Special Issues in Like-Kind Exchanges
Given the right circumstances, it’s possible to dispose of appreciated property and avoid capital gains taxes by exchanging it rather than selling it.
October 25, 2007
by Mary Bernard, CPA/MST
A like-kind exchange is an exchange of any property held for investment or for use in a trade or business for other like-kind investment property or trade or business property. The definition of “like-kind” for this purpose is very broad. If the exchange is real estate for real estate, or equipment for equipment, it will generally qualify. However, a few types of property will not qualify for tax-deferred treatment, such as inventory or stock.
In a qualifying exchange, neither buyer nor seller recognizes a gain or loss in the transaction and the basis of the acquired property is the same as the basis in the property given up. Usually, the properties are not of exactly equal value and require additional property, frequently cash or debt, to be included in the deal. This additional property known as “boot” will cause some gain to be recognized, but only up to the extent that the boot received in the transaction exceeds the boot given up.
Deferred Like-Kind Exchange
It is possible to structure a deferred, or non-simultaneous, like-kind exchange of property. This arrangement allows more time to locate an appropriate property to exchange. In order to qualify, the following time limits must be met:
The second requirement may dictate an extension of your personal income tax return when the exchange occurs at the end of the tax year.
If these requirements are impossible to meet, it is still possible to structure an alternative arrangement. You could lease your property to the other party for a period of time, rather than transferring it outright. You could also grant an option to buy to the interested party to be exercised when the replacement property becomes available. Alternatively, you could transfer your property to an independent trust or escrow arrangement to be held until the transfer can occur.
Reverse Like-Kind Exchange
Occasionally, circumstances require that replacement property must be acquired prior to the disposition of the relinquished property. This transaction would be considered a reverse exchange, sometimes called a “reverse Starker,” named after the 1979 case first allowing this transaction. Technically, a reverse exchange does not technically qualify for like-kind exchange treatment. In order to qualify the transaction for like-kind treatment, the replacement property must be temporarily transferred to an accommodation party until a transferee is identified. If certain guidelines are followed, as set forth in a revenue procedure, the IRS has typically approved this type of transaction. This differs from the use of a qualified intermediary in a regular like-kind exchange in that the accommodation party must actually take beneficial ownership of the property whereas a qualified intermediary normally does not take title to the property. This makes the transaction more expensive and complicated than a traditional like-kind exchange and should be used only when absolutely necessary to accomplish the tax deferral benefits of an exchange.
Generally, exchanges of partnership interests do not qualify for like-kind exchange treatment. When partners want to end their relationship, the interests cannot be exchanged for other interests or property. The simplest way to accomplish partnership dissolution is to distribute the properties to the partners pro rata as co-tenants. This is generally a tax-free distribution of property to partners. Each individual partner can then exchange his real property interest for separate property in a like-kind exchange.
In the case where not all partners want to dissolve the relationship, an exchange situation can still be structured. The remaining partners, or new partners, may purchase the interest of the withdrawing partners prior to any exchange of property. A risky alternative to this approach would involve the distribution of co-tenancy interests in the partnership property to the retiring partners. They can either exchange or sell their interest in the property. The partnership can then exchange its interest in the property for a replacement property.
A less desirable result occurs where a retiring partner desires cash in exchange for his interest. The partnership could receive cash boot in the exchange and specifically allocate the gain to the partner receiving the cash. The problem with this alternative is that the resulting gain recognized by the partnership on the transaction may exceed the amount allocated to the retiring partner, thus causing all partners to be taxed on a portion of the gain.
If an individual is interested in exchanging a real property interest for a more valuable property, additional partners may be required in order to finance this larger acquisition. Development or management expertise might be required to accomplish the transaction. Once additional individuals are involved, it is possible that a partnership arrangement may be necessary for financing purposes. Under these scenarios, a like-kind exchange may still be structured to defer the gain on the disposition.
One alternative would involve the use of tenancy-in-common interests. The new replacement property is acquired by the individual and the other interested parties as a tenancy-in-common interest. The tenants in common could continue ownership as tenants or contribute the asset to a partnership, if desired or required. The individual then contributes the relinquished property to the partnership, while the other partners contribute cash. The newly created partnership then affects the like-kind exchange of properties.
As with many planning alternatives, there are certain areas of possible attack by the IRS. The major issue at risk involving partnerships is the question of whether co-tenancy results in a partnership for tax purposes. Several cases have addressed the issue and found that a partnership existed even where the title was held as co-tenants. The factors considered by the courts in determining if actual co-tenancy exists are typically the following: 1) agreement of the parties and their manner of executing its terms; 2) the contributions made by each party; 3) the parties’ control over income and capital and the right to make withdrawals; 4) whether business was conducted in the joint names of the parties; 5) whether separate books were maintained and partnership tax returns filed; and 6) whether the parties exercised mutual control over the enterprise. Co-tenancy will not be determined where the owners operate the enterprise as a business entity. The co-owners’ activities should be limited to those ordinarily performed in connection with maintenance and repair of rental real estate.
Another risk involves the IRS invoking the step transaction, or substance over form, to attack the exchange. When partnerships are involved, care should be taken to avoid this challenge. The distribution of property by a partnership should take place as long as possible before sales negotiations. All deeds should be properly recorded to substantiate the exchanges. If partnerships are to be dissolved, all state laws should be followed to affect dissolution. Sales contracts should be executed by the proper entity — individuals when co-tenancy is desired, not the partnership. All closing documents, books and records and tax returns should reflect the proper entity ownership and disposition of properties. Operating income and expenses should be paid or received by the individuals when co-tenancy is desired.
There is also exposure to challenge in the area of qualified use of the properties involved in a like-kind exchange when partnerships are involved. The IRS can question whether either the property relinquished or the property acquired is actually held by the taxpayer “for productive use in trade or business or for investment.” This is a requirement for like-kind exchange treatment under code section 1031. The IRS has attacked transactions in which the taxpayer has either received property from an entity prior to the exchange or contributed property to an entity after an exchange on the basis that the taxpayer did not hold the property for a qualified use. The IRS has refused to attribute the entity’s qualified use to the taxpayer. Fortunately, the courts have generally ruled in favor of the taxpayer when entity distributions are involved before or after the exchange. The courts have based their decisions on the rationale that the taxpayer is continuing the investment in a different form.
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Mary F. Bernard, CPA/MST is a Tax Principal and Director of State and Local Tax Services at Kahn, Litwin, Renza & Co., Ltd. in Providence, RI. She has over 20 years of experience with national and local accounting firms working with a variety of individual, partnership and corporate clients, with particular focus on corporate multi-state tax issues. She has also provided advisory and compliance services to our extensive nonprofit clients. Bernard is a member of the AICPA, the Massachusetts Society of CPAs and serves as President-elect of the board of directors for the Rhode Island Society of CPAs.