Wednesday, November 14, 2012

Like Kind Exchanges Section 1031

Like-Kind Exchanges - § 1031
          i.     Basic Rule and Elements:
1.     § 1031 provides Nonrecognition of gains and losses incurred on the transfer of property in exchange for other property of “like kind”
2.     SCOPE:  § 1031(a)(1): It is limited to property that is used in a business or held for investment.
a.     There must be sign of continuous investment. Stuff cannot just sit there.
b.     LITIGATED ISSUE: The cases often turn on this requirement.
3.     EXCEPTIONS: § 1031 (a)(2): Precludes applicability of this Nonrecognition rule to several categories or property, among which are stocks, bonds, and notes; partnership interest, and inventory property. Most types of financial instruments are excluded
4.  Party claiming like-kind exchange must not be dealer in type of property exchanged.
        ii.     Policy Justification
1.     The asset is not liquid, so the taxpayer might not have cash to pay the tax on gain.
2.    Is the real justification, then, that a taxpayer who receives like-kind property should not be taxed because he has not changed the fundamental nature of his investment?
a.     Congress probably considered:
                                                                i.     Difficulty of valuation
                                                              ii.     Lack of liquidity
                                                            iii.     Continuation of the basic nature of the taxpayer’s investment.
      iii.     What qualifies? The LIKE KIND concept- VERY BROAD
1.  Regulations say that the concept refers to the “nature and character” of the property, and not to its “grade of quality”. BROAD WITH REAL ESTATE AND MORE LIMITED WITH OTHER ASSETS
2.     “same asset class” STANDARD
a.     The properties must be in the same asset class.
b.     Allows people to trade stuff of many different values
c.   They can be more different than properties that lack the material difference requirement for realization. SIMILAR NATURE OR CHARACTER
3.     In determining if two properties are of like kind, look first to the characterization of the properties in question.
a.     If both are real property, the answer will almost be yes.
b.   All real property is considered “like kind” for purposes of the statute, even if one is improved and the other is not, or if they are in different states.
c.     Both properties must be in the US to qualify § 1031(h)

        iv.     What qualifies as an “exchange”?
1.     Three party exchanges are OK. Someone can buy real estate from a third party, then trade it or other real estate.
2.     The IRS acknowledges that a properly structured three-party transaction such as this can qualify for Nonrecognition under § 1031.
3.     If the law did not permit such three-party exchanges, the practical significance of § 1031 would be very limited.

          v.     Boot in § 1031 transactions – Gain only recognized up to the boot for taxes
1.     Boot = Equalizing the transaction by throwing in cash. Does that mean anything thrown into the boot will spoil the transaction for § 1031 purposes?
a.     § 1031(b) says that if the taxpayer has gain on the property she transfers and receives consideration both in the for of qualified (like-kind) property and nonqualified property or cash (generally referred to as “boot” in either case), then the gain realized on the transferred property will be recognized, but only up to the amount of the boot – the amount of cash or the fair market value of the nonqualified property.
                                                                i.     It is necessary, in order to apply the rule of § 1031(b), to determine the taxpayer’s gain realized, which in turn requires a determination of the taxpayer’s amount realized – including the fair market value of the property.
                                                              ii.     Is it really possible to defend § 1031 as a response to valuation difficulties?
b.     1031(c) says that if the taxpayer has experienced a loss on the transferred property of like kind, then none of the loss is to be recognized if the consideration received is a mix of qualified and nonqualified property or cash. COMPLETE NONRECOGNITION
c.     Taxpayers with losses that they are disposing prefer not to qualify under § 1031.
        vi.     Basis of the acquired property in Like Kind Exchange § 1031(d)
1.     The basis of the acquired property will be an “exchanged basis” meaning that the historic adjusted basis in the transferred property will become the basis in the acquired property. Three adjustments required:
a.    Decreased by the amount of any money received (BOOT) by the taxpayer in the transaction;  In order to reflect the allocation of basis to the cash received by the taxpayer.
b.  Increased by the amount of any gain recognized by the taxpayer on the transaction;. To ensure that he is not taxed twice. The total basis to which the taxpayer is entitled is his old basis in the transferred property, plus his gain recognized on the transfer.
c.  Decreased by the amount of any loss recognized by the taxpayer on the transaction.
d.     INCREASE BASIS BY MONEY PAID. Not specified in statute: It is that the basis in the acquired property must be increased by any money paid by the taxpayer as part of the like-kind exchange.
                                                                i.     The regulations state that when additional consideration is given in a § 1031 transaction, the basis of the acquired property is the basis of the transferred property, increased by the amount of the additional consideration.
2.     POLICY: Most recognize built in gain.

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