-1 C.B. 687; Jordan Marsh Company v. Comr., 269 F.2d 453 (2d Cir. 1959).
As for land that is being sold under an installment land contract, the buyer’s rights under the contract have been held to be the same as a fee simple interest in the real estate. See, e.g., Starker v. Comr., 602 F.2d 1341 (9th Cir. 1979).
In Peabody Natural Resources Co. v. Comr., 126 T.C. 261 (2006), the Tax Court determined that under New Mexico law, coal supply contract constituted real property interests and were like-kind to gold mine. The case involved the exchange of an operating gold mine, including real estate, for operating coal mines which were subject to coal supply contracts obligating the owner to provide electric utilities with coal. The IRS denied like-kind exchange treatment on the basis that the coal supply contracts weren’t real property. However, the Tax Court determined that under New Mexico law (the state where the coal mines were located) the coal contracts were servitudes (an interest on the underlying land) under New Mexico law. As for the nature and character of the contracts, the Tax Court determined that they couldn’t be separated from the ownership of the coal reserves. They were ancillary to the ownership of the coal reserves. As a result, the contracts were like-kind to the gold mining property.
Perpetual water rights are like-kind to land. Rev. Rul. 55-749, 1955-2 C.B. 295. However, 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, there can be an exception to that outcome. 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).
Impact of State Law
It could be concluded from a read of the above cases and rulings that state law plays a predominant role in determining whether a property interest is an interest in real property that can potentially be eligible for like-kind exchange treatment. That was certainly the case in the early cases dealing with the issue. See, e.g., Morgan v. Comr., 309 U.S. 78 (1940); Aguilino v. United States, 363 U.S. 509 (1960); Comr. v. Crichton, 122 F.2d 181 (5th Cir. 1941); Priv. Ltr. Rul. 200424001 (Dec. 8, 2003). But, other cases indicate that the like-kind determination is a matter of federal law rather than state law. See, e.g., Fleming v. Comr., 24 T.C. 818 (1955), rev’d., 241 F.2d 78 (5th Cir. 1957).
In 2012, the IRS clarified its position on the impact of state law in determining whether a property interest is in interest in real property. In C.C.A. 201238027 (Sept. 21, 2012), the IRS determined that federal income tax law, not state law, controls whether exchanged properties are of like kind for I.R.C. §1031 purposes. While the IRS stated that state law property classifications are relevant for determining if property is real or personal, they aren't determinative of whether properties are of the same nature and character. Instead, that determination is to be made by considering all of the facts and circumstances of the particular transaction and the property interests involved. Id.
The TCJA eliminated the ability to treat personal property trades under the I.R.C. §1031 rules. However, real estate can still be traded in a tax deferred exchange transaction. What constitutes “real estate” is an important first determination. The nature and character of the properties involved in the transaction is the next determination. If those hurdles are successfully cleared, the I.R.C. §1031 rules can provide a preferential tax result.