Like-Kind Exchanges
WHAT TYPES OF PROPERTY CAN BE EXCHANGED?
Like-kind property is property of the same nature, character, or class rather than same grade or quality. Following are the main rules:
Real property may be exchanged even if the properties are not of similar grade or quality;
Personal property exchanges must involve nearly identical property;
Depreciable tangible personal property is like kind if it is of like kind or of like class;
Other personal property must be like kind; and
Real property and personal property are not the same class or kind of property.
Many businesses and investors have limited opportunities and resources to search for like-kind property for which they can exchange an existing asset. To fill that need, a commercial like-kind exchange “industry” has developed. Although most such services serve specific business types (for
Top_Fed_07_book.indb 2.6
Top_Fed_07_book.indb 2.6 11/15/2006 2:41:15 PM11/15/2006 2:41:15 PM
M O D U L E 1 — C H A P T E R 2 — L i k e - K i n d E x c h a n g e s 2.7
example, firms specializing in exchanges of investment apartment buildings), some connected with large financial institutions have been setting up full-service like-kind exchange units to serve a varied corporate clientele. Many of these service businesses are themselves part of the transaction, serving as qualified intermediaries (QIs) (see the discussion of Section 440 later in this chapter).
Even for the “do-it-yourselfer,” however, the chances of finding a suitable property to enable a like-kind exchange has been facilitated by the development of the law over the years to permit “delayed” like-kind exchanges in several flavors (see the discussion of Section 435 later in this chapter).
Excluded Property
Certain types of property can never qualify for nonrecognition. These are:
Stocks, bonds, notes, or other securities;
Stock in trade or other property held in inventory for sale;
Partnership interests;
Certificates of trust or beneficial interest; and Choses in action (basically, contract rights).
Partnership interests. Partnership interests do not qualify for nonrecogni-tion. For this rule, it is irrelevant whether the partnership interest is a general or a limited partnership interest or whether the interests are in the same part-nership or in different partpart-nerships. Partpart-nerships that have elected not to be treated as partnerships for tax purposes are not included in this rule. Interests in these types of partnerships are treated as interests in each of the assets of the partnership in determining whether like-kind treatment is available.
Choses in action. A chose in action is a personal right not reduced to possession but recoverable by bringing and maintaining a lawsuit. Some rights, however, such as professional sports players’ contracts, are considered property used in a trade or business and may qualify for nonrecognition.
PRACTICE POINTER
The IRS has held that trade names are not choses in action because they do not confer a right to recover property or money in a lawsuit.
Real Property
Real property may be exchanged even if the properties are not of similar grade or quality. For example, improved real estate qualifies as like kind to unimproved real estate. Any number of parcels of real property can be exchanged, and fractional interests may be exchanged for an entire interest in another property.
Top_Fed_07_book.indb 2.7
Top_Fed_07_book.indb 2.7 11/15/2006 2:41:15 PM11/15/2006 2:41:15 PM
PRACTICE POINTER
For like-kind exchange purposes, the fee title to real estate is like kind to a leasehold with 30 years or more to run.
Personal Property
Personal property exchanges generally must involve nearly identical prop-erty. The analysis may be different, however, if the property is depreciable tangible personal property or other personal property.
Tangible or depreciable personal property. Depreciable tangible personal property qualifies for like-kind treatment in one of two ways:
If the depreciable personal property is exchanged for property that is like kind; or
If the depreciable personal property is exchanged for property that is in a like class.
Whether tangible personal property is in a like class to another personal property depends on whether the personal properties in the exchange are in the same product class or the same asset class as of the date of the ex-change. A property cannot be classified within more than one general asset or product class and property classified within a general asset class cannot also be classified within a product class.
Product classes. Product classes (TRC, SALES: 30,102.10) for depreciable tangible personal property are described in the six-digit classes of Sectors 31, 32, and 33 of the North American Industry Classification System (NAICS).
Any six-digit NAICS product class having a last digit of 9 (indicating a miscellaneous category) is not a product class for tax purposes. A property that is listed in more than one product class is treated as listed in any one of those classes. The six-digit product class is referred to as the NAICS code. The NAICS Manual can be obtained from the National Technical Information Service, an agency of the U.S. Department of Commerce. If personal property is exchanged for other personal property that is in the same product class, the exchange will qualify for like-kind treatment.
General asset classes. Depreciable tangible personal property may be classi-fied into one of 13 general asset classes (TRC, SALES: 30,102.05). If personal property is exchanged for other personal property that is in the same asset class, the exchange will qualify for like-kind treatment. The classes are:
Office furniture, fixtures, and equipment;
Information systems;
Data handling equipment;
Airplanes (other than commercial airliners or freight carriers);
Top_Fed_07_book.indb 2.8
Top_Fed_07_book.indb 2.8 11/15/2006 2:41:16 PM11/15/2006 2:41:16 PM
M O D U L E 1 — C H A P T E R 2 — L i k e - K i n d E x c h a n g e s 2.9
Automobiles and taxis;
Buses;
Light general purpose trucks;
Heavy general purpose trucks;
Railroad cars and locomotives, except those owned by railroad trans-portation companies;
Tractor units for use over-the-road;
Trailers and trailer-mounted containers;
Vessels, barges, tugs, and similar water-transportation equipment, except those used in marine construction; and
Industrial steam and electric generation and/or distribution systems.
Other personal property. An exchange of any other personal property (and depreciable tangible personal property that is not in the same asset or product class as the property being received in the exchange) will be af-forded like-kind treatment under a test that is stricter than the one for real property, the properties’ nature or character must be nearly identical.
EXAMPLE
A truck must be exchanged for another truck to be like-kind and a pas-senger automobile must be exchanged for a paspas-senger automobile. A passenger automobile exchanged for a truck will not qualify for like-kind treatment. The IRS recently held that a sports utility vehicle is like kind to a passenger automobile.
If the property must be “nearly identical,” what is the business case for making an exchange at all? There may be several reasons. First, “nearly identical” may not be good enough for a particular business use. More com-mon, however, is the situation in which the property relinquished doesn’t continue to serve a particular business or investment purpose because it is old. The property received in the exchange is usually new or newer.
Usually, to make the deal work, cash must be given along with the old property, several items of older property must be exchanged for a single item of new property, or several multiple exchanges take place at once. The most common example of the former situation is an old car trade-in. In that case, the depreciable basis of the vehicle received in the trade-in is equal to the sum of the remaining undepreciated basis of the traded-in vehicle (the carryover basis) plus the additional cash paid for the new vehicle.
Intangible personal property. In the case of intangible personal property, like-kind treatment turns on the nature or character of the rights involved, and also on the nature or character of the underlying property to which the intangible personal property relates.
Top_Fed_07_book.indb 2.9
Top_Fed_07_book.indb 2.9 11/15/2006 2:41:16 PM11/15/2006 2:41:16 PM
Foreign Property
Property that is deemed to be foreign must satisfy additional requirements in order to be considered like kind to U.S. property.
Foreign personal property. Generally, personal property used in the United States and personal property used outside of the United States are not like kind to each other. The test is whether the property is predominantly used outside of the United States for a particular time period. For surrendered property, the predominant use is tested based on the two years ending on the date it is relin-quished. For acquired property, the predominant use is tested based on the two years following the acquisition date. If the holding period is less than two years, the actual holding period will determine the predominant use of the property.
Some property is deemed not to be used predominantly outside of the United States, despite it being foreign property. This exception comprises property that is used both within and outside the United States but is con-sidered to be used in the United States and includes 12 categories of property excluded from foreign use classification that would require use of the accelerated depreciation system (ADS).
Foreign real property. As with domestic real property, the rules for foreign real property differ from the rules for foreign personal property just de-scribed. In the case of foreign real property, the rule is straightforward—real property located in the United States and real property located outside of the United States are not like kind.
Other Types of Property
Livestock, natural resources, and unharvested crops also follow a special set of rules in determining whether exchanges of these types of properties qualify for like-kind treatment.
Livestock: Livestock of different sexes is not property of like kind. An exchange of male calves for female calves does not qualify as a like-kind exchange. However, as long as the cattle are of the same sex, they do not have to be the same grade.
Natural resources: An exchange of an interest in a natural resource for another such interest, or for a fee title to land, qualifies for like-kind exchange nonrecognition treatment if the interests exchanged are both either realty or personalty under the relevant state law and of the same character as defined by federal tax law. State law determines whether the interest is realty or personalty.
Unharvested crops: Unharvested crops are part of the land on which they are growing and can be exchanged with the land for other qualifying real property. Tracts of timberland can be exchanged without regard to the quality or quantity of timber growing on the land. Timberland qualifies as like kind to land that is bereft of any crop.
Top_Fed_07_book.indb 2.10
Top_Fed_07_book.indb 2.10 11/15/2006 2:41:16 PM11/15/2006 2:41:16 PM
M O D U L E 1 — C H A P T E R 2 — L i k e - K i n d E x c h a n g e s 2.11
Latest Twists
The law on like-kind exchanges continues to evolve. (Some tax practitioners claim that there has been too much “evolution” and the rules are now so complicated and voluminous that Congress should scrap the entire Code sections and start from scratch—but that won’t happen soon.)
Many of the more recent cases and rulings in the like-kind arena that have been welcomed by practitioners have focused on whether properties were sufficiently similar to be classified as “like kind.” These cases tend to clarify and illustrate which personal properties are identical enough to be like kind.
Unfortunately, however, these cases also reveal a disturbing trend in which exchanges of intangible personal property are becoming less likely to win like-kind treatment.
Timberland. In a 2005 letter ruling the IRS held that old-growth timberland was like-kind to reproduction timberland of equal value because the age, quality and species of the timber growing on the land did not change the class or kind of the property being exchanges, which was land (Ltr 200541037). It further held that the cutting of the old-growth timberland within two years of the exchange would not result in gain recognition, even though it was a related-party transaction (see the discussion of the related party two-year rule later in this chapter), because it would not be deemed to be a “disposition”
of property within the same transaction within two years.
FCC licenses. In another 2005 ruling, the IRS held that an FCC radio license was like kind to a different FCC radio license, finding the differences between the licenses were not differences in nature or character but rather in grade or quality (Ltr 200532008) (IRS Letter Ruling 200532008).
In that same year, the IRS and the FCC provided further guidance by is-suing a joint coordinated paper holding that FCC licenses can be exchanged in nontaxable like-kind exchanges but that network affiliations and goodwill must be valued and treated separately, recognizing any gain that may be at-tributed to those intangibles (News-Federal, 2006TAXDAY, (June 09, 2005), Item #I.3).
SUV and passenger automobiles. In still another ruling, the IRS clarified to the relief of many businesses that sports utility vehicles and passenger automobiles were like kind to each other (Ltr 20045005). The IRS saw any differences as one of grade or quality but not nature or character.
Mines and supply contracts. A 2006 Tax Court decision held that a gold mine was like kind to a coal mine and the supply contracts that went with the mine (Peabody Natural Resources Co. v. Cmmr, 126 TC No. 14).
Under New Mexico law, the contracts were equitable servitudes, real prop-erty-related interests, and as such were not personal property. Although the
Top_Fed_07_book.indb 2.11
Top_Fed_07_book.indb 2.11 11/15/2006 2:41:16 PM11/15/2006 2:41:16 PM
court refused to approve a blanket rule that all real property interests are necessarily like kind, they were in this case because the nature or character of the properties was similar.
Railroad tracks. In a recent field advice, the IRS Chief Counsel’s Office ruled that railroad tracks attached to the land were not like kind to unas-sembled track components (TAM 200424001). Again, state law was critical in the analysis. The tracks attached to the land were real property under state law, whereas the unassembled tracks were personal property.
Intangible personal property. The like-kind property of intangible proper-ties has been at the center of a debate that has lasted as long as Section 1031 itself. The latest developments in this debate have been decidedly against facilitating qualifying like-kind exchanges in the area. In a nutshell, the IRS is moving toward a more restrictive approach to intangibles.
Recently, the IRS issued a technical advice memorandum for its field agents that examined several business transactions involving exchanges of busi-ness intangibles (TAM 2006023034). The results were not encouraging.
Under the facts, a taxpayer transferred and acquired tangible and intangible assets held by two of its subsidiaries and claimed like-kind treatment for the intangible assets. The intangible property included patents, trademarks and trade names, unregistered intellectual property, and foreign intangibles.
No blanket analysis was permitted. The IRS held that taxpayers could not engage in a blanket like-kind exchange of intangible business assets for other intangible business assets without examining the underlying assets. The multiple property rules (described below) do not apply.
Nature and character of rights matter. The IRS further ruled that whether intangible property qualified as like kind was determined under the test that examines the nature and character of the rights involved and the nature and character of the related underlying property. The IRS used the General Asset and Product Classes where applicable to compare the underlying property.
Patents. Finding that the nature or character of the rights under a patent does not vary from patent to patent, the IRS found that that prong of the test was met with regards to exchanges of patents for patents. The IRS then held that patents in the same general asset class or product class were like kind. Only one of the patents met this test.
Unregistered intangibles. The taxpayer’s unregistered intangibles included designs, drawings, trade secrets, secret know-how, and software. All of the unregistered intangibles were offered the same legal protection so they met the first prong of the test—the nature and character of the rights involved analysis. Again, in determining whether the underlying property was of the same nature and character, the IRS used the general asset and product
Top_Fed_07_book.indb 2.12
Top_Fed_07_book.indb 2.12 11/15/2006 2:41:17 PM11/15/2006 2:41:17 PM
M O D U L E 1 — C H A P T E R 2 — L i k e - K i n d E x c h a n g e s 2.13
classes and granted like-kind treatment for those assets that were in the same general asset or product class.
Trademarks and trade names. Trademarks and trade names are not af-forded like-kind treatment. The IRS determined that they were too closely related to the goodwill or going concern value of a business, which is not like-kind property under the regulations.
Foreign intangible property. Intangible property of a company outside the United States was not like kind to intangible property of a domestic company. The enjoyment or use test was applied by examining where the property was licensed.
Multiple Properties
Exchanges of multiple properties can qualify for like-kind treatment. The general property-by-property comparison that is made to compute gain and basis of the property received in the exchange, however, usually does not apply in an exchange of multiple properties. Instead, gain, loss, and basis must be computed for each group of properties that are of like-kind or like class.
These transactions are common in exchanges of similar businesses. In such cases, an asset-by-asset comparison is required first to determine whether the like-kind exchange rules apply to the underlying assets; then the assets are divided into :exchange groups” so that gain and basis may be computed on a group by group basis.
Exchange groups. An exchange group is a group of all the properties transferred or received within a group that are of like-kind or like class. An exchange is considered to be an exchange of multiple properties that requires the “exchange group” method for gain and basis comparisons if:
More than one exchange group is created; or
Only one exchange group is created but more than one property is transferred or received within that exchange group.
Properties are placed into an exchange group by matching up properties of like kind or like class. Each exchange group consists of the properties transferred and received in the exchange that are of like kind or like class. If a property can be included in more than one exchange group, the property can be included in any of those groups. However, each exchange group must consist of at least one property transferred and one property received in the exchange.
Residual group. A residual group must be created when the aggregate fair market value of the properties transferred in all of the exchange groups differs from the aggregate fair market value of the properties received in
Top_Fed_07_book.indb 2.13
Top_Fed_07_book.indb 2.13 11/15/2006 2:41:17 PM11/15/2006 2:41:17 PM
all of the exchange groups (including liabilities). Practically speaking, there always will be some property falling into the residual group in the case of most multiple-property exchanges.
The residual group consists of an amount of money or “other property”
The residual group consists of an amount of money or “other property”