#11517 - Like Kind Exchanges - U.S. Income Tax Law

LIKE-KIND EXCHANGES

1. Like-Kind Exchanges (§1031)—the exception to general rule that all gains are recognized. Basically preserves historical basis.

   1. Gain is still realized, it is just not yet recognized. TP maintains historical basis in one or more of the new assets, so any differences b/w that basis and the FMV of the assets preserves the opportunity to recognize gain/loss when the asset is later sold.

   2. §1031(a): In general, no gain or loss shall be recognized on the exchange of property (i) held for productive use in a trade or business or for investment if such property is exchanged (ii) solely for property of (iii) like kind which is (iv) to be held either for productive use in a trade or business or for investment.

      1. Note on T/B: For an item that has both personal and investment/ T/B/ qualities, inquiry is on primary use. Also, we only care about how the TP in question uses the property. Don’t care about how the person with whom she exchanges will use it.

      2. Similar deduction (§1033) allowed for replacements, where property has been involuntarily converted (e.g., by condemnation or physical destruction).

   3. Meaning of Like Kind:

      1. Like kind refers to “nature and character” of the property, not its “grade or quality.” So Ferrari for Kia is like-kind. (Reg §1.1031(a)(1)(b))

      2. Must be in same asset class. So farm house for city apartment is fine. Ferrari for Kia fine. Ferrari for tractor is not. (§1.1031(a)(2)).

      3. Things that are not like-kind.

         • Stock in trade (inventory) (§1031(a)). Otherwise would create huge tax shelters for companies to swap inventory.

         • Stock, partnership interests, and other securities(1031(a)(2)).

         • Goodwill is never like kind (in regs).

         • Livestock of different sex are not like kind (§1031(e))

   4. Boot Payments (§1031(b)):

      1. Allows for exchanges of like-kind property that are not exactly equal in value (which they almost never are)

      2. Gain realized on the transferred property will be recognized only up to the lesser of the boot or the amount of gain realized.

         • So if I buy house for $100K, it rises to $150K in value, and I trade it for a house worth $140K plus $10K cash, I have realized $50K gain, but I only recognize $10K now.

      3. For the person paying a boot you have to bifurcate into two exchanges to analyze tax consequences:

         • Exchange: The gain on his exchange of property for better like-kind property is realized, but not recognized, under 1031.

         • Sale: For tax purposes, the boot is him buying $20 worth of the better like-kind property for $20 (see Fred example in class notes). No gain or loss, just a simple purchase. So he has no gain or loss in the exchange, and he adjusts his basis in the property up $20.

      4. Note: the boot does not have to be cash. It can be assumption of liability, can be other types of property, or anything else. But for the exam it will be cash.

   5. Losses in mixed consideration transaction (§1031(c)): If exchanging property for like-kind property with boot (or other mixed consideration) totaling less than your basis in the original property, you cannot deduct any loss.

      1. So you’d rather just sell the property straight up take the loss, and then buy the like-kind in a separate transaction.

   6. Basis with boots (§1031(d)):

      1. Start with the TP’s old basis in original property

      2. Decrease basis by amount of cash received in the exchange

      3. Increase by any amount of cash paid in the exchange (Reg. §1.1031(d)-1(a)).

      4. Increase by any amount of gain recognized in exchange

      5. Decrease by any amount of loss recognized in exchange

   7. Policy Justification:

      1. Considerations include: difficulty of valuation, lack of liquidity, and continuation of the basic nature of TP’s investment.

      2. Maybe Congress trying to remove unnecessary transaction costs or disincentives or lock-ins where trades are otherwise Pareto optimal.

2. Character

   1. Intro on Cap Gains—applies to capital assets.

      1. Only long-term gets the special rate.

      2. Currently is 15%, since 2003. Supposed to return to 20% 1/1/2013.

      3. Qualifying dividends treated as cap-gains through 2012 (§1(h)(11)). Non-qualifying treated as ordinary income. Before 2003, dividends used to be taxed as ordinary income

   2. Maximum Capital Gains Rate (1(h))

      1. Cap gains can never have the effect of increasing rates, so taxpayers in the 15% marginal bracket pay 0% on cap gains.

   3. Other Capital Gains Rates:

      1. Collectibles (art, rugs, antiques, stamps, coins, metals, jewels, wines §1(h)(5)).

      2. Depreciable property and real estate is dealt with in §230A

   4. What is a Capital Asset? (§1221): Property held by taxpayer (business or indiv), excluding: inventory or other property held for sale to customers in ordinary T/B; depreciable real property; most IP, notes, commodities derivatives, govt publications.

      1. Interest in a lease is not a capital asset (Hort v Commis, US 1941, p 919);

         • Hort was comm. landlord, had tenant buy out rental contract--cancel a lease w/ some time remaining. Tried to write off diff b/w amount received and foregone expected future rent, arguing interest in future stream of rental payments was capital asset. Court says no—doesn’t matter that the income arose out of property—the rental income itself (or the contractual right to receive future rental income is not itself a capital asset). He has to pay ordinary income tax now on the amount received.

         • Maginnis v US (9^TH CIR 2004 p 923): Maginnis sold his right to receive $9m in periodic payments on lottery tickets to a bank for $3.5 mil up front. Tried to deduct the difference as capital loss. Court says no. Right to receive future lottery income is not a capital asset. Finds two factors dispositive:

           • He did not make any underlying investment of capital in return for receipt of the lottery right

           • Sale of the right did not reflect an accretion in value over the cost to any underlying asset he held

   5. Quasi-Capital Asset? (§1231): T/B depreciable property or real estate or involuntary conversions. [NOT ON EXAM]

      1. For corporations, depreciable trade/business assets held for more than a year are treated as capital assets when sale generates a gain, and ordinary assets when sale generates a loss.

   6. Holding Period (§1223(1)): TP’s holding period tacks onto those of prior owners if acquired in a transaction in which you take their basis (e.g., gifts, divorce settlement, like-kind exchange)

      1. Special rule for heirs under §1014: heirs treated as having held property for long-term as soon as they receive it.

   7. Classes of gains: §1222 has definitions of short term gain, loss, long term gain, loss, net short term gain, etc. Blank wants us to go through systematically and point to code section for each thing.

      1. Short-term gain (1222(1))

      2. Short-term capital loss (1222(2))

      3. Long-term capital gain (1222(3))

      4. Long-term capital loss (1222(4))

      5. Net Short-term capital gain (1222(5))

      6. Net Short-term capital loss (1222(6))

      7. Net Long-term capital gain (1222(7))

      8. Net Long-term capital loss (1222(8))

   9. Netting

      1. Long-term gains net against long-term losses

      2. Short-term gains net against short-term losses

      3. Net Capital Gain (§1222(11)): Refers to net long-term cap gains, minus net short-term cap losses, (if any).

         • If Net L-T and Net S-T have the same sign, then they’re treated independently. But if they have different signs, then they are netted out against each other, and the net amount takes the character (long/short) of one with greater absolute value. So if you have Net LT gain of $4K and net ST loss, of $3K, you have net LT gain of $1K and vice versa.

      4. Net short-term losses are first netted against the highest-tax-rate assets. This is very pro-taxpayer

   10. Limitation on Losses (§1211(b)):

       1. Individuals can deduct losses from sales or exchanges of capital assets against gains. But to the extent that losses exceed gains, you can...