What factors should a tax or real estate advisor consider when determining whether or not properties are "like-kind" to each other in a §1031 exchange? In the context of real property exchanges, the meaning of "like-kind" is generally straightforward. A variety of rulings, however, demonstrate the potential complexity of the definition. Are water rights like-kind to fee simple real estate? Are timber-cutting rights conveyed by timber deed like-kind to fee simple? We will examine several rulings that give us some guidance, but leave some unanswered questions.
Section 1031 of the Internal Revenue Code stipulates 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."1 In the context of real estate like-kind exchange transactions, the words "like kind" have been broadly defined. Like-kind refers to the nature or character of the property (i.e, real estate exchanged for real estate) and not to its grade or quality (i.e, unimproved land exchanged for improved land.)2 Generally, properties will be deemed "like-kind" if each property independently qualifies under state law as real property, and each property also meets the qualified use test of being either "investment property" or "held for productive use in a business or trade". Examples in the Treasury Regulations of like-kind properties include: "city real estate for a ranch or farm", "a leasehold of a fee with 30 years or more to run for real estate", and "improved real estate for unimproved real estate."3 The like-kind definition should not be assumed, however, simply because a particular property constitutes a real property interest under state law. In light of some interesting rulings, the "nature and character" test of like-kind real property interests must also be considered.
As early as 1955, the IRS considered whether or not water rights are like-kind to fee simple. Revenue Ruling 55-749 held that, "[W]here, under applicable state law, water rights are considered real property rights, the exchange of perpetual water rights for a fee interest in land constitutes a nontaxable exchange of property of like kind within the meaning of section 1031(a) . . . provided the requirements of that section as to holding for productive use in the trade or business or for investment are met." (Italics supplied.)4 This ruling emphasized the perpetual nature of the water rights in determining that the nature and character of the real property interests were like-kind. It explains, "the fact that the two varieties of property, namely water rights and land, may be legally classified as real property does not of itself signify that the two are property of like nature or character within the meaning of section 1031(a) of the Code" . . . "Under the circumstances in the instant case, where the water right, whatever its size, is in perpetuity, as distinguished from a right to a specific total amount of water or to a specific amount of water for a limited period, the water rights and the land involved are regarded as sufficiently similar to constitute property of like kind."5
A recent case, Wiechens v. U.S., further tested this holding.6 The taxpayer had previously acquired, by contract with the state, the right to receive Colorado River water on an annual basis to irrigate its land. The taxpayer exchanged its water rights with a fair market value of almost $500,000 (which were sold back to the state) for an interest in farmland. The court conceded that under Arizona law, the water rights were a real property interest. Arizona had a perpetual water right granted by the Department of Interior, but its subcontracts to landowners were limited to a fifty-year duration. Based on the Revenue Ruling discussed above, the court found that the properties were not like-kind since the taxpayer's water rights were not perpetual. The taxpayer's water rights had a remaining duration of approximately forty years. The taxpayer argued that the duration of the water rights was equivalent to a leasehold of a fee for thirty years or more. The court was unconvinced and held that the nature and character of the properties were not sufficiently similar. The court explained, "Factors to be considered include the respective interests in the physical properties, the nature of the title conveyed, the rights of the parties and the duration of the interests."7 The court held that the water rights were narrowly restricted, limited in priority, quantity and duration, and not like-kind to the farmland.
It has long been held that fee simple in timberland, including the value of the standing timber located on the property, is like-kind to other fee simple real property. In Revenue Ruling 72-515, the taxpayer's relinquished property consisted of a fee simple interest in timberland from which he had previously sold most of the merchantable timber.8 His replacement property was a fee simple interest in timberland supporting substantial amounts of virgin timber. The Service reiterated the principal that "like-kind" refers to the nature or character of the property and not its grade or quality. Citing Laird v. United States, 115 F.Supp. 931 at 933 (W.D. Wis. 1953), it reminded us that, "[T]imber growing on the land is a part of the land." The taxpayer's conveyance of fee simple and receipt of fee simple were like-kind, regardless of the grade, or quality of the timber on the property. The taxpayer's exchange was valid. Similarly, the Tax Court has held that an exchange of timber-cutting rights on one property for timber-cutting rights on another property, where both were held for investment rather than utilized, was a valid personal property exchange.9 But, are timber-cutting rights, if considered real property under state law, like-kind to fee simple?
Some states consider the conveyance by Timber Deed of the right to cut standing timber a real property conveyance, while others consider the sale of cutting rights a personal property conveyance. In Oregon Lumber Co. v. Comm., 20 T.C. 192 (U.S. Tax Ct., 1953), the taxpayer entered into an agreement to exchange fee simple timberland for cutting rights on other timberland. The court examined Oregon case law, and determined that in Oregon the sale of standing timber and the right to cut it is a personal property conveyance, not a real property conveyance. The taxpayer was not entitled to non-recognition treatment under §1031, because real property is never like-kind to personal property. A 1995 Technical Advice Memorandum examined slightly different facts. The taxpayer's conveyance of two-year timber-cutting rights by timber deed (apparently a real property conveyance in this jurisdiction) was deemed not like-kind to fee simple.10 The Service cited two mineral rights cases in reaching its conclusion. In Comm. v. Crighton mineral rights conveyed apart from a fee simple interest in the land were like-kind to fee simple where the rights conveyed were an overriding royalty interest which lasted until all the minerals were depleted.11 In contrast, Fleming v. Comm. held that a carved-out right to oil payments for a limited duration was not like-kind to fee simple, because the nature and character of the interests were not like-kind.12 The distinguishing factor between these cases was the quantity and duration of the interests. Although the taxpayer in this TAM did not limit the quantity of trees being cut, the service held that a two-year limitation amounted to a de facto restriction on the number of trees being removed.
The reader should keep in mind that a Technical Advice Memorandum is only the IRS's position on a particular issue for that taxpayer, and carries no authority for other taxpayers. The Service attempted to create precedent for its position in the TAM by litigating the case, Smalley v. Commissioner.13 Under similar circumstances, Smalley exchanged two-year timber-cutting rights, conveyed by timber deed for fee simple real property. Smalley's transaction crossed two tax years. He relinquished the timber cutting rights in 1994 and received the replacement property within 180 days - in 1995. Unfortunately, the IRS only brought the 1994 tax return before the court. The court determined that it need not decide the like-kind issue. Since Smalley received either like-kind property or non-like-kind property in 1995, he would not recognize any gain in the transaction until 1995 under installment sale rules. The court discussed the like-kind issue only to the extent that Smalley might reasonably believe the properties were like-kind, establishing a bona fide intent in 1994 to effect a §1031 exchange. The court examined Georgia law, and determined that there was a strong argument that timber-cutting rights conveyed by timber deed in Georgia were a real property interest, and then declined to make a like-kind ruling on this issue. Given the decision in Wiechens that was discussed above, it is questionable whether or not the nature and character of timber-cutting rights are sufficiently like-kind to real property, even if defined as real property under state law.
Miscellaneous Rulings and Remaining Questions
A number of other interesting rulings have addressed the like-kind question. Perpetual agricultural conservation easements have been found like-kind to fee simple interests.14 A taxpayer who had made an election under §1033(g)(3)(A) to characterize its outdoor advertising as real property was able to exchange the billboards which were attached to real estate (that the taxpayer did not own) for fee simple real estate.15 Stocks, bonds, and notes are specifically excluded as exchangeable property under §1031(a)(2). But, where shares of stock in a cooperative constitute a real property interest under state law, and the cooperative interest includes a leasehold in excess of thirty years, the stock was deemed like-kind to a condominium acquisition.16 A scenic conservation easement is like-kind to fee simple.17 A perpetual agricultural conservation easement is like-kind to fee simple.18 A remainder interest in fee simple has been deemed like-kind to a life estate in another property, where the life tenant had a life expectancy of thirty years.19 In an IRS Notice, the Service treated the tax consequences of farmers who receive peanut quota buyout payments resulting from the repeal of the peanut quota program.20 The Service gave guidance characterizing the gain as a capital gain, and stated that, "[A] peanut quota is an interest in land," opening the door for like-kind exchanges involving peanut quota buyouts for real property. Another unanswered question: are boat slips conveyed by deed like-kind to fee simple in real property? An option to purchase real estate is both a contract right and an interest in real property. If the option is of sufficient duration, could it be exchanged for fee simple? In light of existing guidance regarding the nature and character of real property interests, advisors should carefully consider the like-kind requirement. The answer may not be as straightforward as it appears.
|1 I.R.C. §1031(a)(1).
2 Treasury Regulation §1.1031(a)-1(b).
3 Treasury Regulation §1.1031(a)-1(c).
4 Rev Rul 55-749, 1955-2 CB 295.
6 Wiechens v. U.S., 228 F.Supp.2d 1080 (D.Ariz., 2002).
7 Id. at 1085.
8 Rev. Rul. 72-515, 1972-2 C.B. 466.
9 Everett v. Comm., T.C. Memo. 1978-53 (U.S. Tax Ct., 1978).
10 TAM 9525002.
11 Comm. v. Crighton, 122 F.2d 181 (5th Cir. 1941).
12 Fleming v. Comm., 24 T.C. 818 (1955).
13 116 T.C. No. 29 (U.S. Tax Ct., 2001).
14 PLR 9215049, PLR 96-1-46, PLR 9851039, PLR 200201007.
15 PLR 200041027.
16 PLR 8810034, PLR 8445010, PLR 200137032.
17 PLR 9621012.
18 PLR 9215049, PLR 9601046, PLR 9851039, PLR 200201007.
19 Rev Rul 78-4. 1978-1 CB 256.
20 I.R.S. Notice 2002-67, 2002-42 I.R.B. 715.