Bob Willens 2

The often-used Section 1031 rule allows two companies that swap similar properties to defer recognition of capital gains until a sale takes place. Essentially, if two corporations exchange two properties of “the like kind” the gain is not immediately recognized. The term “of a like kind” usually refers to property that are the same in nature or have the same characteristics, regardless of whether they differ in quality.

The Internal Revenue Code is clear. In Section 1031(a) it states 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 a “like kind” which is to be so held. The 1031 rule also says that if other property or money ‚ aside from the like kind property — was received in the swap and was counted as a gain, then that excess amount must be recognized at its fair market value. (See Section 1031(b).)

In an 1989 revenue ruling (Rev. Rul. 89-121, 1989-2 C.B. 203), an example was offered to illustrate how Section 1031 worked in practice. Essentially, two corporations — Xena Corp. and Yuba Corp. made a deal to exchange television stations they owed. In the deal, Xena swapped its two television stations, WXKK and WXLL, for Yuba’s WYHH. As is prescribed by Section 1031, the deal was completed for good business reasons, and to comply with regulatory imperatives.

An earlier revenue ruling (Rev. Rul. 85-135, 1985-2 C.B. 181), which originally addressed the corporate exchange, held that Xena and Yuba each received property of a like kind, and therefore each corporation qualified for non-recognition under Section 1031(a).

However, in so holding, the first ruling failed to address the manner in which like kind property is determined in the exchange. So the 1989 ruling filled the void, concluding that transfer of assets cannot be treated as an exchange of a single property for another single property in applying Section 1031(a). Rather, to determine whether Section 1031(a) applies, an analysis of the underlying assets exchanged is required. This comminution approach is now firmly embedded in the regulations 1.

More important, a new private letter ruling from the IRS indicates that its possible that some gain must be recognized with respect to a like kind exchange — even when the properties exchanged are of a like kind, and no cash or other property is received in the exchange.

Matching Up Properties

In a IRS letter dated September 29, 2008, (LTR 200901004, ) a situation is describe in which the taxpayer owns an “old facility” and proposes to exchange it for like kind property referred to as the “new facility.” No liabilities will be assumed by either party or transferred from one party to the other in connection with the exchange. No land interest is involved in the transaction.

The letter refers to the 1031 rule — specifically IRS Regulation Section 1.1031(a)-2(b)(1) — with regard to personal property, and goes on to say that depreciable tangible personal property is considered to be exchanged for property of a like kind if the property being swapped is either of like kind or “like class.” Like class, in this case, is defined as properties within the same General Asset Class or within the same Product Class.

The September missive also points out that the next section of the rule — Regulation Section 1.1031-2(c)(1) — states that an exchange of intangible personal property or non-depreciable personal property qualifies for non-recognition treatment only if the exchanged properties are of a like kind. No like classes are provided for this intangible personal property.

The regulation goes on to say that intangible personal property is considered of the like kind depending on the nature or character of two elements of the deal: the rights involved (i.e., patent or copyright); and the underlying property to which the intangible personal property relates. Most notably, as indicated in the 1989 revenue ruling — and reiterated in Regulation Section 1.1031(j)-1(a) — the application of Section 1031 requires a property by property comparison for the purpose of computing the gain to be recognized and the basis of the property received.

Therefore, the September letter concludes that the properties relinquished that constitute the old facility are of like kind to the new replacement facility that the taxpayer will receive. However, the ruling admonishes that even though the properties exchanged are of like kind, and even though no cash is received in the exchange, it is still possible that some of the gain realized by the taxpayer must be recognized.

The IRS provides an example in the letter to buttress its conclusion. Assume, it says, that a taxpayer exchanges properties A and B for properties C and D. The fair market value of property A is $100x and the fair market value of property B is $250x.

By contrast, the fair market value of property C is $85x and the fair market value of property D is $265x. Property A, in turn, is of like kind to property C (but not to property D) and property B is of like kind with respect to property D (but not to property C). Further, the taxpayer had a zero basis in properties A and B.

The example concludes that the taxpayer is considered to have received $15x of non-like kind property. That’s because the taxpayer is considered to have received $15x worth of property D in exchange for property A — and as indicated, property D is not of like kind with respect to property A.

Consequently, the taxpayer, even though the properties exchanged are of like kind and no money is received in the exchange, has $15x of gain that is not deferred. Therefore, in the case of an exchange of multiple properties it is almost inevitable that some gain will be recognized. Indeed, even though the properties received and relinquished are of like kind to one another, the “exchange group” approach adopted in the regulations will almost always lead to the conclusion that the exchanging taxpayer has received “other property” with respect to the exchange of one or more of the properties conveyed.

Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for


1 See Regulation Section 1.1031(j)-1(a)

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