IRS ruling highlights benefits of like-kind exchange, deferred tax arrangements
Gain or loss is not recognized when property held for productive use in a trade or business or for investment is exchanged for like-kind property. Instead, the taxpayer's basis and holding period in the property transferred carries over to the property acquired in the exchange. Deferring taxable gain, always a good strategy, makes more sense than ever after the recent rise in tax rates for many taxpayers under the American Taxpayer Relief Act of 2012. In particular, Code Section 1031 like-kind exchanges deserve a close second look by many businesses and investors.
More than two properties can be exchanged and more than two parties can participate in a transaction that qualifies for non-recognition treatment. Intermediaries may be used to purchase other property before completing like-kind exchange. Taxpayers can participate in acquisition of other property and qualify for like-kind treatment if there is no actual or constructive receipt of cash proceeds from sale of their property.
It is not required that the properties be given up and received on the same day. However, if the exchange of properties is not simultaneous, the property to be received must be identified within 45 days after the date the relinquished property is transferred. In addition, the identified property must be received within 180 days after the date of transfer or the due date for the return for the tax year in which the transfer occurred, whichever date is earlier.
Property not qualifying for this treatment includes inventory, securities, foreign real estate and foreign personal property. In an otherwise qualifying exchange, the receipt of boot, in the form of cash, relief from liability, or other non-qualifying property, results in the recognition of realized gain or loss to the extent of the boot received. However, gain so recognized can be postponed if the installment sale rules apply. Depreciation recapture may also result from a like-kind exchange. Losses are not recognized on the acquisition of like-kind property. To recognize a loss, the transaction must be arranged so that the non-recognition provision does not apply.
Literal conformity to the requirements of the non-recognition provisions may not be sufficient to prevent recognition of gain. The substance of the transaction must also satisfy the underlying purpose of the statute. Continuity of investment purpose continues to be emphasized as the primary rationale for non-recognition in a like-kind exchange.
Latest success story
IRS Chief Counsel just this past month approved a taxpayer's exchange of properties as tax-free under Code Sec. 1031 even though the taxpayer used proceeds from the sale of relinquished property to pay down its liabilities. In CCA 201325011, Chief Counsel determined that such use did not trigger constructive receipt. Although taking a look at this winning arrangement may get a bit technical, it is worthwhile if only to provide another example of how like-kind exchange transactions can help your business's tax expenses.
The arrangement. The taxpayer rents equipment to customers. The taxpayer has implemented a like-kind exchange (LKE) program to defer gain from the sales of its rental equipment. The taxpayer has engaged in multiple exchanges under a Master Exchange Agreement (MEA) with a qualified intermediary (QI). Under the MEA, the taxpayer transfers relinquished property to the QI. The QI transfers the relinquished property and acquires replacement property, which it transfers to the taxpayer.
The taxpayer maintains two lines of credit, which are used to purchase replacement property. The taxpayer also uses the lines of credit for general business operations. The lines of credit are secured by the taxpayer's rental properties, accounts receivable, and new equipment sold to customers. The full value of the rental property secures the entire balance on the lines of credit.
The QI must deposit sales proceeds from relinquished property into a joint taxpayer/QI account, and must use the proceeds to pay down the line-of-credit balances. The QI does not use proceeds from the account receivables or the new equipment sales to pay down the lines of credit. The taxpayer then uses borrowed funds to acquire replacement property and complete its exchange. The taxpayer finances the acquisition with new debt in an amount that equals or exceeds the debt that encumbered the relinquished property. Under the MEA, the taxpayer does not have the right to receive, pledge, borrow or otherwise use the money held by the QI.
Chief Counsel's analysis. The IRS field attorney argued that the debt pay-down arrangement gives the taxpayer actual or constructive receipt of the proceeds from the relinquished property before the deadline for the taxpayer to obtain replacement property. IRS Chief Counsel's Office, however, disagreed. It concluded that the taxpayer was not in constructive receipt of the proceeds received for the relinquished property. This conclusion was not affected by the use of the debt to purchase replacement property and for general business operations, or the QI's use of the proceeds to pay down the lines of credit.
If a taxpayer receives, in part, non-like-kind property, the taxpayer must recognize gain (boot) for the amount of this property. The assumption of a liability, or the transfer of property subject to a liability, is treated as boot. If the relinquished property and the replacement property are both subject to a liability (such as a mortgage), the liabilities are netted and the difference is boot to the party being relieved of the larger mortgage.
Chief Counsel concluded that the taxpayer's transaction was permitted by the regulations where the taxpayer is relieved of debt on the transfer of relinquished property and incurs debt on the acquisition of the replacement property. Under the boot netting rules, there is no gain to the taxpayer.
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