We think the like-kind exchange provisions of United States tax law (IRC § 1031) have survived the careful tax law deliberations just concluded by Congress. [That’s what we thought when we wrote this blog posting. It now appears that the Senate-House compromise removed personal property from like-kind treatment, preserving only real property as qualified exchange property. Read this posting in that light and assume the current tax bill will be enacted.] So, today’s blog posting might describe the kind of property that can qualify for like-kind, tax-deferment treatment. Or, it might describe what used to be eligible. With that in mind, we remembered that a number of years ago we prepared a Q&A information sheet to explain what property might be eligible for tax deferred, like-kind exchange treatment under § 1031 of the United States Internal Revenue Code and to highlight the availability of such treatment for items of personal property. Tax free exchanges pursuant to § 1031 are subject to strict substantive and procedural rules and it is highly inadvisable to rely on summary materials when structuring such exchanges. Something came up last week that caused us to think about this topic. So, the topic of taxes being all over the press, we thought we would gussy up our prior work and share it with our readers. Some of the phrasing comes from the Regulations that explain the Internal Revenue Code. That’s a hint that any reader wanting to know more would be wise to look there as well.
What kind of property might qualify for § 1031 like-kind exchange tax treatment?
Q.1 What kind of property can be exchanged?
A.1 Both the Relinquished Property and the Replacement Property must qualify under Section 1031 of the Internal Revenue Code AND each must be held for productive use in a trade or business or for investment. Inventory does not qualify. Property for personal use does not qualify. Real property and personal property, even intangible property can qualify.
Q.2 Are there other necessary characteristics of the exchanged property?
A.2 The Relinquished Property and the Replacement Property must be “like-kind” to each other.
Q.3 Can you give some examples of real property that would qualify for a like-kind exchange, in each case assuming that the property is held for productive use in a trade or business or for investment?
A.3 Example 1: A shopping center or office building or apartment building or industrial building can be a qualified property as can vacant land held for investment. And, they are all “like-kind” to each other. This means that a shopping center can be relinquished and then replaced with vacant land.
Example 2: A leasehold interest in real property where the remaining term of the Lease (inclusive of genuine extension options) is at least thirty years is eligible property that can be exchanged for other such qualifying or shopping centers or office buildings or apartment buildings or industrial buildings or vacant land.
Example 3: Development rights, which interestingly, can be like-kind to a fee interest if they are “in perpetuity” and the development rights are related to the taxpayer’s use and enjoyment of the underlying real property and the exchange of the development rights was an arms-length transaction.
Example 4: An interest in a real estate cooperative, which can be like kind to real estate if treated as such under local law.
Q.4 What about personal property?
A.4 Business personal property, otherwise qualified, may be used for a Section 1031 like-kind exchange. There are additional rules for such personal property and they are found in Internal Revenue Code Regulation § 1.1031(a)-2. The rules are complex, but the general principle is that there are both General Asset Classes and Product Classes. Personal property in the same General Asset Class qualifies for exchange for replacement personal property in the same General Asset Class, but not for property in a different General Asset Class. If personal property is not included within one of the thirteen listed General Asset Classes, then it is like-kind to property listed in the same Product Class. Product Classes are based on the North American Industry Classification System (NAICS). There are exceptions to these general guidelines.
Q.5 Can you give some examples of personal property that would qualify for a like-kind exchange, in each case assuming that the property is held for productive use in a trade or business or for investment?
A.5 Example 1: A truck for a new truck or a passenger automobile for a new passenger automobile to be used for a like purpose, including as a trade-in of a vehicle with a fair market value in excess of the relinquishing party’s tax basis
Example 2: Major League or similar sports contracts for similar contracts.
Example 3: Concurrency bullion-type gold coins (even if exchanged for Canadian maple leaf coins)
Example 4: Chamber of Commerce memberships for like-kind memberships.
Example 5: Half-blood heifers for three-quarter blood heifers (but livestock of different sexes are not like-kind to each other).
Example 6: Fishing permits for other fishing permits.
Example 7: FCC licenses even with spectrum rights containing bandwidth differences.
Example 8: The assets of similar businesses, such as the assets of one restaurant for that of another or the assets of a telephone company for that of another telephone company or the assets of a television station for the assets of another television station.
Example 9: Rolling Stock for Rolling Stock.
Example 10: Intellectual Property, including Trademarks, but the exchanged property must be like-kind one to another and must be separately described and valued apart from good will. A simple example is that a copyright for a novel is like-kind to a different copyright for a novel, but not to a copyright for a song.
Example 11: Airport take-off or landing slots may be exchanged, even one for the other.
Q.6 What about personal property that would not qualify even if held for productive use in a trade or business or for investment?
A.6 Example 1: Good will and going concern value of a business because it is not like-kind to that of another business and is inseparable from the businesses.
Example 2: Intellectual property cross-licensing rights.
Example 3: Covenants not to compete.
Example 4: Partnership or LLC membership interests.
Example 5: Stocks, bonds, and notes.
Example 6: Other securities or evidences of indebtedness or interest.
Example 7: Certificates of trust or beneficial interests
Example 8: Choses in action
Q.7 What does it mean that the property is held for productive use in a trade or business or for investment?
A.7 This question is essentially factual in nature, and each case considering such a question necessarily turns upon its own peculiar facts. Raymond Bauschard, 31 T.C. 910, affd. 279 F. 2d 115. Although there is no one decisive test by which this question may be determined, see Ralph J. Oace, 39 T.C. 743, the courts have enumerated several factors which should be considered. Among these criteria which have evolved are: (1) the purpose for which the property was initially acquired; (2) the purpose for which the property was subsequently held; (3) the extent to which improvements, if any, were made to the property by the taxpayer; (4) the frequency, number, and continuity of sales; (5) the extent and nature of the transactions involved; (6) the ordinary business of the taxpayer; (7) the extent of advertising, promotion or other active efforts used in soliciting buyers for the sale of the property; (8) the listing of property with brokers; and (9) the purpose for which the property was held at the time of sale. See John D. Riley, 37 T.C. 932, affd. 328 F. 2d 428; C. E. Mauldin, 16 T.C. 698, affd. 195 F. 2d 714; Malat v. Riddell, 347 F. 2d 23, certiorari granted 382 U.S. 900 (1965).
Q.8 Do the courts find it easy to distinguish the difference?
A.8 An “investor” or “speculator” is usually anticipating a gradual appreciation in value of the property, or a rather sudden increase in value in the event of fortuitous circumstances, without doing much to cause that increase in value; whereas a “dealer” is typically looking for a rapid increase in price over a relatively short time, most frequently as a result of some efforts on the dealer’s part to cause the increase. Unfortunately, these categories are only the extremes and do not cover the entire spectrum of transactions. Those that fall in between are the most difficult to characterize for tax purposes.
Q.9 Can you illustrate how, in one situation, a property is not considered to be held for productive use in a trade or business or for investment and, in another case, the exact same property would qualify?
A.9 Here is an illustration. In a 2007 Tax Court case where a taxpayer sold a vacation home and purchased another vacation home as a replacement and neither home was ever rented to third parties, the homes did not qualify as property held for investment. But, following that Tax Court decision, the Internal Revenue Service issued Rev. Proc. 2008-16, 2009-10 IRB 547 which says that vacation homes held for at least 24 months where during each of the 12- month periods immediately preceding the exchange, the taxpayer rented the home to third parties for at least 14 days at fair rental value and the taxpayer did not use the home for the greater of 14 days or 10% of the number of rental days, would qualify.
Q.10 How about an illustration where personal property is not considered to be held for productive use in a trade or business or for investment?
A.10 Example 1: Collectables are an easy example if one can tell if the item or items were transferred by a dealer in the particular item or held for personal use or as an investment. Collectables are works of art, metals, gems, stamps, coins, antiques, and other items including items specified by the Secretary of the Treasury.
Example 2: Certainly, automobiles in a car dealers inventory won’t qualify nor would a manufacturer’s inventory.
Example 3: Inventory and other property held for the primary purpose of selling it in the ordinary course of business.
Q.11 So, do I know everything I need to know to do a § 1031 like-kind exchange?
A.11 NOT BY A LONG SHOT. This is a complicated area, especially made so because the Internal Revenue Service appears to never have accepted that Congress granted a tax deferral opportunity for imaginary transactions that look like actual sales (where gain or loss would be recognized) and purchases by calling some of those paired transactions: “swaps.” So, the rules are strictly construed and enforced. There are myriad procedural and substantive rules to be followed. The Internal Revenue Service has promulgated “safe harbor” rules for some aspects of a § 1031 like-kind exchange and still accepts transactions that meet the statutory requirements but fall outside of the “safe harbor” rules.
Q.12 So why did Ruminations write these Questions and Answers if they are woefully incomplete and highly generalized?
A.12 They were written to tantalize the reader as to the opportunities to structure a transaction that could result in the deferral of otherwise payable taxes, but to leave the reader with the need to rely on more complete and specific sources to see if the transaction can actually be undertaken and find out what would need to be done to make it pass muster under the Internal Revenue Code.
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