Archive for September 24th, 2012

Under the tax law, taxpayers are afforded favorable treatment when instead of selling appreciated property, they “exchange” it for other property; the idea being that the taxpayer has not cashed out its investment in the property, but rather simply changed the form of the investment.

Specifically, Section 1031(a) of the Code provides that “no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.”

Stated simply, a taxpayer recognizes no gain if instead of selling appreciated property, they exchange it for property that is “like kind.” And this, as you can imagine, is where issues arise. What is “like kind” property? The regulations offer scant guidance:

Section 1.1031(a)-1(b) of the regulations provides that the words “like kind” have reference to the nature or character of the property and not to its grade or quality. The fact that any real estate involved is improved or unimproved is not material, for that fact relates only to the grade or quality of the property and not to its kind or class.

This much is clear, however: This like-kind requirement precludes a taxpayer from exchanging real property for personal property, or vice versa.

As a result, over the years numerous court cases have sought to answer the question of whether Property A was “like kind” to Property B by looking to state law classifications. For example, in Commissioner v. Crichton[i], the 5th Circuit determined that a mineral right was real property under Louisiana state law and thus of like kind to other real property. Similarly, in Peabody Natural Resources Co. v. Commissioner[ii], the Tax Court determined that under New Mexico law, coal supply contracts constituted real property interests and were of like kind to the relinquished gold mine.

These decisions have led some practitioners to question whether state law classifications are in fact determinative in concluding whether two properties are of like kind. Last Friday, in PLR 201238027, the IRS clarified that state law classifications, while relevant, are not determinative of whether properties are of like kind. Rather, all facts and circumstances should be considered.

In the Ruling, the IRS presented four scenarios. In each of the four scenarios, similar properties were exchanged for one another. Under state law, however, the properties were classified differently. For example, in Case 1, a natural gas pipeline in State A (constructed along a right of way on real property) that was classified as personal property in State A was exchanged for a State B natural gas pipeline that was  constructed along a right of way on real property and that was classified as real property in State B. (The right of ways associated with the exchanged pipelines in State A and State B are also exchanged.)

The IRS declined to base its decision as to the like kind nature of the properties solely on their respective state law classifications. Instead, the Service looked to certain informative sections of the Code to glean how they classified property as personal or real, specifically, Sections 48, 263A, and 1245:

For example, § 1.263A-8(c)(1) of the regulations provides, in part, that real property includes land, unsevered natural products of land, buildings, and inherently permanent structures. Section 1.263A-8(c)(3) describes “inherently permanent structures” as including “property that is affixed to real property and that will ordinarily remain affixed for an indefinite period of time, such as swimming pools, roads, bridges, tunnels . . . telephone poles, power generation and transmission facilities, permanently installed telecommunications cables, broadcasting towers, oil and gas pipelines, derricks and storage equipment. . . .”

Section 1.48-1(c) of the regulations provides in part, that for purposes of § 1.48-1, the term “tangible personal property” means any tangible property except land and improvements, including structural components of such buildings or structures. It further provides that “production machinery, printing presses, transportation and office equipment. . . contained in or attached to a building constitutes tangible personal property for purposes of the credit allowed by section 38.”  

Finally, § 1245(a)(3) provides that “§ 1245 property” is any property which is or has been subject to depreciation under § 167 and which is either personal property or other tangible property used as an integral part of certain activities, including manufacturing.  

Acknowledging that relying solely on state law classifications could yield absurd results – for example, in Case 1 where identical pipelines are exchanged but their respective states classify them as personal and real property, respectively, treating the properties as not being like kind would make little sense — the IRS concluded the basic nature and character of the property involved should override the state law treatment.

Applying these concepts to Case 1, since both pipelines were inherently permanent structures that were affixed to real property that will remain for an indefinite period of time, they both qualified as real property under the definition found at Regulation Section 1.263A-8(c)(1). Thus, the exchange of one pipe line for the other qualified as a like kind exchange under the meaning of Section 1031.

[i] 122 F.2d 181 (5th Cir. 1941).

[ii] 126 T.C. 261 (2006).

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I spent the weekend doing some mountain bike-assisted leaf peeping, as the fall colors are in “full splendor” mode right now in the Rockies:

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On to the tax stuff. For good or bad, there’s no bigger story in the tax world right now than the release of Mitt Romney’s 2011 tax returns. It’s a shame in a way, because it has to suck to publish your most sensitve personal information only to immediately have every hack (i.e., me) scrambling to their laptops to offer up their unsolicited opinions regarding your financial dealings on the internet. But such is the way of the world, so below are some links to other, more reputable sources and their thoughts on the Romney returns:

NY Times

Washington Post

The Atlantic


Of course, as I’ve mentioned before, the bigger question is: will the information contained within those 300 pages of tax return really have an impact on election day? The Wall Street Journal has some theories.

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