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By David I. Kempler, Esq., Elizabeth Carrott
Minnigh, Esq. and Christine Bowers, Esq.
Buchanan Ingersoll & Rooney PC, Washington, DC
In CCA 201325011, the Chief Counsel's Office advised that a
taxpayer did not have actual or constructive receipt of
relinquished property (RQ) sale proceeds for purposes of §1031 of
the Internal Revenue Code (the "Code"), where the RQ secured the
taxpayer's lines of credit used both to purchase the RQ and for
general business operations and the taxpayer's qualified
intermediary (QI) was required to use the proceeds to pay down the
amounts owed under the lines of credit. In this CCA, Chief
Counsel's Office concluded that the exchange is tax-free under
§1031 of the Code even though funds received from selling
relinquished property were used for the taxpayer's benefit.
As a general rule, under §1031, a taxpayer may exchange property
that has been used productively in a trade or business or held for
investment for other like-kind property used in a trade or business
or held for investment without recognizing the taxable gain on the
sale of the property. Under §1031(a)(3), these like-kind exchange
provisions extend to deferred transactions if the replacement
property is received within 180 days of the date the relinquished
property is transferred. In a deferred exchange, Regs.
§1.1031(k)-1(f) provides that a taxpayer is prohibited from
actually or constructively receiving any portion of the sale
proceeds until the exchange has been completed. However, under
Regs.§1.1031(k)-1(g)(4), QI is permitted to hold the sale proceeds
for the benefit of the taxpayer during the exchange process, to
disburse funds for the purchase of replacement property and return
any unused portion of the funds to the taxpayer at the end of the
exchange. Under Regs. §1.1031(k)-1(g)(4)(iii), a "qualified
intermediary" is a person who (i) is not the taxpayer or a
disqualified person with respect to the taxpayer under
Regs.§1.1031(k)-1(k), and (ii) enters into a written exchange
agreement with the taxpayer and, in accordance with that agreement,
acquires the relinquished property from the taxpayer, transfers the
relinquished property, acquires the replacement property and
transfers the replacement property to the taxpayer.
Taxpayer rented equipment to customers for use in farming,
construction, manufacturing and warehousing. In 2003, Taxpayer
implemented a like-kind exchange program in order to defer the
recognition of gain from the sale of its rental equipment. Taxpayer
maintained lines of credit with two creditors, which were used to
purchase replacement properties under the like-kind exchange
program and also for general business purposes. Under the credit
agreements, all rental properties, including properties
relinquished and acquired in the like-kind exchange program,
secured the outstanding balances on the lines of credit. The
outstanding balances on the lines of credit were also secured by
Taxpayer's accounts receivable and equipment held by Taxpayer for
sale in the ordinary course of business. All properties were
separately listed as collateral for one or the other, but not both,
of the lines of credit.
As part of its like-kind exchange program, Taxpayer entered into
a master exchange agreement (MEA) with a QI to engage in these
exchanges. Under the MEA, Taxpayer did not have the right to
receive, pledge, borrow or otherwise obtain the benefits of money
or other property held by QI. The MEA also provided that QI must
use the proceeds from the sale of the relinquished property, but
not proceeds from its accounts receivable and new equipment sales,
to pay down Taxpayer's outstanding balances on the lines of
credit. Consequently, the proceeds from the disposition of
relinquished property as part of any exchange under the MEA were
deposited directly into a joint QI-Taxpayer account and then
immediately disbursed by QI to satisfy Taxpayer's obligation on one
or the other line of credit.
Under Regs. §1.1031(k)-1(g)(4)(ii), the agreement between a
taxpayer and a QI must expressly limit the taxpayer's rights to
receive, pledge, borrow, or otherwise obtain the benefits of money
or other property held by the qualified intermediary. In addition,
Regs. §1.1031(k)-1(g)(6), requires that the exchange agreement
between a taxpayer and the QI provide that the taxpayer have no
right to receive, pledge, borrow, or otherwise obtain the benefits
of money or other property held by the qualified intermediary
before the end of the exchange period, other than those provided in
Regs. §1.1031(k)-1(g)(6)(ii) and (iii).
The Chief Counsel's Office concluded that the facts of the case
were similar to the situation described in Example 5 of Regs.
§1.1031(k)-1(j)(3), wherein B, the transferor of RQ in a deferred
exchange, transferred property that was encumbered with a $30,000
mortgage to C on May 17, 1991. C assumed the mortgage on that date.
On July 15, 1991, B received the replacement property and assumed a
$20,000 mortgage encumbering the replacement property. Under the
boot netting rules of Regs. §1.1031(b)-1(c), the gain required to
be recognized by the taxpayer in Example 5 was the excess of the
debt relieved on the transfer of the RQ and the debt incurred on
the acquisition of RP. Thus, the consideration received by B in the
form of the liability assumed by C ($30,000) was offset by the
consideration given by B in the form of the liability assumed by B
($20,000), and the excess of the liability assumed by C over the
liability assumed by B, $10,000, was treated as "money or other
property." As a result, B recognized gain in the amount of $10,000
in accordance with §1031(b). In the example, the taxpayer was
relieved of debt on the transfer of RQ and incurred debt on the
acquisition of RP. The example concluded that the taxpayer had not
actually or constructively received all or a portion of the
proceeds of the RQ, but rather that the boot received in the form
of debt relief was offset by the debt assumed.
In relying on this example, the Chief Counsel's Office
recognized that there were two important differences between the
facts in Example 5 and those in the present case: (1) that the debt
that was secured by the RQ was incurred not only to purchase RQ but
also for general business operations, whereas Example 5 provided
only that the RQ was "encumbered by a mortgage of $30,000" and did
not discuss when or why the property was encumbered, and (2) the
transferee of the RQ in Example 5 assumed the RQ debt whereas, in
the present case, the QI used the RQ proceeds to pay down the RQ
debt. The Chief Counsel's Office concluded, nonetheless, that these
differences did not result in Taxpayer having actual or
constructive receipt of the RQ proceeds for purposes of Regs.
In reaching this conclusion, the Chief Counsel's Office
explained that the result in Example 5 should not change if the
debt was incurred as a result of refinancing the RQ and using the
proceeds for general business operations, and that it was not aware
of any authority for making a distinction along the lines of the
purpose of the encumbrance or whether the taxpayer used the
proceeds for more than the purchase of RQ. To that effect, the
Chief Counsel's Office stated that the fact that the debt in the
present case was incurred for more than the acquisition of the RQ
should not result in actual or constructive receipt of the RQ
proceeds when QI pays off the RQ debt.
In addition, in reaching its conclusion, the Chief Counsel's
Office relied on Barker v. Commissioner,1 in
which the Tax Court held that proceeds from the disposition of RQ
can be used to pay off debt on the RQ without triggering gain if a
taxpayer incurs or assumes a liability on the purchase of RP that
equals or exceeds the debt on the RQ. In Barker, which was
decided before the issuance of deferred exchange regulations of
Regs. §1.1031(k)-1, the taxpayer received cash in the exchange but
was contractually obligated by the transferee of the RQ to use the
cash to pay off the RQ debt. The Tax Court held in Barker
that the boot netting principle in Regs. §1.1031(b)-1(c) covers not
just assumptions of debt but also situations in which the proceeds
of the RQ are used to pay off RQ debt.
Accordingly, the Chief Counsel's Office concluded that, even
though the RQ debt was used not only to purchase RQ but also for
general business operations and the QI used the RQ proceeds to pay
down Taxpayer's lines of credit, the payments did not result in
Taxpayer being in actual or constructive receipt of the RQ proceeds
for purposes of Regs. §1.1031(k)-1. Accordingly, the Chief
Counsel's office advised that Taxpayer's exchanges would qualify as
a §1031 like-kind exchanges if Taxpayer met the other requirements
of §1031 of the Code and the regulations thereunder.
This commentary also appears in the October 2013 issue of
the Real Estate Journal.For more information in the
Tax Management Portfolios, see Levine, 567 T.M., Taxfree
Exchanges Under Section 1031, and in Tax Practice Series, see
¶1510, Like-Kind Exchanges.
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