montywalker

Possible or Impossible?

Whenever business or investment property is sold for a gain, generally tax on the gain is recognized and becomes due at the time of sale. Internal Revenue Code "IRC" Section 1031 provides an exception and allows the paying of tax on the gain to be postponed if the proceeds are reinvested in similar property as part of a qualifying like-kind exchange. Gain deferred in a like-kind exchange under Section 1031 is tax-deferred, but it is not tax-free.

"Like-kind" refers to the nature or character of the property and not to its grade or quality. One kind or class of property can be exchanged for property of the same kind or class. Real estate can be exchanged for other real estate, and personal property can be exchanged for other personal property.

A key like-kind issue is the fact that the qualifying property is not determined based on its grade or quality. For example, in Letter Ruling 200450005, the IRS determined that the differences between automobiles and sport utility vehicles "SUVs" do not rise to the level of a difference in nature or character. Instead, they are merely different in grade or quality under the General Asset Class and Product Class guidelines.

Accordingly, the IRS ruled that the exchange of an SUV for an automobile would qualify as a like-kind exchange under Section 1031.

The like-kind exchange of real estate is very liberal with generally any type of real estate being considered like kind to any other type of real estate. On the other hand, personal property is much more restrictive requiring the assets be of the same kind or asset class.

Thus, the key to a successful like-kind exchange is to properly identify property of like-kind.

Background:

Section 1031 of the Internal Revenue Code has a very long and somewhat complicated history dating back to 1921. The first income tax code was adopted by the United States Congress in 1918 as part of The Revenue Act of 1918, and did not provide for any type of tax-deferred like-kind exchange. The first tax-deferred like-kind exchange was authorized as part of The Revenue Act of 1921, when the United States Congress created Section 202(c) of the Internal Revenue Code, allowing Investors to exchange securities and non-like-kind property unless the property acquired had a "readily realizable market value."

These non-like-kind property provisions were quickly eliminated with the adoption of The Revenue Act of 1924. The Section number applicable to tax-deferred like-kind exchanges was changed to Section 112(b)(1) with the passage of The Revenue Act of 1928. In 1935, the Board of Tax Appeals approved the first modern tax-deferred like-kind exchange using a Qualified Intermediary and the "cash in lieu of" clause was upheld so that it would not invalidate the tax-deferred like-kind exchange transaction.

The 1954 Amendment to the Federal Tax Code changed the Section 112(b)(1) number to Section 1031 of the Internal Revenue Code and adopted the present day definition and description of a tax-deferred like-kind exchange, laying the groundwork for the current day structure of the tax-deferred like-kind exchange transaction.

The two specific types of property applicable to a like-kind exchange are IRC Section 1250 Property which is Real Estate and IRC Section 1245 Property which is Personal Property.

Real estate includes rental buildings, office buildings, stores, manufacturing plants, warehouses, raw land, etc... It does not matter if the real estate is improved or unimproved. Thus, for example, unimproved land can be exchanged for an apartment complex.

Personal property includes tangible and intangible property. Tangible property includes office furniture, vehicles, equipment, etc. Intangible property includes copyrights, trademarks, customer-based intangibles, etc... Personal property cannot be included in a like-kind unless the property of one kind or class is exchanged for property of the same kind or class. Thus, for example, a vehicle can be exchanged for another vehicle but a vehicle cannot be exchanged for a pizza oven.

Like-Kind Exchange Of An Entire Business...

When dealing with the transfer of an entire business, the exchange of one business for another business cannot be treated as an exchange of a single property for another single property (Revenue Ruling 89-121). The assets held in a business must be analyzed and compared to the assets held in another business to determine which assets will and will not qualify for like-kind exchange treatment.

Per Regulation Section 1.1031(a)-2(c)(2), the goodwill or going concern value of one business is not of a like-kind to the goodwill and going concern value of another business. Accordingly, like-kind exchange treatment is not available for the entire exchange of one business for another business. To maximize the use of Section 1031 for the like-kind exchange of assets included as a part of a complete business transfer, a planning tactic is to value intangibles which can be separated from goodwill and going concern. Per Chief Counsel Advice 200911006, intangibles such as trademarks, trade names, customer-based intangibles, etc... that can be separately valued apart from goodwill qualify as like-kind property.

Thus, even though an entire business cannot be exchanged for another business, through creativity and utilization of proper business valuation techniques, it is possible, depending on the facts associated with a specific business, to transfer a significant portion of a business using the like-kind exchange provisions of Section 1031.