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Posts in Like-Kind Exchanges.


haircutOn February 21, 2014, then House Ways and Means Committee Chairman Dave Camp (R-Michigan) issued a discussion draft of the “Tax Reform Act of 2014.” The proposed legislation spanned almost 1,000 pages and contained some interesting provisions, including repealing IRC § 1031, thereby prohibiting tax deferral from like-kind exchanges. Not only would taxpayers have been impacted by this proposal, but it would have turned the real estate industry upside down. Qualified intermediaries would have been put out of business. Likewise, title and escrow companies, as well as real estate advisors specializing in exchanges, would have been adversely affected by the proposal.


Actual or constructive receipt of the exchange funds during a deferred exchange under IRC Section 1031 totally kills an exchange and any tax deferral opportunity.  Treasury Regulation Section 1031(k)-1(f)(1) tells us that actual or constructive receipt of the exchange proceeds or other property (non-like-kind property) before receiving the like-kind replacement property causes the exchange to be treated as a taxable sale or exchange.  This is the case even if the taxpayer later receives the like-kind replacement property. In accordance with Treasury Regulation 1.1031(k)-1(f)(2), a taxpayer is in constructive receipt of money or property if it is credited to his, her or its account; set apart for the taxpayer’s use; or otherwise made available to the taxpayer.

The treasury regulations specifically tell us that security (such as a third party guarantee, letter of credit or mortgage) put in place to ensure a transferee (including the Qualified Intermediary) actually transfers the replacement property to the taxpayer does not constitute actual or constructive receipt of the exchange funds.

Last, where the exchange funds are held in a “qualified escrow account,” no actual or constructive receipt exists by the mere fact that the escrow holds the funds.  A qualified escrow account exists if two criteria are met:

Requirement #1: The Escrow may not be established so that the holder of the funds is the taxpayer or a “disqualified person.”

Under Treasury Regulation Section 1.1031(k)-1(k), a disqualified person is:

  • Any person or firm that acted as the taxpayer’s employee, attorney, accountant, investment  banker or business broker, or real estate agent within two (2) years prior to the transfer of the relinquished property (or when there are multiple relinquished properties, the time period starts at the transfer of the earliest relinquished property).  For this purpose, some services are ignored such as services routinely provided by title insurance companies, escrow companies, and financial institutions.

  • The attribution rules of IRC Sections 267(b) and 707(b) come into play, but we have to substitute 10% for 50% in applying these rules.  So, for example, related persons include: the taxpayer’s spouse, siblings, ancestors, and lineal descendants; a corporation or a partnership owned more than 10% by the taxpayer or a related person; or a trust in which the taxpayer or a related person is a beneficiary or the fiduciary.

Requirement #2: The terms of the escrow must expressly provide that the taxpayer’s rights to the funds are limited.

The taxpayer cannot be allowed to receive, pledge, borrow against or otherwise obtain the benefits of the funds until after the exchange period expires, until after the 45 day identification period where the taxpayer failed the exchange by not identifying any replacement property, or after the time when the taxpayer has received all of the property identified within the 45 day identification period.

Chief Counsel Advice 201320511

Chief Counsel Advice 201320511 raises a not so obvious issue in the area of constructive receipt of exchange funds.  An issue that likely occurs often.

In the CCA, Chief Counsel was presented with a taxpayer that was in the equipment rental business.  It regularly engaged in Code Section 1031 deferred exchanges to dispose of its rental equipment and to obtain new rental equipment in a tax deferred environment.  Machinery and equipment rental businesses, rental car businesses, trucking companies and airlines likely find themselves in this same predicament.

The taxpayer maintained various lines of credit that it used to assist in funding operations during parts of the year and to acquire new rental equipment.   The lines of credit, as you may suspect, were secured by the equipment.

Under the exchange agreement, the two specific requirements of a qualified escrow were met, but the Qualified Intermediary was required to pay down the lines of credit with the exchange proceeds and then (through the taxpayer) use the same lines of credit to fund the purchase of the replacement property.  Again, one would assume this often occurs in personal property exchanges by taxpayers in related or similar businesses.

The specific issue presented to Chief Counsel was whether the use of the exchange proceeds to pay down the taxpayer’s debt (which may or may not have been directly related to the relinquished property) constituted constructive receipt by the taxpayer of the exchange funds, thereby killing the taxpayer’s opportunity to obtain tax deferral.  The taxpayer was getting the benefit of the exchange funds during the time the deferred exchange was ongoing.

Chief Counsel, citing the boot netting rules, concluded in favor of the taxpayer and held no actual or constructive receipt existed.  The new debt secured by the replacement property equaled or exceeded the debt secured by the relinquished property which was paid off in the exchange.

Put this Chief Counsel Advice in your bag of tricks.  The issue may come up when taxpayers undertake personal or real property exchanges where a line of credit serves as security.


Under Code Section 1031(a), the relinquished property must have been held by the taxpayer for productive use in a trade or business, or held for investment.  Likewise, the replacement property, at the time of the exchange, must be intended to be held by the taxpayer for productive use in a trade or business, or for investment.

As you know, it is ok to exchange trade or business property for investment property, and vice versa.  At least two (2) recent tax court cases look at this issue.

Adams v. Commissioner, TC Memo 2013-7 illustrates a common issue in the Code Section 1031 environment -- whether the taxpayer intended to hold the replacement property for use in a trade or business, or for investment purposes.

The facts of the case are fairly straightforward.  The taxpayer exchanged an investment property in San Francisco for a rental home in Eureka that required loads of work.  By mere coincidence, the taxpayer’s son lived in Eureka.  The taxpayer even told the IRS that he acquired the rental home in Eureka because it was large enough to accommodate his son’s large family.  By further coincidence, the son had vast experience renovating homes.

Post-exchange, the son and his family put in about sixty (60) hours per week, working on the renovation of the home.  The son and his family eventually moved into the father’s replacement property.  They did pay rent, but it was below the market.  The Service asserted that the below-market rent equated with the taxpayer using the property as personal use property.  The taxpayer argued that, while the rent payment alone was below market, when you add in the value of the services that the son and his family performed on the property, it equated to market rent.  Also, the taxpayer asserted, if the rental payments and services together did not equate to fair rent, the difference was a gift from him to his son.

The tax court properly focused on the taxpayer’s intent at the time of the exchange.  It concluded that the taxpayer did not intend to charge below market rent.  Rather, he reduced the rent to take into consideration all of the renovation work being performed by the tenant.  Evidence supported the conclusion that the actual rent paid and the renovation work performed by the son and his family on the property together equated to fair rental value.  If this had not been the case, the exchange would have failed.  The son’s use of the property for less than market rent would have likely rendered the taxpayer’s holding of the replacement property as personal use.

Mr. Adams clearly won the battle, but he may have lost the war.  The value of the renovation services should have been reported by the taxpayer as rental income on Schedule E of his income tax return.  Mr. Adams received renovation services in consideration of the son being able to reside in the home at less than fair market rent.  Under Code Section 61, the fair value of the renovation services should be taxable income to Mr. Adams.  Also, the value of the improvements, to the extent they do not constitute repairs, should be added to basis, capitalized and depreciated over 27 ½ years under Code Section 168(c).

Yates v. Commissioner, TC Memo 2013-28 is another recent tax court case dealing with the “held for productive use in a trade or business, or investment” standard.  In that case, the taxpayers, husband and wife, exchanged a rental home for a property which, at least they said, they intended to use as a bed and breakfast.  Unfortunately, the facts were not consistent with that intent.

Rather than apply for permits to use the property as a bed and breakfast, as the purchase agreement expressly stated would be done by the taxpayers, the Yates simply moved into the home a few days post-closing and lived there happily ever after, or at least until they received a notice of audit from the IRS.

The IRS quickly challenged the validity of the exchange on the ground that the replacement property was acquired for personal use.  In other words, the Service asserted that the taxpayers had no intent at the time of the exchange, evidenced by the facts and circumstances, to use the replacement property for trade or business, or investment purposes.

The proper focus is on the taxpayer’s intent at the time of the exchange.  At least two facts show that the taxpayers’ intent at the time of the exchange was to use the replacement property for personal use rather than for use in a trade or business or for investment purposes:

  • #1:  The taxpayers never did anything to obtain permits to use the property as a bed and breakfast.  In fact, no efforts to use the property as a bed and breakfast were evident.  They simply moved into the property shortly after closing.  The taxpayers never advertised the property as a bed and breakfast.  No evidence that the taxpayers ever attempted to rent the property to others existed.  In fact, they never actually rented it to others.
  • #2:  The taxpayers moved into the home a mere four (4) days after closing.  There was no intervening time or intervening facts to change their intent post-exchange.

The Yates lost!  At the time of the exchange, the taxpayer must intend to hold the replacement property post-exchange for either use in a trade or business, or for investment.  The burden of proof is on the taxpayer.  It is that simple.

The goodwill of a business can never be exchanged for the goodwill of another business. Goodwill is not like kind property. Treasury Regulation 1.1031(a)-2(c)(2) makes that crystal clear, providing:

 The goodwill or going concern value of a business is not of a like kind to the goodwill or going concern value of another business.

I-Stock telecommunicationsDeseret Management Corp. v. Commissioner, 112 AFTR 2d 2013-5530 (Ct. Fed. Cl. 2013), illustrates the fact that goodwill may exist and be intermixed with business assets being transferred in an exchange under IRC Section 1031. The existence of goodwill creates taxable boot.

Whether goodwill exists is a question of facts and circumstances; the possible existence of goodwill cannot be ignored. The issue comes down to expert valuation testimony -- does it exist and what value should be assigned to it?

In the Deseret Management Corp. case, the taxpayer exchanged the assets of a radio station, including the FCC license, for the assets of another radio station. It followed all of the personal property grouping rules. The Service disputed whether goodwill was properly accounted for and the value assigned to goodwill, which would be treated as taxable boot.

The value of the assets being exchanged was $185 million. The parties stipulated that the hard assets had a value of a little over $8.2 million. The taxpayer argued that the remaining $176.8 million or so was mostly, if not all, properly allocable to the FCC license. The Service, on the other hand, asserted that a big chunk of the $176.8 million should be allocated to goodwill or going concern value.

A battle of the experts ensued. Fortunately, for the taxpayer, its experts were more credible than the government’s experts. Only a small amount of the value attributable to the assets was found to account for goodwill. In fact, the court concluded the amount of goodwill or going concern value was “at most, negligible.”

The moral to the story is simple. In an exchange of business assets, you need to carefully consider whether goodwill or going concern value exists.  An otherwise tax deferred exchange may be taxable.  Careful thought is required.  Also, a qualified appraisal is warranted in order to avoid unwanted surprises down the road.

Deseret Management Corp. serves as a good reminder that goodwill or going concern value could be lurking among the business assets being transferred in a Section 1031 exchange.

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Larry J. Brant

Larry J. Brant is a Shareholder in Foster Garvey, a law firm based out of the Pacific Northwest, with offices in Seattle, Washington; Portland, Oregon; Washington, D.C.; New York, New York, Spokane, Washington; and Beijing, China. Mr. Brant practices in the Portland office. His practice focuses on tax, tax controversy and transactions. Mr. Brant is a past Chair of the Oregon State Bar Taxation Section. He was the long-term Chair of the Oregon Tax Institute, and is currently a member of the Board of Directors of the Portland Tax Forum. Mr. Brant has served as an adjunct professor, teaching corporate taxation, at Northwestern School of Law, Lewis and Clark College. He is an Expert Contributor to Thomson Reuters Checkpoint Catalyst. Mr. Brant is a Fellow in the American College of Tax Counsel. He publishes articles on numerous income tax issues, including Taxation of S Corporations, Reasonable Compensation, Circular 230, Worker Classification, IRC § 1031 Exchanges, Choice of Entity, Entity Tax Classification, and State and Local Taxation. Mr. Brant is a frequent lecturer at local, regional and national tax and business conferences for CPAs and attorneys. He was the 2015 Recipient of the Oregon State Bar Tax Section Award of Merit.

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