Like Kind Exchanges Alive and Well: An Update
Attempts by the Obama administration to curtail or eliminate IRC § 1031 exchanges were decidedly unsuccessful. Based upon their pronouncements, neither Ms. Clinton nor Mr. Trump would be expected to attempt to curtail the statute. Increased tax rates and increased real properly values have rekindled interest in deferred exchanges. Most of the litigation, and many of the PLRs issues in past two years have involved the (i) related party exchanges under IRC §1031(f); (ii) the qualified use requirement under IRC §1031(a)(1); reverse exchanges under Rev. Proc. 2000-37; and (iv) “LKE programs” pursuant to Rev. Proc. 2003-39. In North Central Rental & Leasing, LLC v. U.S., No. 13-3411 (8th Cir. 2015), the Court of Appeals upheld a determination that 398 (essentially identical) exchanges made by the taxpayer were invalid under because they were structured to avoid the related-party exchange restrictions under Section 1031(f). The Court found that exchange transactions were unnecessarily structured to involve and provide a cash windfall to an entity related to the taxpayer.
Taxpayer Northern Central Rental & Leasing (““Northern Central”) was a 99 percent subsidiary of Butler Machinery. Both Butler Machinery and Northern Machinery conducted businesses relating to agricultural, mining and construction equipment. Butler Machinery sold equipment, while Northern Machinery rented and leased equipment. The exchange transactions allowed North Central to replace used equipment with new equipment. The structure of each exchange transaction was as follows: Northern Central conveyed relinquished equipment to a qualified intermediary (“QI”), who then sold the equipment to an unrelated third party. Later, Butler Machinery purchased replacement equipment from an equipment manufacturer with whom it had a business relationship. The QI used the proceeds from the sale to purchase the replacement equipment from Butler Machinery before transferring the equipment to North Central.
As a result of this exchange as structured, the QI paid the proceeds derived from the transfer of the relinquished property to an unrelated third party to Butler Machinery instead of directly to the party from whom the eventual replacement property was acquired. At the same time, Butler Machinery benefited from a financing arrangement with the equipment manufacturer which allowed Butler Machinery to make payments six months after purchasing equipment. During that six-month period, Butler Machinery had free use of the relinquished property sales proceeds. Thus, each exchange transaction amounted to a six month zero-interest loan made to Butler Machinery.
The Court questioned the reason for any involvement at all by Butler Machinery, citing cases from the Eleventh and Ninth Circuits which held that transactions were structured to avoid the purposes of § 1031(f) when unnecessary parties participated and when a related party ended up receiving cash proceeds. The Ninth Circuit in Teruya Bros. v. Comm’r, 580 F.3d 1038 (9th Cir. 2009), had found that the taxpayer could have achieved the result through “far simpler means” and that the transactions “took their peculiar structure for no purpose except to avoid § 1031(f)’s restrictions.” Similarly, the Eleventh Circuit in Ocmulgee Fields v. Comm’r, 613 F.3d 1360 (11th Cir. 2010), had found no “persuasive justification” for the complexity of its transaction other than one of “tax avoidance.”
Section 1031(f) was enacted as part of RRA 1989 to eliminate revenue losses associated with “basis shifting” in related party exchanges. Basis shifting occurs when related persons exchange high basis property for low basis property, with the high basis (loss) property being sold thereafter by one of the related persons and gain on the low basis property being deferred. Basis shifting allows the parties to retain desired property but shift tax attributes. Section 1031(f)(1) causes deferred realized gain to be recognized if, within two years, either related party disposes of exchange property, unless the disposition falls within one of three exceptions, the most important of which being that the exchange does not have as “one of the principal purposes” tax avoidance. On the other hand, even if an exchange is outside the literal scope of the statute (i.e., by engaging a QI, but was “structured” to avoid the related party rules, the entire exchange will fail under Section 1031 ab initio.
The Tax Court was recently called upon to ascertain whether a person the son of the exchanger constituted a “disqualified person” in connection with the qualified intermediary (“QI”) deferred exchange regulations. In Blangiardo v. Comm’r, T.C. Memo 2014-1010 (2014), the taxpayer’s son, who was also an attorney, acted as a qualified intermediary, pursuant to Treas. Reg. § 1.1031(k)-1. The regulations define a disqualified person as anyone who has acted 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.” Treas. Reg. § 1.1031(k)-1(k)(2). Disqualified persons include persons related to the taxpayer as defined by IRC § 267(b), which include siblings, spouses, ancestors and lineal descendants. Treas. Reg. § 1.1031(k)-1(k)(3). As a lineal descendant, a son thus appears to be clearly within the definition of a disqualified person. The taxpayer argued that an exception should be made because (i) his son was an attorney; (ii) the funds from the sale of the relinquished property were held in an attorney trust account; and (iii) the real estate documents referred to the transaction as a IRC §1031 exchange. The Court dismissed the arguments as irrelevant since the regulations do not provide for any exceptions.
Although like kind exchanges are most often associated with real property or tangible personal property (e.g., an airplane), exchanges involving intangible personal property, consisting of customer lists, going concern value, assembled work force, and good will may also occur. An exchange of business assets requires that the transaction be separated into exchanges of its component parts. Revenue Ruling 57-365, 1957-2 C.B. 521. Unlike the case involving exchanges of real property or tangible personal property, little regulatory guidance is provided for exchanges of intangible property. Whether such an exchange qualifies under Section 1031 is therefore reduced to an inquiry as to whether the exchanged properties are of “like kind” under the statute itself. In published rulings, the IRS has imported concepts from the regulations dealing with real property exchanges. As might be surmised, exchanges of intangible personal property are at times problematic.
Treas. Reg. §§ 1.1031(a)-2(c) provides that whether intangible personal properties are of like kind depends on the nature and character of (i) the rights involved and (ii) the underlying property to which the intangible personal property relates. PLR 201532021 held that agreements providing intangible rights with respect to the manufacture and distribution of a certain set of products are of like kind since they meet the requirements of the regulation. The nature or character of the agreements are of like kind because the terms of the agreements are substantially similar, despite differences in grade or quality. The underlying property to which the intangible rights relate are of like kind because the products are distributed in a similar manner to a common set of customers.
Section 1031(a)(1) provides that
NO GAIN OR LOSS SHALL BE RECOGNIZED ON THE EXCHANGE OF PROPERTY HELD FOR PRODUCTIVE USE IN A TRADE OR BUSINESS OR FOR INVESTMENT IF SUCH PROPERTY IS EXCHANGED SOLELY FOR PROPERTY OF LIKE KIND WHICH IS TO BE HELD EITHER FOR PRODUCTIVE USE IN A TRADE OR BUSINESS OR FOR INVESTMETN. (EMPHASIS ADDED).
The phrase ““held for” means the property must be in the possession of the taxpayer for a definite period of time. Exactly how long has been the subject of considerable debate. PLR 8429039 stated that property held for two years satisfies the statute. Some have suggested that, at a minimum, the property should be held for a period comprising at least part of two separate taxable years (e.g., November, 2010 through October, 2011). However, it should be taxpayer’s intent that is actually determinative. Therefore, an exchange of property held for productive use in a trade or business should qualify even if it were held for less than two years provided the taxpayer’s intent when acquiring the property was to hold the property for productive use in a trade or business or for investment, (rather than to hold it just long enough to qualify for exchange treatment). Of course, evidencing the taxpayer’s intent for a short period of time might be difficult, and for this reason guidelines, such as that articulated in PLR 8429039 are useful.
Chief Counsel Advisory (CCA) 201605017 addressed whether an aircraft that is used for both personal and business purposes meets the IRC § 1031(a)(1) requirement that property be “held for productive use in a trade or business or for investment” (i.e., the “qualifying use” requirement). The IRS advised that an aircraft is considered only one type of property that is either held for a qualifying use under Section 1031, or for personal use. Whether the qualifying use (“held for”) requirement has been met involves an all-or-none determination. Property cannot partially meet the held for requirement.
IRS counsel further noted that whether property meets the held for requirement must be determined on a case-by-case basis based upon the particular facts and circumstances. The IRS determined that the fact that more than half of flights made by the relinquished aircraft during the year it was relinquished were for personal purposes suggests that the property was not held for productive use. However, other factors should be considered, such as the number of flight hours. The IRS did not opine, however, as to whether the qualifying use requirement could be met where less than half of the use of the aircraft was for personal purposes.
CCA 01601011 also involved the qualifying use (“held for”) requirement in connection with aircraft. Here, however, the IRS addressed the question of whether the intent to earn a profit is necessary in order to satisfy the qualifying use requirement. The taxpayer exchanged relinquished aircraft for replacement aircraft. The aircraft were the only operating assets of the taxpayer. Both the relinquished and replacement aircraft were leased to a related entity. The lease payments in both cases were not intended to generate economic profit, but rather to cover the carrying costs of the aircraft. The Chief Counsel determined that lack of intent to generate an economic profit from the aircraft rental does not cause a failure to meet the productive use in a trade or business standard of § 1031.
Technical Advice Memorandum (TAM) 201437012 involved an “LKE Program,” as defined in Revenue Procedure 2003-39. An LKE Program is an ongoing program involving multiple exchanges of 100 or more properties conducted by a taxpayer that regularly and routinely enters into agreements to sell and agreements to buy tangible personal property. Rev. Proc. 2003-39 provides that in order to receive nonrecognition treatment under IRC § 1031 in connection with an LKE Program, relinquished properties must be “matched” with replacement properties received. The auditor had determined that replacement property which had been properly identified during the identification period was not of “like kind” to relinquished property with which it had been matched. Consequently, the taxpayer asserted that other property which had been acquired during the 45 day identification period was of like kind and thus the transaction qualified for exchange treatment. (Normally, property acquired during the 45 day identification period need not be formally identified. This is known as the “actual purchase” rule, which is a corollary to the three normal identification requirements.) In this case, even though the actual purchase rule was satisfied, the auditor found that since the taxpayer had previously “matched” other property that failed to satisfy the “like kind”” requirement, that failure could not be later remedied by “matching” other property, even though the later property was of like kind, and was properly identified and acquired.
Sensibly, the TAM found that nonrecognition and rematching was appropriate since the previously unmatched replacement property met the requirements of IRC § 1031. This was true irrespective of the fact that the previously matched replacement property failed to be of like kind. In essence, the TAM correctly concluded that the requirements of an LKE program do not trump the requirements of IRC § 1031 itself, the rationale being that Section 1031 is not (technically) an elective provision. If properties exchanged are of like kind, and the other statutory requirements of Section 1031 are met, the transaction will constitute a like kind exchange, even if the taxpayer does not so desire.
It has been suggested that where the taxpayer desires to recognize a loss in a transaction otherwise qualifying under Section 1031, the taxpayer could purposely fail to identify other replacement property within the 45 day identification period. It is doubtful that this strategy would work; at the very least it would invite litigation.
Although the deferred exchange Regulations apply to simultaneous as well as deferred exchanges, they do not apply to reverse exchanges. In a reverse exchange, the taxpayer acquires replacement property before transferring relinquished property. Perhaps because they are intuitively difficult to reconcile with the literal words of the statute, reverse exchanges were slow to gain juridical acceptance. An early case, Rutherford v. Comm’r, TC Memo (1978) held that purchases followed by sales could not qualify under Section 1031. However, Bezdijian v. Comm’r, 845 F.2d 217 (9th Cir. 1988) held that a good exchange occurred where the taxpayer received heifers in exchange for his promise to deliver calves in the future. Following Bezdijian, taxpayers began engaging in a variety of “parking” transactions in which an accommodator (i) acquired and “parked” replacement property while improvements were made and then exchanged it with the taxpayer (exchange last); or (ii) acquired replacement property, immediately exchanged with the taxpayer, and “parked” the relinquished property until a buyer could be found (“exchange first”). Just as deferred exchanges were recognized by courts, so too, reverse exchanges soon received a judicial imprimatur.
In an Exchange First reverse exchange, the EAT purchases the relinquished property from the taxpayer through the QI. The purchase price may be financed by the taxpayer. Using exchange funds obtained from the EAT, the QI purchases replacement property which is transferred to the taxpayer, completing the exchange. The EAT may continue to hold the relinquished property for up to 180 days after acquiring QIO. During this 180-day period, the taxpayer will arrange for a buyer. At closing, the EAT will use funds derived from the sale of the relinquished property to retire the debt incurred by the EAT in purchasing the relinquished property from the taxpayer at the outset.
In an Exchange Last reverse exchange, the EAT takes title to (i.e., acquires “QIO”) and “parks” replacement property at the outset. Financing for the purchase may be arranged by the taxpayer. The EAT may hold title to the replacement property for no longer than 180 days after it acquires QIO. While parked with the EAT, the property may be improved, net-leased, or managed by the taxpayer. During the period in which the replacement property is parked with the EAT, the taxpayer will arrange to dispose of the relinquished property through a QI. The taxpayer must identify property (or properties) to be relinquished within 45 days of the EAT acquiring title (QIO) to the replacement property, and must dispose of the relinquished property (through the QI) within 180 days of the EAT acquiring title (QIO). Following the sale of the relinquished property to a cash buyer through a QI, the QI will transfers those proceeds to the EAT in exchange for the parked replacement property. The EAT will direct-deed the replacement property to the taxpayer, completing the exchange. The EAT will use the cash received from the QI to retire the debt incurred in purchasing the replacement property.
PLR 201416006 blessed a proposed transaction in which the taxpayer and two related entities intending to complete a Exchange Last reverse like-kind exchange involving the same “parked” replacement property would each simultaneously enter into separate Qualified Exchange Accommodation Arrangements (“QEAAs”) with the same Exchange Accommodation Titleholder (““EAT”). Under this scenario, it would be unclear at the time that the EAT acquires the replacement property which entity (or entities) would ultimately complete the exchange.
Each QEAA would expressly acknowledge the existence of the other two QEAAs. Each QEAA would further reference the right of all three related parties to acquire the replacement property, in whole or in part. The three QEAAs would provide that the right by each party to acquire the replacement property would be accomplished by notifying the EAT of that party’s intent. Once exercised, the right of the other parties would be extinguished (to the extent thereof, in the case of an exercise with respect to only a portion of the replacement property). The taxpayer’s proposed QEAA was valid. The fact that related entities would enter into concurrent QEAAs in connection with the same replacement property, was of no moment since the taxpayer and both related entities had a bona fide intent to acquire the replacement property under the terms of their respective QEAAs. The PLR further noted that the Revenue Procedure providing for safe harbor for reverse exchanges (Rev. Proc. 2000-37) does not prohibit an EAT from acting as such with respect to more than one taxpayer under multiple simultaneous QEAAs for the same parked exchange property.
PLR 201408019 approved a proposed reverse exchange where the EAT would sublease vacant land from an entity related to the taxpayer pursuant to a sublease exceeding 30 years, construct improvements on the land, and then transfer the leasehold interest to the taxpayer as replacement property. The leasehold interest would be purchased with funds held by a qualified intermediary, originating from the sale of relinquished property (a fee simple interest in a retail building) to an unrelated person. The IRS determined that the IRC § 1031 (f) related party rules were inapplicable. Although the related entity provided the leasehold interest, no cash left the related party exchange group. Gain would be recognized however to the extent exchange funds were not applied to improvements upon the earlier of (i) the transfer of the leasehold interest to the taxpayer or (ii) the termination of the 180 day exchange period. Section 1031(f)(4) provides that like kind exchange treatment will not be accorded to any exchange that is a part of a transaction, or series of transactions, structured to avoid the purposes of Section 1031(f). One test used in determining whether the Section 1031(f)(4) “catch all” applies is to determine whether the related persons, as a group, have more cash after the related party transaction than before. If cash “leaves” the group, there is less chance that a tax avoidance motive is present. Conversely, if cash “enters” the group, a tax avoidance purpose is more likely.
PLR 201425016 drew upon IRC § 1031 for determining when a date of sale of property occurs for the purpose of IRC §512(a)(3)(D). IRC §512(a)(3)(D) provides for the nonrecognition of gain from qualifying sales of property made by certain exempt organizations. The IRS applied the IRC § 1031 rule that the date of sale triggering the commencement of the 45-day identification period for a like kind exchange transaction is the date when the taxpayer relinquishes control of the property.
Prior to this PLR, there was some question as to when a taxpayer relinquishes control of the property. Does the identification period begin to run on the closing date? The date the deed is recorded? Or when the exchange funds are transferred if that date is not coincident? The PLR seems to resolve this issue. The IRS ruled that date of sale is the date that local law determines that a taxpayer relinquishes control and title transfers. Thus, if local law states that the date of title transfer is the date of closing, than the date of closing would be the date of sale for purpose of a § 1031 exchange.