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Individual Suggests Changes to Like-Kind Exchange Regs

AUG. 11, 2020

Individual Suggests Changes to Like-Kind Exchange Regs

DATED AUG. 11, 2020
DOCUMENT ATTRIBUTES

August 11, 2020

CC:PA:LPD:PR (REG-117589-18)
Room 5203
Internal Revenue Service
P.O. Box 7604
Ben Franklin Station
Washington, DC 20044

Re: Statutory Limitations on Like-Kind Exchanges

Dear Sir or Madam,

This letter comments on four issues in REG-117589-18, Statutory Limitations on Like-Kind Exchanges, 85 Fed. Reg. 35835 (June 12, 2020). It is submitted in my personal capacity.

1. Denominator of the incidental personal property rule

2. Effective date of new incidental personal property rule

3. The ditch exception and grandfathering for other real properties

4. Reexamine some numerical examples as to whether $187,500 and $87,500 add up to $250,000 or $275,000

1. Denominator of the incidental property rule

Treas. Reg. § 1.1031(k)-1(g)(6) generally provides that a taxpayer's agreement with a qualified intermediary must provide that the taxpayer has no rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property before the end of the exchange period. Two exceptions are allowed for pro rations and transactional costs in Treas. Reg. § 1.1031(k)-1(g)(7)(i) and (ii).

Prop. Treas. Reg. § 1.1031(k)-1(g)(7)(iii) adds a new exception to allow the taxpayer to receive, or have the right to receive, personal property that is incidental to real property acquired in a like-kind exchange. Personal property is incidental to real property acquired in an exchange if (A) the personal property is typically transferred together with the real property in standard commercial transactions and (B) the aggregate fair market value of the incidental personal property transferred with the real property does not exceed 15% of the replacement real property's aggregate fair market value.

In order to reduce confusion and traps for the unwary, the value of the incidental personal property should be included in the denominator of the 15% test. For example, a taxpayer who disposes of $1,000,000 of real property could easily think that it can acquire up to $150,000 of incidental personal property under the 15% test, when in fact the numerical limit is only $130,434 (i.e., $130,434 / ($1,000,000 - $130,434) = 15%). The incorrect calculation may be more intuitive for some taxpayers who are looking at the test after disposing of its $1,000,000 of relinquished property.

Inclusion of the personal property in the denominator of a 15% test is consistent with the REIT 15% tests in section 856(d)(1)(C), section 856(c)(9)(A)(ii)(III), and section 856(c)(9)(B)(i) for a REIT's rents from real property, gains from the dispositions of real property, and mortgage loans. The REIT 15% tests all include personal property in the denominator.

A similar 15% rule exists in Treas. Reg. § 1.1031(k)-1(c)(5) about property identification, which should also be conformed to include the personal property in the denominator.

2. Effective date of new incidental personal property rule

The incidental personal property exception is generally effective for like-kind exchanges in 2018 and later.1

The incidental personal property would still be taxable boot to the extent that the taxpayer does not otherwise acquire sufficient replacement real property in the like-kind exchange,2 but the new exception ensures that the incidental personal property does not disqualify the entire like-kind exchange. The preamble described the total disqualification concern at 85 Fed. Reg. 35838:

taxpayers have asked whether an exchange fails to meet the requirements of §1.1031(k)-1(g)(6)(i) if funds from the transfer of relinquished property held by the qualified intermediary are used to acquire an office building, including the personal property in the office building. Taxpayers and qualified intermediaries are concerned that a taxpayer would be considered to be in constructive receipt of all of the exchange funds held by the qualified intermediary if the taxpayer is able to direct the qualified intermediary to use those funds to acquire property that is not of a like kind to the taxpayer's relinquished property. Under § 1.1031(k)-1(a), if a taxpayer actually or constructively receives the funds held by a qualified intermediary before receiving the replacement property, the transaction is a sale and not a section 1031 like-kind exchange.

If the above concern is a real problem, the concern is not limited to post-TCJA like-kind exchanges in 2018 and later years when only real property is eligible for like-kind exchanges. A taxpayer may have disposed of unimproved land in 2015 and then acquired (through a qualified intermediary) several buildings with incidental personal property. The same concern would entirely disqualify the 2015 like-kind exchange, because the taxpayer may be considered to be in constructive receipt in 2015 of the incidental personal property that is not of a like kind to the taxpayer's unimproved land that was the relinquished property.

In order to completely address the concern, the final regulations should provide that the incidental personal property exception should be effective retroactively, to either (i) the 1984 enactment of the deferred exchange rules in section 1031(a)(3) in Public Law No. 98-369 (Deficit Reduction Act of 1984) or (ii) the 1991 effective date of the Treas. Reg. § 1.1031(k)-1 deferred exchange final regulations as enacted by T.D. 8346, 56 Fed. Reg. 19937 (April 25, 1991).

3. The ditch exception and grandfathering for other real properties

Prop. Treas. Reg. § 1.1031(a)-3(a) provides that “local law definitions are not controlling for purposes of determining the meaning of the term real property under” Treas. Reg. §1.1031(a)-3 and section 1031, with a limited exception for shares in a mutual ditch, reservoir, or irrigation company described in section 501(c)(12)(A) if, at the time of the like-kind exchange, the shares have been recognized by the highest court of the State in which the company was organized, or by a State statute, as constituting or representing real property or an interest in real property.

The ditch exception arose from a footnote in the TCJA's Conference Report: “It is intended that real property eligible for like-kind exchange treatment under present law will continue to be eligible for like-kind exchange treatment under the provision. For example, a like-kind exchange of real property includes an exchange of shares in a mutual ditch, reservoir, or irrigation company described in section 501(c)(12)(A) if at the time of the exchange such shares have been recognized by the highest court or statute of the State in which the company is organized as constituting or representing real property or an interest in real property.”3

The ditch exception is not found in the statutory text of current section 1031, which applies only to real property and not to stocks.

The IRS Chief Counsel Office had concluded after a well-reasoned analysis in GCM 39536 (Mar. 11, 1986) that: “Because IRC 1031 specifically excludes stock from nonrecognition treatment, and because we do not think the state law characterization of mutual ditch company stock overrides this exclusion, the exchange would not qualify for the nonrecognition treatment of section 1031.” GCM 39536 further noted that the stock of mutual ditch companies were not “like-kind” to other types of real property. The ditch exception was created in 2008, when Public Law No. 110-246 (the Food, Conservation, and Energy Act of 2008) enacted (former) section 1031(i) to allow like-kind exchanges of shares of certain mutual ditch companies completed after May 22, 2008.

When the TCJA amended section 1031(a) to provide that only real property can be exchanged, section 1031(i) could have been retained as an exception to the general requirement of exchanging like-kind real property. But section 1031(i) was repealed in its entirety, effective for exchanges of shares of mutual ditch companies completed after December 31, 2017.

Treasury and the IRS should review the statutory authority to treat stock of a mutual ditch company as real property that is like-kind to other real property. If the non-statutory ditch exception is justified based on Congressional intent as described in a footnote sentence within a Conference Report, the same grandfathering effect should be given to Congress's preceding sentence in the footnote that “It is intended that real property eligible for like-kind exchange treatment under present law will continue to be eligible for like-kind exchange treatment under the provision.” Specifically, any property of a type that was considered real property eligible for like-kind exchange treatment between May 22, 2008 and December 31, 2017 should be grandfathered as eligible for like-kind exchange treatment in 2018 and later years. Such parity would treat similarly situated taxpayers similarly and reduce taxpayer compliance burdens, expense, and complexity.

3. Reexamine some numerical examples as to whether $187,500 and $87,500 add up to $250,000 or $275,000

The final regulations should review the numerical examples in Treas. Reg. § 1.1031(k)-1, such as $187,500 and $87,500 adding up to $250,000 in Treas. Reg. § 1.1031(k)-1(d)(2) Ex. (2).

The sum of $187,500 and $87,500 is $275,000.

I would be happy to discuss my comments if that would be helpful.

Sincerely,

Libin Zhang

FOOTNOTES

185 Fed. Reg. 35839 (June 12, 2020); Prop. Treas. Reg. § 1.1031(k)-1(g)(9).

2See Prop. Treas. Reg. § 1.1031(k)-1(g)(7)(vi) Ex. (6).

3H. Conf. Rep. 115-466, at 396 n. 726 (2017).

END FOOTNOTES

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