AVOIDING LIKE-KIND TREATMENT
Situations When Like-Kind Treatment Not Advantageous
Before entering into an exchange under Code Sec. 1031, an exchanger should review the specific tax status of the property being received and the property being relinquished in order to determine the actual effects of Code Sec. 1031. Although exchangers often presume that Code Sec. 1031 is advantageous, there are situations when this presumption is not correct. Examples of situations in which an exchanger may wish to avoid like-kind treatment include:
Where there is built-in capital loss in the property being transferred that the exchanger could recognize in a sale, but not an exchange;
EXAMPLE: Abel owns Whiteacre with a cost basis of $20,000 and a fair market value of $10,000. Baker owns Blackacre with an adjusted tax basis of $2,000 and a fair market value of $10,000. Baker wants to acquire Whiteacre from Abel in a like-kind exchange. Abel does not want to acquire Blackacre but he wants to recognize a capital loss with respect to Whiteacre. If he enters into a simple like-kind exchange with Baker, Abel cannot recognize the built-in loss. Thus, it is more advantageous for Abel to sell Whiteacre, which results in recognizable loss. Note that both parties can reach their desired result by entering into a four-party exchange.
Where the exchanger has a current capital loss or net operating loss carryforward that can be used to offset all or part of the gain generated by a sale of the property;
EXAMPLE: Abel owns Blackacre with a fair market value of $10,000 and an adjusted loss basis of $5,000. Abel also has a current capital loss of $5,000. Baker owns Whiteacre and wants to acquire Blackacre in a like-kind exchange. If Abel enters into a like-kind exchange, the gain realized on the exchange is not recognized and, therefore, cannot be used to offset his current capital loss. If Abel sells the property and recognizes a gain, however, he can offset the capital loss with the gain recognized.
NOTE: If a sale generates capital gain in excess of an exchanger’s current capital loss carryforward, the exchanger may use such loss to offset the gain. This is an important factor to the extent that the property acquired is depreciable since the basis of the acquired property would be $10,000 in the case of a purchase using the proceeds of the sale, as opposed to $5,000 in the case of an exchange.
When the payment of tax in the current year is preferable to the deferral of tax. In this regard, exchangers should consider potential changes in their income, any anticipated changes in tax rates or capital gain benefits, and the anticipated holding period for replacement property received in the exchange; and
EXAMPLE: Abel wants to dispose of Whiteacre (which has appreciated in value) and obtain replacement property. Abel is not sure, however, if it is more advantageous to enter into a like-kind exchange, or a sale. If he enters into an exchange, he can defer paying tax on the gain until he disposes of the property received in the exchange. If he sells Whiteacre, he must pay a tax on the gain currently. At the time of disposition, Abel is in the 15% marginal tax bracket. If Abel believes that in future years he will be in a higher marginal tax bracket, it may be advantageous for Abel to sell the property in the current year (the proceeds of which can be used to purchase replacement property) rather than subjecting the deferred gain to an anticipated higher tax rate. Abel must consider the time period that he plans to hold onto the replacement property and assumptions as to future tax rates.
Depreciation benefits from the purchase of the replacement property are more beneficial than the cost of the tax on the capital gain from the sale of the property.
EXAMPLE: Abel has an adjusted tax basis of $60,000 in Property B which has a fair market value of $100,000. At an assumed capital gains rate of 20%, the current tax on the sale of B is $8,000 ($40,000 gain × 20%). If Abel exchanges B for Property W pursuant to Code Sec. 1031, he has a carryover basis in W of $60,000. If, on the other hand, Abel sells B and purchases W for $100,000, he will have a cost basis of $100,000. This creates additional depreciation deductions of $40,000 assuming all of W is depreciable. This depreciation is deductible against ordinary income in future years. Thus, the cost of the tax paid upon the sale of the property is clearly less than the benefit derived from the potential increased depreciation deduction. This is particularly important if there is a preferential capital gains rate. In that case, the deferred depreciation deductions will offset income subject to tax at ordinary income rates, while Abel pays tax currently on the gain at a preferential capital gains rate.
NOTE: Lost depreciation benefits are also a factor in the event the property being transferred in a Code Sec. 1031 exchange was acquired before the accelerated cost recovery system rules were adopted in 1981. In that event, the exchanger not only takes a carryover basis in the replacement property, but under Code Sec. 168, will be unable to use any accelerated cost recovery method.
Notwithstanding the general deferral of taxes on an exchange, Code Sec. 1245 and Code Sec. 1250 include provisions requiring the recapture of any depreciation involved in the event gain is realized in the exchange. This issue may be particularly troublesome with respect to nonresidential real property subject to recapture under Code Sec. 1245.
Methods of Avoiding Like-Kind Treatment
Lack of Mutual Dependency
Avoiding the mandatory nature of Code Sec. 1031 requires breaking the “mutual dependency” of the transaction. For example, many exchangers enter into a deferred exchange agreement as a matter of course when selling property that may qualify for exchange treatment. In the event that it is determined after the agreement is executed that exchange treatment would not be beneficial, the exchanger may attempt to avoid Code Sec. 1031 by allowing the time periods contained in the agreement to identify and close on the replacement property to lapse. This allows the exchanger to then gain unrestricted control of the proceeds and use those proceeds to acquire suitable property, thereby destroying the mutual dependency of the agreement.
Substance Versus Form
In order to receive like-kind exchange treatment, an exchanger must satisfy both the formalistic and substantive requirements of Code Sec. 1031 . Thus, an exchanger can avoid exchange treatment by structuring the transaction as something other than a like-kind exchange. If an exchanger purposely fails to meet the formal requirements under Code Sec. 1031 , but the substance of the transaction still resembles a like-kind exchange, the IRS and the courts generally will treat the transaction as an exchange and the exchanger will receive nonrecognition treatment. Rev. Rul. 61-119, 1961-1 C.B. 395 ; Greene, Joanne, (1991) TC Memo 1991-403, PH TCM ¶91403, 62 CCH TCM 512 . See Redwing Carriers Inc v. Tomlinson, (1968, CA5) 22 AFTR 2d 5448, 399 F2d 652, 68-2 USTC ¶9540 ; Biggs, Franklin B., (1978) 69 TC 905, affd (1980, CA5) 47 AFTR 2d81-484, 47 AFTR 2d 81-484, 632 F2d 1171, 81-1 USTC ¶9114. But see Young, Robert G., (1985) TC Memo 1985-221, PH TCM ¶85221, 49 CCH TCM 1439 ; Swaim, Emsy H. v. U.S., (1979, DC TX) 45 AFTR 2d 80-1276, 79-2 USTC ¶9462, affd & revd (1981, CA5) 48 AFTR 2d 81-5653, 651 F2d 1066, 81-2 USTC ¶9575.