1. §1031 Like-Kind Requirement, Generally.

    1. General Rule. Under Internal Revenue Code (“IRC”) §1031(a)(1), no gain or loss is recognized if property held for productive use in a trade or business or for investment is exchanged solely for property of a “like-kind” to be held either for productive use in a trade or business for investment. Fed. Reg. §1.1031(a)-1(a). Under IRC §1031(a) the words “like-kind” refer to the nature or character of the property and not to its grade or quality. The main rationale for non-recognition of gain or loss on an exchange is that the taxpayer following such a transaction maintains a continuity of investment and the profit or loss derived from the investment is merely theoretical until realized in cash or other property, not of same kind, but having a fair market value. HR Rep. No. 704, 73d Cong., 2d Sess. (1934).

    2. Like Kind Requirement. The kind of real property that can be exchanged within the meaning of IRC §1031 is extremely broad. Under IRC §1031(a) the words “like-kind” refer to the nature or character of the property and not to its grade or quality. The fact that any real property is improved or unimproved is not material, for that fact relates only to the grade or quality and not to its kind or class. Fed. Reg. §1.1031(a)-1(b); e.g., PLR 9431025 (lot held for investment and townhouses to be used as rental property are like-kind). The determination of the kind or class of use is made at the time of the exchange without regard the taxpayer’s motive before the exchange. Thus, the IRS has ruled that unimproved real estate qualified for a like-kind exchange where the taxpayer abandoned his original intention to construct a personal residence on it and, thereafter, held it only for investment. Rev. Rul. 57-244, 1957-1 C.B. 247. The regulations set forth the following examples of exchanges of real property that are to be considered of a “like-kind”: (i) the exchange of city real estate for a ranch or farm; (ii) the exchange of improved real estate for unimproved real estate; or (iii) the exchange of investment property and cash for investment property of a like-kind. 1.1031(a)-1(c). Virtually any fee simple interest in real estate is of like-kind to another fee simple interest in real estate.

    3. Holding Period. With the sole exception of exchanges between related parties (which is not at issue in this matter), neither the IRC nor the Federal Regulations set forth a specific holding period requirement for either the relinquished property or the replacement property. The IRS’ position that if the taxpayer acquired the property immediately before the exchange, the taxpayer acquired the property primarily to dispose of it, rather than to hold it for productive use in trade or business or for investment. Rev. Rul. 84-121. However, the courts have been fAr more liberal in determining whether a taxpayer has properly held “property” (see discussion at paragraph 2). In fact, there is no precedent establishing a safe holding period specified for a property to automatically qualify it as having been held for a qualified purpose. However, the IRS has stated that a minimum two year holding period would be sufficient for the qualified use test. PLR 8429039.

  2. IRC §1031 Exchanges Immediately Preceding or Following a Tax-Free Transfer of Property.

    1. IRS Argument. The argument has been successfully advanced by the IRS that a taxpayer is not entitled to take advantage of the non-recognition treatment otherwise available under IRC §1031 in conjunction with a transfer that immediately precedes or follows a purported IRC §1031 exchange. See generally Rev. Ruls. 77-337; 75-292. The reason accepted in those instances was that at the time of the transfer, the taxpayer did not hold the property for productive use in his trade or investment or for productive use; instead, the taxpayer held the property passively, merely to trade for other property.

    2. Tax Court Holding Since 1983.

      1. Prior Rule Overturned. Several cases have since been heard by the U.S. Tax Court in which differing result was achieved. In 1983, the court heard two cases which have defined the current rules relating to tax free transfers immediately preceding and following IRC §1031 exchanges. In Boelker, the taxpayer liquidated his wholly-owned corporation by accepting its sole asset in return for his shares in an IRC §333 tax-free transfer and immediately transferred the property for another in a purported IRC §1031 exchange. Boelker v. Comm., 81 T.C. 782 (1983). In Magneson, the taxpayer first completed an IRC §1031 exchange of real property and subsequently transferred that property to a partnership in return for a 10 percent ownership interest in an IRC §721 tax-free transfer. Magneson v. Comm., 81 T.C. 767 (1983).

      2. Holding and Reasoning. In both cases, the court recognized the requirement that the property must be held for productive use in trade or business or for investment purposes prior to the exchange and immediately following the exchange. It reasoned in the case of the tax-free transfer immediately preceding an IRC §1031 exchange that where a taxpayer surrenders stock for real estate owned by an entity, the taxpayer continues to hold an economic interest in essentially the same investment, although there has been a change in the form of his ownership. Bolker at 805. Because of this and because the taxpayer’s basis in the real property acquired on liquidation is equal to his basis in the stock surrendered, the gain is not to be recognized, but deferred until gain on the continuing investment is realized through a liquidating distribution. Id; Magneson at 772. This holding observes the basic premise for IRC §1031 tax-free transfers set forth by Congress: both liquidating and contributing tax-free transfer provisions within the IRC recognize the taxpayer’s continuing investment in property following both types of transactions. IRC §1031 is designed “to apply to such circumstances and to defer recognition of gain or loss where the taxpayer has not really ‘cashed in’ on the theoretical gain, or closed out a losing venture.” Bolker at 806. (Note that Magneson was decided over sharp dissent.) Today, “a like-kind exchange may be preceded by a tax-free acquisition of property at the front end, or succeeded by a tax-free transfer of property at the back end.” Maloney v. Comm., 93 T.C. 89 (1989).

    3. Ascertaining Which Party “Makes the Exchange.” Although the courts currently seem willing to permit tax free transfers of property both immediately before and after IRC §1031 exchanges, the IRS has been successful in arguing in some cases that the exchange transaction was actually entered by the distributing entity and that the taxpayer was merely acting as a conduit through which to pass title. Court Holding v. Comm., 2 T.C. 531, 538, affd. Comm. V. Court Holding, 324 U.S. 331. In determining whether a pattern of events fits the mold of the Court Holding case, the U.S. Supreme Court recognized that the distinction “may be particularly shadowy and artificial when the corporation is closely held.” U.S. v. Cumberland Services, 338 U.S. at 455. In attempting to define the level and nature of an entity’s involvement which must be present before any sale of exchange might be imputed:

      “[i]t is not necessary to reconcile all of the litigated situations where it has been held the stockholders’ sales after liquidation in kind were not attributable to the corporation. Certain it is from all of the authorities [that] the sale cannot be attributed to the corporation unless the corporation has, while still the owner of the property, carried on negotiations looking toward a sale of the property, and in most cases the negotiations must have culminated in some sort of sales agreement or understanding so it can be said the later transfer by the stockholders was actually pursuant to the earlier bargain struck by the corporation — and the dissolution and distribution in kind was merely a device employed to carry out the corporation’s agreement or understanding.”

      Bolker at 800-801. In Bolker, the corporation was wholly-owned by a sole shareholder. In addition, the corporation and the ultimate exchangor had entered into extensive discussions relating to the sale of the real property which was the subject of the case. However, the discussions were separated in time by approximately two years and circumstances indicating a need for the taxpayer to liquidate the entity (divorce). In that case, the taxpayer conducted the negotiations which led to the ultimate exchange and entered the agreement in his personal capacity. The court held that the evidence in that case clearly established that in substance, the taxpayer and not his corporation, negotiated and culminated the transaction.