Taxfree Exchanges Under Section 1031 (Portfolio 567)

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The Taxfree Exchanges Under Section 1031 Portfolio analyzes the nontaxable exchange provisions of §1031 of the Internal Revenue Code. The Portfolio's analysis of §1031 includes a discussion of the types of property that do and do not qualify for nonrecognition treatment; the concepts of “like-kind,” “boot” and “exchange”; the deferred exchange rules; the rules relating to the allocation of boot; and the determination of the basis and holding period of properties received in such exchanges. The Portfolio also discusses the problems involved in sale and leaseback transactions, multi-party exchanges, multi-asset exchanges, and reverse exchanges.
Section 1031 provides that the exchange of certain types of property will not result in the recognition of gain or loss. The property exchanged and received in the transaction must be of like kind and must be held either for investment or for productive use in the taxpayer's trade or business; however, such property does not include stock in trade or other property held primarily for sale, partnership interests, stocks, bonds, notes, choses in action, certificates of trust or beneficial interest, and other securities or evidences of indebtedness or interest.
Gain is recognized in a transaction which otherwise qualifies under §1031 if, in addition to nonrecognition property, the taxpayer receives other property, so-called “boot.” Losses, as a general rule, are not recognized in a transaction that qualifies under §1031. However, if the taxpayer surrenders boot in addition to qualifying property, gain or loss is recognized on the boot surrendered. Although a liability of the transferor assumed by the transferee is deemed boot to the transferor, the regulations permit netting of boot given by the transferor against such a liability.
Section 1031 establishes certain basis rules: in general, the property received acquires the basis (and holding period) of the properties surrendered, (i) reduced by any money received or liabilities assumed by the transferee to the exchange, and by any loss recognized to the transferor, and (ii) increased by the amount of gain recognized to the transferor. The basis as thus computed is allocated first to the “boot” property received to the extent of fair market value, and the remaining basis is allocated among the nonrecognition properties received, apparently in proportion to relative fair market values as of the date of the exchange.

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Howard J. Levine, B.A., Hunter College (1969); J.D., State University of New York at Buffalo (cum laude, 1972); LL.M. (Taxation), Georgetown University Law Center (1976); attorney and assistant branch chief, Office of Chief Counsel, Internal Revenue Service (1972–1976); adjunct lecturer in Real Estate Taxation, American University Law School (1980–1982); adjunct professor, The George Washington University Law School and Georgetown University Law Center LL.M. Tax Programs (1982–1993); contributing editor, The Journal of Real Estate Taxation; Tax Management Distinguished Author (2000); member, Bloomberg BNA U.S. Income Advisory Board. Co-author, 936 T.M., U.S. Income Tax Treaties — The Limitation on Benefits Article; partner, Roberts & Holland LLP, Washington, D.C. and New York, N.Y.; member, American Bar Association (Chairman, Committee on Sales, Exchanges and Basis, and Subcommittee Chairman, Like Kind Exchanges, Tax Section 1990–1994), New York Bar, District of Columbia Bar.


Detailed Analysis

I. Introduction

II. Statutory Requirements

A. In General

B. Exchange Property Must Be Currently Held for Productive Use in Trade or Business or for Investment

1. In General

a. Held for Productive Use in Trade or Business

b. Held for Investment

c. Vacation Homes and Hobbies

d. Recent Construction on Relinquished Property

2. Recent Acquisitions

a. In General

b. Recent Acquisitions from Related Parties

(1) In General

(2) Related Entity

(a) Estates and Trusts

(b) Partnerships

(c) Corporations

(d) Mergers

3. Related Individuals

4. Acquisition by Gift or Inheritance

C. The Exchange Requirement

1. In General

2. Section 1031 Exchange Not Always Desirable

3. Sales Treated as Exchanges

4. Receipt of Recently Constructed Property

5. Receipt of Improvements on Taxpayer-Owned Land

6. Sale-Leaseback

7. Exchange Versus Lease Bonus

8. Multiparty Transactions

9. Related Party Transactions

10. Natural Resources

a. Oil and Gas Unitization Agreements

b. Timber

11. Exchange of Property to Avoid Foreclosure

D. Exchange Property and Transferred Property Must Be of Like Kind

1. In General

2. Personal Property

a. In General

b. Use of NAICS System

c. Livestock

d. Functional and Nonfunctional Currency

e. Artwork

f. Foreign Personal Property

3. Intangibles

a. In General

b. TAM 200602034 and CCA 200911006

c. Notice 2006-34

d. FCC Licenses

4. Real Estate

a. Real Estate or Personal Property?

b. Improvements

c. Leasehold Interests

d. Conservation Easements

e. Development Rights

f. Air Rights

g. Water Rights

h. Mitigation Credits

i. Other Natural Resources

j. Payment for Tobacco Quotas

k. Foreign Real Estate

5. Multiple Asset Exchanges

a. Background

b. Regulations

(1) General Principles

(a) Grouping

(b) Recognition of Gain and Loss

(c) Basis

(d) Examples

(2) Holding Period

(3) Application of § 1245 to Multiple Asset Exchanges

(4) Fragmentation

6. Liabilities

a. In General

b. Definition of Liability

c. Treatment of Contingent Liabilities

d. Multi-Asset Exchanges

7. Multi-Use Assets

E. Exchange Property Received Must Be Held for Productive Use in Taxpayer's Trade or Business or for Investment

1. In General

2. Holding Requirement

3. Subsequent Taxable Sales or Exchanges

4. Subsequent Nontaxable Transactions

5. Gift of Exchange Property

6. Death of Taxpayer

F. Special Holding Rules for Related Parties - § 1031(f)

1. In General

a. Operation of § 1031(f)

b. Section 1031(g)

c. Effective Dates

2. Suggested Situations Where § 1031(f) Should and Should Not Apply

a. In General

b. Situations Where Related Party Rules Should Apply

c. Situations Where the Exception in § 1031(f)(2)(C) Should Apply

d. Situations Where the Anti-Avoidance Rule of § 1031(f)(4) Should and Should Not Operate

(1) Situations Where Anti-Avoidance Rule Should Operate

(2) Situation Where the Anti-Avoidance Rule Should Not Operate

3. IRS Guidance

4. Teruya Brothers, Ltd. v. Comr. and Ocmulgee Fields, Inc. v. Comr.

5. Related Party Leasehold Improvements

III. Excluded Property

A. In General

B. Stock in Trade

C. Other Property Held Primarily for Sale

D. Stocks, Bonds, Etc.

E. Choses in Action

1. In General

2. Contract Rights

3. Franchises, Patents, Copyrights, Trademarks, and Trade Names

F. Certificates of Trust or Beneficial Interest and Other Securities or Evidence of Indebtedness or Interest

G. Grantor Trust Interests

H. Partnership Interests

IV. Special Problems Relating to Partnerships and Co-Ownerships

A. Section 761(a) Election

B. When Not All Partners Desire § 1031 Treatment

C. Delaware Series LLC

D. Undivided Interests

1. In General

2. Rev. Proc. 2002-22

3. Private Letter Rulings

a. PLR 200327003

b. PLR 200513010

4. Open Issues under Rev. Proc. 2002-22

E. Delaware Statutory Trusts

1. In General

2. Rev. Rul. 2004-86

a. Facts

b. Classification of the DST for Federal Tax Purposes

c. Exchange of Real Property for Interests in the DBT under § 1031

d. Significance of the Ruling

V. Multi-Party Exchanges

A. In General

1. IRS Recognition

2. Current Issues and Practical Problems

B. Trend of Cases

1. Rutland v. Comr.

2. Everett v. Comr.

3. Biggs v. Comr.

4. Garcia v. Comr.

5. DeCleene v. Comr.

6. Dobrich v. Comr.

7. True v. U.S.

C. Participation of Taxpayer in Location, Negotiation, and Acquisition of Exchange Property

1. In General

2. IRS Position

3. Court Decisions

D. Necessity for Exchangor to Have Legal Title

E. Escrow and Trust Arrangements

1. Closings Effected Through Escrows

2. Rogers v. Comr.

3. Barker v. Comr.

4. Allen v. Comr.

5. Garcia v. Comr.

6. Hillyer v. Comr.

7. Klein v. Comr.

8. St. Laurent v. Comr.

9. Florida Industries Investment Corp. v. Comr.

F. Use of Safe Harbors in Simultaneous Exchanges

VI. Delayed (Forward) Exchanges

A. In General

1. IRS Position

2. Pre-Starker Authority

B. Starker v. U.S.

C. Aftermath of Starker

1. In General

2. Ancillary Issues

3. Improvements Constructed After Exchange

4. Rutherford v. Comr.

D. Delayed Exchanges After Tax Reform Act of 1984

1. Overview

a. General Requirements of Statute

b. Effective Date

c. Issuance of Final Regulations

2. Identification and Receipt Requirements

a. In General

b. Identification Procedures

c. Identification of Multiple Properties

(1) Alternative vs. Multiple

(2) Multi-Asset Exchanges - Three-Property and 200% Rule

d. Revocation of Identification

e. Receipt of Substantially the Same Property and Constructed Property

(1) In General

(2) Property Constructed During Exchange Period

(3) “Substantially the Same” Requirement

f. Identification of Percentage Interests in Separate Exchanges

3. Use of Regulatory Safe Harbors

a. In General

b. “(g)(6) Restrictions”

c. Security or Guarantee Arrangements

d. Qualified Escrow Accounts and Qualified Trusts

e. Qualified Intermediaries

f. Allowable Payments from a Safe Harbor Account

g. Growth Factor and Reportability and Timing of Interest

h. Additional Restrictions

i. Premature Distributions

j. Disqualified Person

k. Effective Dates

l. Open Issues Under the Deferred Exchange Regulations

(1) Intermediary as Express Agent

(2) Replacement of Intermediary, Escrow Agent, or Trustee

(3) Fragmentation and Consolidation - Part of the “Same” Exchange

(4) Transfers by Partnerships

(5) Deposits on Relinquished and Replacement Properties

(6) Representations and Warranties

(7) Receipt of Note to Fund Replacement Property

(8) Pay Down/Pay Up/Transactions

(9) Ability of Taxpayer to Direct Investments in Exchange Account

(10) Joint Signatures on Exchange Account

(11) Taxpayer's Pledge of His Rights In Exchange Agreement

(12) Substantial Compliance

m. Potential Liability of Intermediaries

(1) Tax and Reporting Liability

(2) Nontax Liabilities

(3) State Regulation Liability

n. Transfers Before May 16, 1990

o. Deferred Exchanges Outside the Regulatory Safe Harbors

4. Mass Asset Exchanges

a. Private Rulings

b. Rev. Proc. 2003-39

c. Rev. Proc. 2003-39 Safe Harbors

(1) Separate and Distinct Exchange Safe Harbor

(2) Constructive Receipt Safe Harbor

(3) Qualified Intermediary and Assignment Safe Harbor

5. Granting of Options and Leases Before Exchange

a. Granting of an Option

b. Granting of a Lease

VII. Reverse Exchanges

A. In General

1. Parking Arrangements

2. Two-Party Reverse Exchange

3. Second ABA Report

B. Rev. Proc. 2000-37

1. Operation of Rev. Proc. 2000-37

2. Further Observations and Open Issues

C. Parking Arrangements/Reverse Exchanges Outside the Safe Harbor

1. In General

2. TAM 200039005

3. DeCleene v. Comr.

4. PLR 200111025

5. FAA 20050203F

VIII. Sale-Leaseback Transaction

A. In General

B. Value of Leasehold

C. IRS Position

D. Judicial Authority

1. Leasehold Has Value

2. Leasehold Has No Value

IX. Boot

A. In General

B. Giving Boot

C. Receiving Boot

1. In General

2. Liabilities

3. Netting Boot and Refinancing

a. In General

b. Refinancing

c. Application of the Netting Rule

d. Partnership Gain

e. Purchase Money Mortgage

4. Offsetting Boot by Exchange Expenses

5. Placing of Mortgage Just Prior to Exchange

a. Garcia v. Comr.

b. PLR 8434015

c. Fredericks v. Comr.

d. Proposed and Final Regulations

6. Placing of Mortgage Just After Exchange

D. Apportionment of Boot

E. Installment Method

1. Before the Installment Sales Revision Act of 1980

2. Installment Sales Revision Act of 1980

a. In General

b. Proposed Regulations

c. Deferred Exchanges

F. Loss from Exchanges Not Solely in Kind

1. Giving of Boot

2. Receiving Boot

X. Basis

A. In General

B. Multi-Asset Exchanges

1. Before April 11, 1991

2. Netting of Boot

3. Multiple Property Exchanges After April 10, 1991

C. Allocation Problem

1. Multiple Use Properties

2. Shifting Basis

a. In General

b. Business Swapping

D. Bargain Sale to Charity

E. Reinvestment of Proceeds from Involuntary Conversion

XI. Holding Periods

A. In General

B. Allocation Problems

1. Nonqualifying Property Received

2. Transfers of Assets with Different Holding Periods

XII. Disregarded Entities

A. Reasons for Using

B. Illinois Land Trusts

1. Background

2. Treatment Under § 1031

C. Grantor Trusts

D. Delaware Business Trust

E. Single-Member LLC

F. Two-Member LLC with a Single Owner

1. PLR 199911033

2. PLR 200201024

3. Rev. Rul. 2004-77

XIII. Depreciation Recapture

A. Section 1245

B. Section 1245 Recovery Property

C. Section 1250

D. Section 1254

XIV. Relation to Other Code Sections

A. In General

B. Section 50

C. Section 1239

D. Section 897

E. Section 341

F. Section 1033

G. Section 469

H. Section 1374

I. Section 168

1. In General

2. Related-Party Exchanges Involving “Tax-Exempt Use Property”

3. Section 470(e)(4)

4. Depreciation - Acquisition of MACRS Property

a. General Operating Rules

b. Conventions

c. Year of the Exchange

d. Excess Basis

e. Deferred and Reverse Exchanges

f. Nondepreciable Property

g. Election Out

h. Multiple Property Exchanges

i. Election to Treat Certain Replacement Property as MACRS Property

5. Bonus Depreciation

6. Cost Segment Study - Effect on § 1031

J. Section 877

K. Section 904(f)

L. Section 467

M. Section 1502

N. Section 121

O. Section 1400N

XV. Reporting Requirements

A. In General

B. Rev. Proc. 2004-67

XVI. State Taxation of Like-Kind Exchanges


Working Papers

Table of Worksheets

Worksheet 1 Formulae for § 1031 Taxfree Exchanges

Worksheet 2 Typical Fact Pattern I

Worksheet 3 Typical Fact Pattern II

Worksheet 4 Conference Report - Tax Reform Act of 1984 (P.L. 98-369) H.R. Rep. No. 861, 98th Cong. 2d Sess. 865 (1984)

Worksheet 5 Senate and Conference Reports Revenue Reconciliation Act of 1989 (P.L. 101-239)

Worksheet 6 Sample Deferred Exchange Agreement Using Qualified Intermediary

Worksheet 7 Sample Deferred Exchange Agreement Using Qualified Trust

Worksheet 8 American Bar Association Tax Section's Report on Open Issues in Section 1031 Like-Kind Exchanges (July 14, 1995)

Worksheet 9 Sample Qualified Exchange Accommodation Agreement

Worksheet 10 Treasury FOIA Letter Concerning Use of Grantor Trust Interests in Like-Kind Exchanges

Worksheet 11 North American Industrial Classification System (NAICS Manual) (2002) (Excerpt)

Worksheet 12 American Bar Association Tax Section - 2006 Section 1031 State Survey Q & A (Final Document - 31 Out of 56 Jurisdictions Reporting) Sales, Exchanges & Basis Committee (As of November 15, 2005)





Committee Reports:

Treasury Rulings: