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EXCHANGING REAL ESTATE

by Dr. Mark Lee Levine

DEDICATION

An "exchange" commonly denotes one item given for another, a quid pro quo. That is the
vernacular use of the term "exchange".

However, is it an "exchange", a quid pro quo, when Rabbi and Doctor I. Benjamin Geller
extends his time, energy, knowledge and helpful hand to teach me and lead me through
the maze and enigmatic non-secular world, only to "receive" my "gratitude and thank
you"?

This "exchange" does not even approach a balanced position. I have taken too much and
given too little. I recognize and appreciate the disproportion. For it I can only reaffirm my
appreciation. I dedicate this Work to Tzaddik, Rabbi/Doctor Geller. Dr. Geller has taught
me that there is more to do (and exchange) than real estate. Dr. Mark Lee Levine

THE AUTHOR

Mark Lee Levine is a full Professor and Director of the Franklin L. Burns School of Real
Estate and Construction Management, Daniels College of Business, UNIVERSITY OF
DENVER, lecturing on tax, real estate, securities, tax aspects of real estate transactions,
liability and law. He is a widely sought consultant in these areas as well. Dr. Levine is
President and Chairman of LEVINE AND PITLER, P.C., Attorneys, and Chairman of the
Board of Directors of LEVINE, LTD., REALTORS , a real estate brokerage and
management firm in Colorado. He is also a director, officer and shareholder in many
other companies in the real estate field.

Dr. Levine is a partner in numerous real estate investments and serves on various
publishing and advisory boards. He holds a collection of academic degrees, including a
Bachelor of Science in business and economics from Colorado State University; a
Doctorate of Jurisprudence from the University of Denver School of Law; a Master of
Laws in tax law from New York University; he is a graduate from the Professional
Accounting Program at Northwestern University Graduate School of Management; Dr.
Levine holds a Phd in Business.

Levine is an active member of various tax, legal and real estate committees. He is a
member of the Denver, Colorado, and American Bar Associations as well as several other
professional groups. He is admitted to the federal, district, circuit, tax, and U.S. Supreme
and State courts. A popular lecturer, he is also Author of 22 books in addition to articles
in many journals. He has been awarded the American Jurisprudence Prize for Excellence.
He appears in Who's Who in Education, Men of Achievement and Selected Outstanding
Educators of America.

PREFACE

The purpose of this text is to provide a single volume reference that explains the basics of
a real estate exchange, along with a sophisticated analysis of the cases, Revenue Rulings,
Revenue Procedures, treatises and other authorities that have affected real estate
exchanges and have molded the current state of the law in this field.

We are concerned with "tax-deferred exchanges," as treated in 26 U.S.C.A. (Internal


Revenue Code of 1986, as amended), particularly Code Section 1031 (Code §1031). A
more apt label than "tax-free exchanges" is "tax-deferred exchanges," since the intent is
to postpone recognition of income taxes. The emphasis on this text is, therefore, on
income taxes, although an exchange may have ramifications in other areas, such as gift
tax and estate tax.

The genesis of this text is an initial chapter covering tax-deferred exchanges in my earlier
text, Real Estate Transactions, Tax Planning, published by West Publishing Co., in 1973,
supplemented in 1974, followed by new Editions and Supplements, including the latest
Edition published in 2000. Inasmuch as the area of real estate exchanges has proven to be
of great import to the real estate field, this text is intended to emphasize the details of this
particular tax planning tool.

The text examines, among other topics, the interworkings of Code Section 1031 (Code
§1031), the general rules applicable to the tax-deferred exchange, the effect of an
exchange, losses, basis adjustments, circumstances when the rule will and will not apply,
what is meant by the term "like-kind" property and exchanges of unique properties.

This material is designed for use by both the novice in the tax field and the more
sophisticated tax planner. Particular emphasis is for real estate practitioners, CPAs and
attorneys.

A great number of cases and Rulings have developed and expanded the language of the
Internal Revenue Code under Code Section 1031 and the Regulations that have
interpreted that Section. These items are examined in detail, as abridged by this Author.
Ellipses indicate the omission of material not considered germane to the topic being
discussed and, in most cases, italicized material has been so emphasized by this Author.

ACKNOWLEDGMENTS

Having published a number of works in real estate tax, real estate securities, business law
and other fields, I readily acknowledge that this, as well as the other Works I have
undertaken, could not have been completed without strong support from other people. It
is, therefore,worthwhile to take a moment to reflect upon the many hours of aid, both
physical and mental, that have been devoted by many people to produce this Work. My
appreciation extends to all who assisted during the many stages of compilation, writing,
reviewing and proofreading of this material.

Specifically, I note the strong support in typing and editing by my wife, Ellen, and
especially by my legal assistant/secretary, Diane Smith.

Technical support has come from many. My partner, Robert L. Pitler, who is also an
attorney and Realtor, as well as numerous other Realtors, attorneys, CPAs, real estate
investors, exchangers and students, have been the backbone for the technical support for
this Work.

To these people and the many others who have given of their time, efforts and ideas, I
extend my warmest personal gratitude.

CAVEAT

Inasmuch as there are differing opinions on a number of legal, tax and related matters
which obviously affect many activities, certainly not limited to those in the exchange
area, it is important for me to emphasize a general Caveat and Disclaimer. I have no
intention of giving legal and/or tax advice by means of this text.

The intent is to state general propositions, specific points, development of case law and
other authority. Any opinions or positions are limited in this respect, and further are
qualified in that they are not necessarily the opinions of any or all parties who might be
involved in producing this text or any portion thereof.

All parties are advised that careful planning necessitates consulting with their own legal,
tax and other counsel. This text should not be a substitute for that advice, but rather, it
should be used as a tool to help inform the user.

Therefore:

This publication is designed to provide accurate and authoritative information about this
subject. The reader is advised that the material contained herein may be inappropriate in
a given situation.The book is sold with the understanding that the publisher and Author
are not engaged in rendering legal, accounting or other professional services through
this publication. Further, due to the nature of this publication, any of the information
contained herein is subject to change without notice. The matters contained herein may
be utilized only as consistent with all applicable laws, regulations and restrictions. If
legal advice or other expert assistance is required, the services of a competent
professional should be sought.

OTHER REFERENCES

References to the "West text" refer to Mark Lee Levine, Real Estate Transactions, Tax
Planning, The West Group (formerly West Publishing Co.), St. Paul, Minnesota (2000),
distributed by West and other companies, e.g., PROFESSIONAL PUBLICATIONS
AND EDUCATION, INC. (PP&E), 2303 East Dartmouth Avenue, Englewood, Colorado
80110-3079 (Telephone:303/758-2221).

ABBREVIATIONS

Acq. Acquiescence

Aff'd Affirmed

Aff'g Affirming

American Federal Tax


A.F.T.R.
Reports

B.N.A. Bureau of National Affairs

Cumulative Bulletin of
C.B.
Internal Revenue Service

Cert. den. Certiorari denied

Commerce Clearing
C.C.H.
House

Code of Federal
C.F.R.
Regulations

Cir. Circuit (Court of Appeals)

Code Internal Revenue Code

D.C. District Court

Fed. Federal Reporter

Financial Institutions
F.I.R.R.E.A. Reform Recovery and
Enforcement Act

Federal Supplement
F.Supp.
Reporter
Federal Reporter, Second
F.2d
Series

Internal Revenue Bulletin


I.R.B.
(weekly)

I.R.C. Internal Revenue Code

I.R.S. Internal Revenue Service

Lawyer's Edition(Supreme
L.Ed.
Court decisions)

Letter Ruling (see also


L.R.
P.L.R.)

P-H Prentice-Hall

P.L.R. Private Letter Ruling

Real Estate Investment


REIT
Trust

Rem'g Remanding

Rev. Proc. Revenue Procedure

Rev. Rul. Revenue Ruling

Rev'd Reversed

Rev'g Reversing

R.T.C. Resolution Trust Corp.

T.C. United States Tax Court

Tax Court Memorandum


T.C.M.
Decisions

Treasury Department
T.D.
Decision
Treasury Decisions Under
Treas. Dec.
Customs and Other Laws

Treas. Regs. Treasury Regulation

United States Code


U.S.C.A.
Annotated

Vac'g Vacating

CHAPTER 1: INTRODUCTION

This text reports on the current state of cases, rulings, procedures, regulations and other
authority impacting exchanges.

Many of the cases filed in court are extreme in one form or another. Sometimes they are
very borderline cases or even involve abuses by taxpayers. In some instances they
represent the government advocating a position. However, the important lesson to glean
from this text is not only to understand the information included, with an attempt to apply
this data to day-to-day transactions, but also to avoid these pitfalls and to ask how to
structure a transaction so as to avoid the problems raised in a given case, ruling, etc.

For example, if we find in a given case that a transaction was structured in a fashion
that generated boot, that is, property that is not subject to special deferral treatment, we
might ask ourselves how the transaction might have been structured to avoid the result.

In another case, a transaction might not have qualified for an exchange because it was
structured improperly. Rather than stopping at that point, we should ask ourselves at the
end of each case, each ruling, and so forth: How could the transaction have been
structured to have it qualify under Section 1031, Internal Revenue Code of 1986, if that is
the desire of the taxpayer?

Sometimes the courts tell us what was wrong and how the result could have been
different. In other instances, we must draw our own conclusions from the information
given. The real benefit of the text must be to try to construct a way to avoid problems and
to be positive in tax planning.

The terminology used to refer to Code Section 1031 varies substantially from area to
area. We often hear the terms exchange, tax exchange, tax-deferred exchange, swap, or
trade, as well as various other labels. In this text, unless otherwise stated, all of these
words refer to 26 U.S.C.A., Code Section 1031, Internal Revenue Code of 1986, as
amended (generally referred to as the Code). Although one might refer to the matter as a
tax-free exchange, the emphasis is on deferring tax. Therefore, the terminology
emphasizing a tax-deferred exchange might be more technically correct, although
common usage often employs the label as "tax-free" exchange.

The discussion in this material focuses on federal income taxes. Thus, there is no
assurance that the rules noted will apply for other purposes, such as local income tax
rules under state laws, sales tax, use taxes, excise taxes, or any other purpose.

As a good example, many jurisdictions assess a sales tax where there is a transfer of
personalty. (This may be labeled a "use tax," if the property in question was previously
sold and is now being resold.) The point is that even though the property might be a
qualified tax-deferred exchange for federal income tax purposes, it may be a recognizable
(taxed) event for sales, use tax or other purposes!

We proceed to the history and development of the key statutory authority for tax-
deferred exchanges, viz., Code Section 1031.

The development of the entire area of tax-deferred transfers contains an interesting


background that lends much support to interpretative problems.

The legislative history of tax-deferred exchanges is traced to 1921, modified in 1924.


The development in 1924 is the predecessor of the concept under Section 1031.

As explained in B.N.A. Portfolio No. 61-3rd at B-9, the legislative history under the
concept of Section 1031 provided, prior to 1924, that gain or loss would not be
recognized, except when the property received in the exchange had a "readily realizable
market value." Since this phrase was unclear and required interpretation, it resulted in a
great number of conflicts; §1031 was modified to provide for the present concept of
nonrecognition for qualified exchanges of property.

Subsequent developments, especially in 1934, emphasized the intent of Section 1031,


and its predecessors, to provide for nonrecognition of property involved in like-kind
exchanges. The development of the "like-kind" test was subsequent to the earlier
language, which had emphasized that the gain or loss would not be taxed until the
taxpayer received marketable property, cash or other property not of the same type.

The provision is under the Revenue Act of 1924, Ch. 234, Section 203, 43 Stat. 256,
from the 68th Congress are:

Recognition of gain or loss from sales and exchanges.

(A) Upon the sale or exchange of property the entire amount of gain or loss,
determined under §202, shall be recognized, except as hereinafter provided in this
section.
(B)(1) No gain or loss shall be recognized if property held for productive use in trade or
business or for investment (not including stock in trade or other property held primarily
for sale, nor stocks, bonds, notes, chooses in action, certificates of trust or beneficial
interest, or other securities or evidence of indebtedness or interest) is exchanged solely
for property of a like kind to be held either for productive use in trade or business or for
investment, or if common stock in a corporation is exchanged solely for stock in the same
corporation, or if preferred stock in a corporation is exchanged solely for preferred stock
in the same corporation.

PURPOSES OF AN EXCHANGE

There are many reasons or purposes for an exchange, but the important point to
emphasize is that there is no impropriety or magic about an exchange. It is simply the use
of Section 1031 to postpone tax on a transaction by transferring qualified properties,
which the Code labels as "like-kind" properties.

Many transactions are possible exchanges, but the individuals involved might not be
aware of Section 1031, might be hesitant to try to employ that section, or might otherwise
hesitate to use this type of transaction. The system of exchanging or bartering property
has existed for thousands of years. The transfer of cash for property is a type of exchange.
However, we tend to think of like-kind property, as opposed to money, when we use the
exchange concept in the general sense. For example, one farmer might exchange one
food product for another type of food product.

In the real estate area, the exchanging of real estate for real estate is the essence of a
tax-deferred exchange. Although there are technical rules involved, the essence in a tax-
deferred exchange is one involving real property for real property, or personal property
for personal property, otherwise qualified.

WHO USES THE EXCHANGE METHOD?

The exchange technique is used by all of us in many transactions in our daily lives. We
exchange dollars for property, such as a loaf of bread, a tangible personal-type property;
we are also exchanging on more substantial transactions through our daily activities. It
may be trading in our old automobile on the purchase of a new automobile; it may be a
transfer of our old lawn mower for a newer lawn mower; there may be a transfer of one
bicycle for another bicycle.

Obviously, the tax benefit in the exchange area, in the pure sense of an exchange with
no unlike property, is the postponement of gain (subject to many detailed rules). This is a
benefit, for postponing the payment of tax gives the parties the time value (use) of
money. If we assume that the tax will eventually be paid on the given property (which is
not always the case), and that there has been a tax-deferred exchange under Section 1031,
the benefit may rest simply in the fact that the taxes, which will eventually be due, are
paid in the future as opposed to the present. The postponement of those taxes gives the
debtor-taxpayer the benefit of using those tax dollars until some future date.

OVERVIEW OF TAX-DEFERRED EXCHANGES

Code Section 1031 provides for the possibility of property held for productive use or
investment being exchanged in a fashion that avoids current recognition of taxable
income.

Section 1031 is not voluntary. It specifically provides that the gain or loss shall not be
recognized (taxed) if property that is held for productive use in trade or business or for
investment is exchanged solely for property of a like-kind to be held either for productive
use in trade or business or for investment purposes.

Section 1031(a) provides a number of interpretive problems. For example, it deals with
"property" that is exchanged. A question might arise as to whether a given transaction
involves property or instead services or some other interest.

It provides that "no gain or loss shall be recognized. Most of the time taxpayers would
prefer to defer tax on gain, but to take a loss in the current year. Therefore, we find
different motivation and different planning by taxpayers, contingent upon whether they
expect a gain or a loss.

It also provides that the gain or loss be "recognized." This term is interpreted in the
Code to mean paying tax or being taxable at the current time. Technically speaking, Code
Section provides generally that on the sale or exchange of property, the entire amount of
gain or loss "shall be recognized." Therefore, Code Section 1031 is an exception to the
general rule under Code Section 1001.

Code Section 1001 compares recognized versus realized gain or loss. Generally
speaking, realized gain is the amount that is obtained from the disposition [Code
§1001(b)]. Although an amount might be a realized gain or loss, it is not necessarily
recognized, meaning, in our general use, reported on the tax return and subject to
taxation.

These points are emphasized since Code Section 1031 is an exception that provides for
the postponement, the nonrecognition, of gain or loss on qualified property.

Section 1031(a) also requires that the property be held for productive use in trade or
business or for investment. More detail on this interpretative problem is discussed
subsequently in this Chapter.

The language also excludes certain items from this category, such as stock in trade,
items primarily held for sale, and certain other types of property. This is discussed fully
later in this Chapter, but it is important to note at this point that not all types of property
qualify for this special postponement rule.

The requirement that the property be exchanged raises substantial interpretative


problems. For instance, does the word "exchange" mean that the transfer from A to B, of
A's property to B, and B's property from B to A, must take place simultaneously? This
problem is examined in detail in the now famous Starker cases, discussed in Chapter 10,
along with similar questions.

Other interpretative problems include, "What is like-kind property?" Generally


speaking, if the property is otherwise qualified, that is, property held for productive use in
trade or business or for investment, one can exchange real property for real property or
personal property for personal property and have a like-kind exchange. This is not an
absolute statement as the reader will see. For example, gain can be recognized when one
exchanges an apartment building (that had been depreciated (or ACRS by an accelerated
method) for raw ground, because of the possibility of recapture of depreciation under
Code Section 1250. The main point is that, in general, one can exchange real estate for
real estate or personalty for personalty and avoid the requirement of currently paying tax
-- assuming that the other Code Section 1031 requirements are met.

Certain types of property are specifically excluded from Section 1031(a). The
subsection provides that it will not apply to stock in trade. What is "stock in trade"? Does
a real estate developer hold all of his property as stock in trade? Possibly property held
"primarily for resale" or stock in trade might be changed as to the intent and purpose for
its use. A home builder might hold real estate to build homes. The intent is to hold the
realty primarily for sale. However, this intent could change as a result of other events,
such as a decision by the developer to hold certain of the homes as rental property. On the
other hand, property that was previously held for investment property could be changed
to a dealer-type property (primarily for resale), as in the conversion of an apartment
building from its general investment or business use to selling off individual units. Under
the current status of the law, this would generally be held to be property held "primarily
for sale" and thus not be qualified for Code Section 1031 treatment. (Obviously, though,
if it was held primarily for resale, it would not meet the definition of Code Section 1221,
defining a capital asset; therefore, the gain or loss generated from the sale of the units
would not be capital gain.)

A number of the points that are mentioned in this Chapter merit greater study, but may
be outside the scope of this text. A good example is the discussion with regard to the
question of dealership. Although that question can also be important under Section
1031(a), a detailed examination of the dealership issue requires additional in-depth
analysis. Subsequent material in this text examines that question in more detail, although
a number of issues may require further study, outside the text, where dealership does not
apply to exchanges. For further reference on general real estate problems, see this
Author's texts, Real Estate Transactions, Tax Planning (see Bibliography for citations).
Section 1031 also mentions that property will not qualify if it involves stocks, bonds,
notes, chooses in action, certificates of trust or beneficial interests, or other securities or
evidence of indebtedness or interest. Does the exchange of property to a group of
investors constitute a real estate security for purposes of the 1933 Securities Act and the
1934 Securities Exchange Act? If it does, then by definition, it would be excluded from
Code Section 1031 treatment.

It is obvious that it may be difficult to know whether a transaction will qualify within
Section 1031 until there has been an interpretation of certain key words. Evidence of
indebtedness, security, primarily held for resale, stocks, partnerships and similar words,
are only a few examples of the myriad number of questions that can arise in interpreting
Section 1031.

Sometimes it may be advantageous to have a tax-deferred ("tax-free") exchange;


sometimes it may not be advantageous. A distinction should be made between a "tax-
free" exchange and a "tax-deferred" exchange. Most exchanges are not in fact tax-free,
per se, but are merely deferred. Section 1031 is intended merely to postpone the gain or
loss in question, not to avoid it altogether. This is examined in more detail under the
discussion of basis, controlled by Section 1031(d), which follows in Chapter 12.

The important point to note is that if the gain was excluded forever, such as when a
person, who is otherwise qualified, sells his principal residence and is allowed to
eliminate or exclude up to $125,000 worth of gain (Code Section 121), this would be a
true elimination or exclusion. This is not the intent of Section 1031. The label "tax-
deferred" as opposed to "tax-free" is more acceptable. However, throughout this text, tax-
free and tax-deferred are usually meant to be synonymous when used by the courts, etc.
(This distinction should nevertheless be kept in mind.)

Section 1031 is not elective. Since it operates automatically if the requirements are met,
a taxpayer who anticipates a loss would not generally desire to postpone the recognition
of that loss on his tax return. Section 1031(c) provides that if an exchange is met under
Code Section 1031(a), the loss will not be recognized.

Since the use of Section 1031(a) is a double-edged sword, cutting and benefiting the
taxpayer, the taxpayer must carefully plan transactions to avoid Code Section 1031 if a
current loss deduction is desired.

This is not to say that taxpayers can simply set up reciprocal arrangements and avoid a
Section 1031 application. As an example, the taxpayer could not agree to buy a new car
from an automobile dealer for a given price and simultaneously, but by a different piece
of paper, agree to sell his car to the auto dealer for a given price. The government would
take the position that Section 1031 applies, even though the taxpayer might have had a
loss on the car which he "sold" separately; the government would in all likelihood take
the position that there were reciprocal arrangements. The loss should not be recognized.
It should be treated as part of the transaction involved in the purchase of the new car.
This would most likely be the practical intent of the parties in any event. This is not to
say that one could not reasonably structure a transaction to have the loss recognized. This
is discussed in detail, later.

As to "like-kind" property, property that can qualify, under the Treasury Regulations
(interpretations by the Internal Revenue Service of the Code), it is property which is like-
kind relative to the character or nature of the property, and not with regard to its grade or
quality. It is not clear how to apply this language. The best thing that can be said at this
point, to generalize, is that in most circumstances, if the property is otherwise qualified
within Section 1031, real property for real property can qualify for an exchange, and so
can personalty for personalty.

The cases that have arisen have been fairly flexible. For example, unimproved ground
could be exchanged for an office building and be tax-deferred. A fee simple interest in
water rights that are considered real estate can be exchanged for a fee simple interest in
land (real property).

Other cases have held that foreign real estate can be traded for domestic real estate.
There is no requirement under Section 1031 that the property be located within the
continental United States.

Personalty cannot be exchanged, tax-deferred, for realty or realty for personalty. This
issue may arise when there are exchanges involving multiple pieces of property, such as
an exchange of a furnished apartment building for an exchange of an unfurnished office
building. Although part of this may qualify, obviously part will not. At least in part, there
is personalty being exchanged for realty.

Code Section 1031(b) provides that if the exchange would be within Section 1031,
were it not for the fact that the property received in the exchange consisted not only of
property which is allowed by the section, but also other property or money, the gain, if
there is any, to the recipient would be recognized and taxed on his return. The amount of
gain taxed will not be in excess of: (1) the sum of money or property (fair market value of
the property), or (2) the gain, again, the lesser of the two. The Regulations have provided
that a leasehold interest of 30 years or more is the equivalent of a fee for purposes of
Section 1031. As such, this type of leasehold can be exchanged for an interest in fee
simple realty and can qualify under Section 1031.

The use of the property that is important in a Code Section 1031 consideration is the
"use" in the hands of the recipient. If B was exchanging property, such as a rental house,
with C, who was occupying the house, it may still be a tax-deferred exchange for B,
when B acquires C's house, if B intends to rent or lease C's house to some third party.
There mere fact that C occupied the premises as his own residence does not disqualify the
property for B.

This would not be a tax-deferred exchange for C; C is not trading like-kind property
used in his trade or business or for investment (income) use.
A number of other situations raise the question as to whether property qualifies as like-
kind property and otherwise meets the definition under Code Section 1031(a). The Meyer
case dealt with the exchange of an interest in a partnership. (The Meyer case is abridged
and analyzed in Chapter 11.)

Another issue is whether, under Section 1031, an interest in a partnership can be


exchanged for another interest in another partnership. Although a few cases permitted
this under limited circumstances, it will not qualify under current laws. (See Chapter 7.)

THE QUESTION OF BASIS

Since the intent of Section 1031 is to postpone gain, to defer it, but not eliminate it, we
need some means to have the gain "come back in" in the future. This method of
postponing gain is accomplished, in part, by an adjustment to basis.

If B transfers property with an adjusted basis of $10,000 to C, for like-kind property,


the transaction would result in a postponement of gain.

If we also assume that the fair market value of the property that B transfers is $50,000,
and assuming there are no mortgages on the property (to simplify the illustration to
concentrate on basis), we could also assume that the property that B is receiving from C
is worth $50,000. If this is the case, without Section 1031, B would have:

Fair market value of C's


$50,000.00
property
Adjusted basis of B's property -10,000.00
Net profit to B (realized gain) $40,000.00

We see a potential, or more correctly, a realized profit, of $40,000. However, since we


have assumed that Section 1031(a) applies, the $40,000 is not recognized; that is, it is not
taxed to B.

Two years after acquiring C's property, which we might label C-1, B disposes of that
property for $60,000. We need to calculate the recognized gain.

If we assume that B has a basis in the C-1 property of $50,000, that is, the fair market
value of the C-1 at the time of the exchange, the gain to B would be $10,000. However, if
this is the case, B would escape the potential of realized gain that he had never reported
because of Section 1031(a). To avoid this result, B must change the basis, as adjusted,
into the new property.

Basis is discussed in more detail in Chapter 12. The basis of $10,000 would be taken by
B into the new property, C-1. As such, the price of $60,000, less the $10,000 basis, would
produce a net gain of $50,000. This is the correct recognized gain for the example, as
$40,000 gain had been deferred. The property has also increased in value.

Section 1031(d) provides that if property is acquired by an exchange under Section


1031(a), the basis to the taxpayer would be the same as that of the property he transfers.
In the example given, this would be $10,000. Section 1031(d) also provides that the basis
is decreased by the amount of any money received by the taxpayer. (In our example, the
taxpayer did not receive any money.)

Basis is also increased by the amount of any gain or decreased by the amount of any
loss to the taxpayer that was recognized when the exchange took place. These
considerations are reviewed later in the text, Chapter 12.

Section 1031(d) also provides that if the property acquired in the exchange consists of
property which is in part like-kind property, and, therefore, qualifies for postponing the
recognition of gain or loss; it also includes property which is not qualified, the basis
which is provided in the Code has to be allocated between the properties, except for
money. (Money [current currency] has a value equal to its face.) For the purposes of
allocation, there has to be an assignment to each property of part of the basis, in
proportion to its fair market value at the date of the exchange. There is an apportionment
or spreading of the basis among the various properties, based on the fair market value at
the time the exchange takes place.

Where the exchange involves liabilities on one side or the other (when the taxpayer
agrees to pay a liability), adjustments must be made for the changes in basis. If B
transfers property worth $50,000 to C for other qualified property transferred from C to
B, which we will label C-1, we must look to the basis rules. If C-1 had a fair market value
of $100,000, with a loan on the property, which B agrees to assume or take subject to, B's
basis would be, generally speaking, B's adjusted basis in the property which he transfers
to C (assume it is $10,000) increased by the loan on the C-1 property that B assumes.

Therefore, B's basis is:


B's basis of the property
$10,000.00
transferred
C-1 loan +50,000.00
Total new/adjusted basis to B $60,000.00

B's basis of $60,000 should make sense if we take the next step and assume B later
disposes of the C-1 property to D. Assuming a prior tax-deferred exchange for B, B
would calculate his gain by taking the fair market value of property received, reduced by
his basis.

Money received by B from D $100,000.00


B's adjusted basis (above) -60,000.00
Total gain to recognize $40,000.00
This is a reasonable conclusion as to what should take place. We are assuming that B
invested $10,000 in his original property, which we labeled B-1; B had a loan on the C-1
property, which we are assuming that B paid: this was another $50,000, or a total of
$60,000 for his adjusted basis. Therefore, the recognized gain will be $40,000 ($100,000
reduced by $60,000).

There are numerous considerations relative to basis and adjustments. These may
include some of the items noted, loans on both sides, and the fair market value of
property received or transferred. Chapter 12 on Basis and Holding Period should be
considered in conjunction with the forms collected in Appendix 3.

When property is received that is not like-kind property, we describe this as "boot."
Boot is simply a label used to refer to non-like-kind property.

MORTGAGES: ASSUMED AND SUBJECT TO, WRAPS, ETC.

Mortgages have a number of implications in the tax-deferred exchange area, whether


the mortgage is personally assumed (i.e., liability in the party "taking over" that debt), or
whether it is taken "subject to," meaning that the person acquiring the property with a
mortgage on it does not agree to pay it, with personal liability, but merely acknowledges
that property is subject to the debt and agrees that if he does not make that payment, the
property could be lost to the holder of the secured interest (i.e., the mortgagee).

We have also seen the development of other types of financing, sometimes called
"creative financing" or other generic terms. Thus, one might use a "wrap-around
mortgage," "all-inclusive Note and Deed of Trust," or "contract for deed" with this
setting. These are not unique to the exchange area. However, definitions and a reasonable
understanding of terms is important for the exchange concept.

1. When we use the term "assume," we are taking the position that the party "taking
over" the mortgage agrees that he is personally liable. If payments are not made, the
holder of the encumbrance (mortgage) on the property and the note could sue the given
party. Thus, if A transfers his property to B, and B assumes the mortgage, B agrees to be
personally liable to the holder of the mortgage, perhaps a bank.

2. If A transfers his property to B, and B agrees to take the property subject to the
mortgage, the bank could look to the property as security, but it could not sue B,
individually, for any debt related to the subject property.

3. Perhaps the loan on the property is wrapped. To illustrate: A transfers property to B,


with a mortgage on it of $50,000. The sales price is $100,000, with B paying $20,000 in
cash to A. Thus, we have a mortgage of $50,0000, cash of $20,000, and a difference of
another $30,000. Rather than assuming or taking subject to the $50,000, the parties agree
that B will execute a "wraparound mortgage" (sometimes referred to as an all-inclusive
note and deed of trust) in favor of A. A would receive $20,000 in cash from B, with a
note for $80,000, and a mortgage or deed of trust in favor of A. B will make his payments
to A on the $80,000, and A will continue making the payments on the $50,000 obligation
owing to the third party. The $50,000 is "wrapped" by the $80,000 Note.

Some of the details and the implications, tax and non-tax, of using these procedures in
an exchange are discussed in Chapter 9, Cash Boot Given and Debt Relief.

4. The contract for deed is similar to the wraparound. The contract for deed or "land
contract," as it is sometimes labeled, imposes an additional point that legal title does not
pass at this time. Using the wraparound example, A might transfer a contract to B for B
to buy the property for $20,000 cash down, with a contract for deed from B to A for
$80,000 owing. The contract would provide that A would transfer legal title to B (or
possibly use an escrow agent), when B makes certain additional payments or possibly
when the balance of the amount owing, $80,000, is paid. The tax and certain other legal
implications for using these documents are examined in Chapter 2.

MULTIPLE TAX-DEFERRED EXCHANGES

In the exchanges we have analyzed thus far, we have assumed that only two parties are
involved in the exchange; we sometimes label this is a "two-way exchange." In may
instances, it may be that B is interested, not in A's property, but in C's. We might need to
involve an additional party, C. It may be that C would exchange his property with B. This
would be Step 1. In Step 2, we might have a subsequent exchange with A for the
property, now held by B. This may satisfy the requirements of all of the parties. This
three-way or multiple party exchange follows many of the same principles that are
developed throughout the text, although there are certain unique factors that must be
considered when multiple parties are involved, as opposed to simply two parties.

This important area of multiple party exchanges illustrates the importance of following
the proper format to support an exchange. If the exchange is not structured properly, if
Step 2 takes place before Step 1, it may destroy a tax-deferred exchange for A, who
desired the tax-deferred treatment. This area is reviewed in detail in Chapter 11 on
Multiple Party Exchanges.

RELATED PARTIES AND TAX-DEFERRED EXCHANGES

There has been much discussion in recent years on exchanges and other transactions
taking place between parties who are related. An exchange between a husband and a
wife, a father and a child, or a parent and a trust created for the children are examples of
exchanges involving related parties. There has been a great deal of discussion on this
topic when there are installment sales between related parties.

There is less concern in the area of exchanges between related parties, although it is
still an important point to consider, especially an exchange which would otherwise allow
recognition of a loss. The loss might be disallowed because of an exchange between
related parties. (See Code Section 267; Levine, Real Estate Transactions, Tax Planning,
West Publishing Co., 1991; see also legislation in 1989, discussed infra.)
TAX-DEFERRED DEFERRED EXCHANGES

There may be a non simultaneous exchange. One might label this a "tax-deferred
deferred exchange." The reason for what might appear to be a redundancy is that in at
least a few major cases, the Starker series, the courts have allowed a non simultaneous
exchange to be tax-deferred. Although a typical Section 1031 transaction defers the
recognition of gain or loss, when it is non simultaneous, we might have a temporary
deferral (or a completion of the deferral) once the exchange takes place.

The essence of the Starker cases (Chapter 10) involves a situation where taxpayers, the
Starkers, transferred property to other parties, Crown Zellerbach and Fibre Products, but
Crown Zellerbach and Fibre did not transfer property to the Starkers, at least at the time
the Starkers transferred their property to Crown and Fibre. The question was whether
these exchanges qualified under Section 1031. As the subsequent material reveals, some
courts have allowed this unusual type of deferral to qualify. The Code now allows some
non simultaneous exchanges to qualify.

For a discussion of the pros and cons of the use of Code §1031 and whether that
Section should continue in existence, or whether Congress should repeal it, see Dorocak,
John, "Protecting Real Estate Investors: The Fight To Maintain the Like-Kind Standard
For Exchanges Under Section 1031," Tax Notes 1203 (5/30/94). For the full article, see
33 Santa Clara Law Review 571 (Spring, 1993). See also Kornhauser, Marjorie, "Section
1031: Conceptually Confused, Inefficient, and Inequitable," Tax Notes 1207 (5/30/94).

CODE §482 AND RELATED PARTIES UNDER CODE §1031: PRIVATE LETTER
RULING 9222005

This Ruling addresses the issue as to whether Code §482, the Section that allows the
reallocation of income, deductions, losses, credits or allowances between related parties
or among certain businesses, if otherwise there would be a distortion of income, can
apply even when there is an exchange under Code §1031 when that exchange involves
related parties.

The Treasury ruled that Code §482 is applicable, even in this setting; therefore, they
would not express an opinion as to whether the transaction qualified for nonrecognition
under Code §1031, given the factual setting with the application of Code §482.

PRIVATE LETTER RULING 9222005

Section 482 ?? Allocations Between Related Parties

Publication Date: May 29, 1992 * * * *

ISSUE
Whether Section 482 of the Internal Revenue Code may be applied when intangible
property is exchanged by related entities pursuant to the terms of a cross?licensing
arrangement.

FACTS

During the taxable years 1984 though 1987, A exchanged know?how and patent rights
with B under the terms of a cross?licensing arrangement dated October 29, 1982. The
arrangement provided that A would transfer certain technology to B, along with future
improvements and developments, and that B would transfer future technological
developments (if it developed any) relating to that technology to A. The parties agreed
that the transfers would be on a royalty?free basis. The technology transferred between A
and B consisted of equipment, processes and products relating to the production and sale
of items incorporating product x. The parties expected to build on each other's
technological developments, and it appears that this expectation was realized. The
taxpayer cites a number of instances in which A received the benefit of B's technology.
Throughout the period in issue, A owned, directly and by attribution, more than 50% of
B.

The taxpayer asserts that the cross?licensing arrangement resulted in a "like?kind"


exchange of property under the terms of Section 1031 of the Code, and, therefore, that no
gain was recognized on the exchange. The taxpayer also argues that when intangible
property is transferred between related entities under a nonrecognition provision, the
Service should not make section 482 allocations with respect to income generated by that
property unless (1) the exchange was undertaken primarily for a tax avoidance purpose,
or (2) the exchange resulted in a distortion of the taxpayer's income for the taxable year
by causing a mismatching of income and expenses. Because we conclude that section 482
is applicable to a transaction between related parties even if that transaction might
otherwise qualify as a nonrecognition transaction under section 1031, it is not necessary
to decide for purposes of this technical advice whether or not the transaction qualifies for
nonrecognition treatment under section 1031 of the Code.

LAW AND ANALYSIS

Section 482 of the Code reads in part as follows:

In any case of two or more organizations, trades, or businesses owned or controlled


directly or indirectly by the same interests, the Secretary may distribute, apportion, or
allocate gross income, deductions, credits or allowances between or among such
organizations, trades, or businesses if he determines that such distribution,
apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to
reflect the income of any of such organizations, trades, or businesses. In the case of any
transfer (or license) of intangible property (within the meaning of section 936(h)(3)(B)),
the income with respect to such transfer or license shall be commensurate with the
income attributable to the intangible. [FN1]

Here, there is no dispute that A and B are separate businesses controlled by the same
interests, and that section 482 could, in general, be applied to transfers of intangible
property between the two entities. The taxpayer simply claims that section 482 can not be
used to recognize income in what would otherwise be a nonrecognition transaction,
except under the circumstances mentioned above.

The taxpayer bases its argument on section 1.482?1(d)(5) of the Income Tax
Regulations, as interpreted by the Tax Court in Eli Lilly v. Commissioner. [FN2] Section
1.482?1(d)(5) provides that section 482 may be applied in circumstances providing for
nonrecognition of gain or loss "when necessary to prevent the avoidance of taxes or to
clearly reflect income." In Eli Lilly, the Tax Court noted that section 482 allocations
involving nonrecognition transactions are generally upheld only in the circumstances
described by A, that is, when the primary purpose of a nonrecognition transfer is tax
avoidance, or when a nonrecognition transfer results in a mismatch of income and
expenses. Thus, the Eli Lilly Court did not allow the Service to completely disregard the
taxpayer's section 351 transfer of intangible property to a subsidiary, refusing to permit
the reallocation of ALL of the income attributable to the intangible property to the parent
company. [FN3] However, the Court also noted that "section 482 authorizes respondent
to make allocations among related taxpayers clearly to reflect income even in the context
of a nonrecognition provision," [FN4] and it permitted a partial section 482 allocation.
[FN5]

Since Eli Lilly was decided, Congress has enacted legislation aimed at preventing abuse
of Internal Revenue Code provisions providing for nonrecognition treatment of transfers
of intangible property from U.S. corporations to foreign subsidiaries. For instance,
section 367(d) [FN6] of the Code states that when intangible property is transferred by a
U.S. person to a foreign corporation in an exchange described in section 351 or 361, the
transferor will be treated as having sold the property, and amounts received will be
characterized as ordinary income from U.S. sources. In a 1986 amendment to the Code,
the second sentence was added to section 482, embodying the "commensurate with
income standard," and sections 367(d) and 936(h) (which allows a possessions
corporation to be treated as a partial owner of intangible property used in a possessions
product) were changed to reflect that standard.

The General Explanation [FN7] of the Tax Reform Act of 1986 gave the following
reason for the legislation: Congress was concerned that the provisions of sections 482,
367(d), and 936 that allocate income to a U.S. transferor of intangibles may not have
been operating to assure adequate allocations to the U.S. taxable entity of income
attributable to intangibles in these situations (the situations included the Eli Lilly transfer
of intangible property to a possessions corporation under section 351). [FN8] In other
words, Congress enacted legislation to ensure that section 482 was applicable to transfers
of intangible property in nonrecognition transactions.
If section 482 of the Code did not apply to section 1031 transactions, a serious gap
would exist in the 1986 legislation. Taxpayers would be able to transfer intangible
property developed in the U.S. to a foreign affiliate in exchange for other intangible
property; however, under the taxpayer's rationale, the Service would never be able to
determine whether the value of the property received by the U.S. entity was
commensurate with the income attributable to the property transferred overseas. Congress
recognized in 1986 that the value of intangible property is often difficult to determine at
the time that the property is transferred. The commensurate with income or "look? back"
rule was added to section 482 to ensure that, when a lump sum price was paid for
intangible property transferred out of the U.S., the Service could adjust the price later to
reflect the income actually generated by the intangible property. The rule ensures that a
U.S. entity will receive an appropriate return for the fruits of research and development
performed in the United States. Congress did not provide an exception to this rule for
property transferred "lump sum" in a section 1031 exchange, and it would undercut the
effectiveness of the commensurate with income standard if such an exception were
implied by the Service.

Section 482 of the Code would not be applied to transfers under the A?B agreement if
the agreement were considered a bona fide research and development cost sharing
arrangement, as defined in section 1.482?2(d)(4) of the regulations. A bona fide cost
sharing arrangement is an agreement, in writing, providing for the sharing of the costs
and risks of developing intangible property in return for a specified interest in the
intangible property that may be produced. The A?B "cross?licensing" arrangement
appears to have the characteristics of such an arrangement: research and development
was conducted by each party, the results were shared, and rights in the intangible
property developed were apportioned by the parties.

However, Notice 88?123 ("A Study of Intercompany Pricing under Section 482 of the
Code") [FN9] indicates that under a bona fide research and development cost sharing
arrangement, a participant must be compensated for fully developed intangible property
contributed to the arrangement, in any amount consistent with the "commensurate with
income" standard. [FN10] Cost sharing may not be used a means of avoiding the
"commensurate with income" standard of section 482. Thus, B should have paid A an
arm's length royalty for the original intangible property that A contributed to the
arrangement.

In addition, parties to a bona fide research and development cost sharing arrangement
must ensure that each participant's benefit from the arrangement is commensurate with
the participant's cost share. Benefit may be measured in a number of ways, such as by the
sales of each participant of products incorporating intangible property developed by the
group. Therefore, if B did not "buy into" A's research, and if A can not show that its
research costs were proportionate to the benefits that it received, a section 482 adjustment
to the income of A should be made.

Thus, on the basis of section 1.482?1(d)(5) of the regulations, allowing section 482 of
the Code to be applied in circumstances providing for nonrecognition of gain or loss
"when necessary to prevent the avoidance of taxes or to clearly reflect income," we
conclude that section 482 may be applied to clearly reflect the income of two controlled
entities engaged in an exchange of intangible property. Our analysis is supported by the
additions made to sections 482, 936 and 367 by the 1986 Act. Specifically, section 482
may be applied to reallocate income with respect to an exchange qualifying under section
1031 even though (1) there was no tax avoidance purpose for the exchange, and (2) there
was no artificial separation of income from expenses.

As a final note, we suggest that the provisions of section 1.482?1(d)(3) of the


regulations be considered in connection with any section 482 allocation of income from
B to A. Section 1.482?1(d)(3) provides as follows: In making distributions,
apportionments, or allocations between two members of a group of controlled entities
with respect to particular transactions, . . . the district director shall also consider the
effect of any other non arm's length transaction between them in the taxable year which,
if taken into account, would result in a setoff against any allocation which would
otherwise be made, provided the taxpayer is able to establish with reasonable specificity
that the transaction was not at arm's length and the amount of the appropriate arm's length
charge. Thus, if the cross?licensing agreement was not an arm's length arrangement, it
may have produced nonearning length results with respect to both A and B in the same
year.

CONCLUSION

Section 482 of the Code may be applied to reallocate income with respect to an
exchange between related parties regardless of whether the transaction otherwise
qualifies under section 1031.

In view of the foregoing, no opinion is expressed regarding whether or not the


transaction in question qualifies for nonrecognition treatment under section 1031 of the
Code.

The section's second sentence was added by the Tax Reform Act of 1986, Pub. L.
99?514 section 1231(e)(1). The amendment applies to transfers and licenses after
November 16, 1985, and to licenses granted before that date "with respect to property not
in existence or owned by the taxpayer on such date." Thus, the provision applies to any
exchange made under the A?B cross? licensing agreement after November 16, 1985.

CHAPTER 2:
HISTORY OF SECTION 1031: CASES

Three cases, Detroit Egg Biscuit, Mercantile Trust Co., and Harr, illustrate the early
development of Code Section 1031. (As mentioned in the Preface, portions of the court
cases throughout the text have been italicized by the Author, for emphasis. Other items,
not relating to the exchange, have been deleted.)
SALE OR EXCHANGE: DETROIT EGG BISCUIT

In the 1928 Detroit Egg Biscuit case, the question was whether the transaction
qualified as an exchange or a sale.

The Court said that where one contracts to transfer a factory and site for money
consideration, and in fact does sell, and in the same contract agrees to use the money
received to purchase a new site and erect a new factory, this is a sale and not an
exchange.

Although the taxpayer intended to take the money for reinvestment, it did not execute a
qualified exchange. Note again the importance of form.

DETROIT EGG BISCUIT & SPECIALTY CO., PETITIONER, v. COMMISSIONER


OF INTERNAL REVENUE, RESPONDENT. 9 B.T.A. 1365 (1928)

This proceeding is for the redetermining of a deficiency in income and profits taxes in
the amount of $19,796.22 asserted by the respondent against the petitioner for the year
1920.

FINDINGS OF FACT

The petitioner is a corporation organized under the laws of Michigan in 1906. In that
year it acquired by purchase real estate at Hastings Street and East Grand Boulevard, in
Detroit, and erected thereon a brick factory building, with wooden joists and floors, 45
feet wide by 79.6 feet long, which covered practically all of the lad. The petitioner
occupied the premises continuously until some time in 1920. The useful life of the
building was 33 years from March 1, 1913.

On December 12, 1919, the petitioner and the Goodyear Improvement Co. entered into
the following written contract:

WHEREAS, the Detroit Egg Biscuit and Specialty Company, a corporation of the City
of Detroit, Michigan, hereinafter called the first party, is the owner of Lot 219 and the
west 1/2 of Lot 218 of Frisbie and Foxen's subdivision of part of fractional section 31,
and Lot 18 of Theodore J. and Dennis J. Campau's subdivision of fractional sections 29
and 32, town 1 south, range 12 east, according to the plat recorded in Liber 6 of plants at
page 78, Wayne County records, upon which is located its plant and first party desires to
sell said property to the Goodyear Improvement Company, a corporation of Akron, Ohio,
hereinafter called second party and second party desires to purchase the same.

AND WHEREAS, first party is about to purchase property at the southeast corner of
Custer and St. Antoine Streets in the City of Detroit aforesaid for the purpose of erecting
thereon a new plant, and is about to erect thereon such new plant under the supervision of
Smith, Hinchman & Grills at a cost of approximately $40,000.00. Now therefore it is
agreed as follows:
1. In consideration of the sum of Eighty five Thousand ($85,000) Dollars to be paid by
second party to first party, first party agrees to convey to second party by Warranty Deed
free and clear from all incumberances the property first above described, and will also
within thirty (30) days after the date of this agreement deliver to second party a Burton or
Union Trust Company abstract, showing good and marketable title in the first party.

2. Said Eighty?five Thousand ($85,000) Dollars shall be paid by second party to first
party as follows: Five Thousand ($5,000) Dollars on the execution and delivery of this
contract, the receipt of which is hereby acknowledged.

Five Thousand ($5,000) Dollars on December 15, 1919. It is agreed that party will use
said $10,000 to purchase said lot at the southeast corner of Custer and St. Antoine Streets.

Five Thousand ($5,000) Dollars on January 1, 1920.


Ten Thousand ($10,000) Dollars on January 15, 1920.
Ten Thousand ($10,000) Dollars on February 1, 1920.
Ten Thousand ($10,000) Dollars on March 1, 1920.
Five Thousand ($5,000) Dollars on March 15, 1920.

The balance of Thirty?five Thousand ($35,000) Dollars shall be paid upon the
execution and delivery of said Warranty Deed and upon the surrender of possession by
first party, which possession shall be surrendered by first party within fifteen (15) days
after Smith, Hinchman & Grills notify first party and second party by letter that said new
building at the corner of Custer and St. Antoine Streets is substantially completed; it
being understood that the item of oven equipment is not a part of the building. No interest
is to be allowed on deferred payments.

3. First party agrees within ten (10) days from the date hereof to purchase said property at
the corner of Custer and St. Antoine Streets and within a like time agrees to enter into a
contract for the erection of a building thereon suitable for their needs, said contract to be
made with reputable contractors, through Smith, Hinchman & Grills. First party further
agrees to use their best efforts to secure the completion of the said building at the earliest
possible date so that second party can be given possession of the property first above
described as soon as possible.

This contract was carried out by both parties according to its terms, and in 1920
petitioner transferred the property to Goodyear Company.

The fair market value of the property on March 1, 1913, was $25,000. In its tax return
for the year 1920 petitioner did not include any profit from its transaction with the
Goodyear Company, but it later admitted a taxable profit on the sale of real estate
amounting to $26,109.53, basing its computation on a fair market value of $60,000 as of
March 1, 1913. The respondent, taking $14,000.46 as the depreciated cost at March 1,
1913, and allowing for subsequent depreciation, computed the profit on the Goodyear
transaction to be $73,468.48.
OPINION

MARQUETTE: The petitioner claims (1) that the Goodyear transaction was an exchange
of property, not a sale, and that there was no taxable gain; (2) that if the transaction is
held to be a sale, then the March 1, 1913, value of the property should be considered as
greatly in excess of its cost, and that this increased value should be the basis of
computing the taxable gain, and (3) that the annual depreciation rate on the building
should be 2 per cent.

The facts do not sustain the petitioner in its contention that it exchanged property with
the Goodyear Company. The latter contracted to buy the petitioner's property and made
the cash payments called for by the contract. The petitioner purchased a new factory site
and erected thereon a new factory building at a total expenditure of about 61 per cent of
the price paid by Goodyear to the petitioner for its property. In our opinion the
transaction was a sale, not an exchange, and the respondent was right in so treating it.

A TAXPAYER MAY PLAN AN EXCHANGE: MERCANTILE TRUST


CO.

In the 1935 decision of Mercantile Trust Co. v. Commissioner, the taxpayer argued that
a hotel building and certain other property known as the Baltimore Street property were
exchanged for cash and like-kind property to be held for investment. The Court confirmed
that the taxpayer could have sold the property for cash. They would have then reinvested
the money that they received. But, to avoid tax, they structured the transaction as an
exchange under then Section 112(b)(1), Revenue Act of 1928.

The government admitted that the transaction certainly did not involve any fraud. The
question was whether there was any impropriety by the taxpayer trying to structure the
matter as an exchange to avoid paying tax.

The purpose and effect of the provisions for a tax-deferred exchange permit the
postponement of recognition of the taxable gain or loss upon an exchange until the
disposition of the property received in the exchange. Nonrecognition of gain or loss does
not depend upon the impossibility of a sale of the property by the taxpayer. The fact that
the taxpayer could have sold it for cash does not mean that he cannot structure it in the
form of an exchange. The Court concluded that the petitioners had exchanged real
property held for investment for like-kind property to be held for investment, plus certain
cash.

MERCANTILE TRUST COMPANY OF BALTIMORE AND ALEXANDER C.


NELSON, TRUSTEES OF THE ESTATE OF CHARLES D. FISHER, PETITIONERS,
v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. 32 B.T.A. 82
(1935)

LEECH: This proceeding seeks redetermination of an income tax deficiency of


$21,285.68 determined against petitioners for the calendar year 1929.

Petitioners assign as error, the respondent's determination that they sold certain real
estate, theretofore held for investment. Petitioners allege that such property was
exchanged for cash and like property to be held for investment. In the alternative, if the
transaction is held to be a sale and purchase and not an exchange, petitioners assign
error in respondent's determination of the March 1, 1913, value of the property,
disposition of which was made in that transaction.

The stipulation of facts pertinent to the first issue, including the agreements, deeds,
checks, and papers executed by the several parties to the 1929 transaction in controversy,
is included herein by reference.

Petitioners are the duly constituted trustees of the estate of Charles D. Fisher, who died
testate in 1905. On and before March 7, 1929, as trustees of the Fisher estate, they held
title to two parcels of real estate known as 114?116 East Baltimore Street, Baltimore,
Maryland, hereinafter referred to as the Baltimore Street property. Such properties were
contiguous to the property known as the Emerson Hotel and were leased to and occupied
by a restaurant. At the same time the estate of Annie E. O. Wylie owned real estate
known as 223 West Lexington Street, Baltimore, Maryland (hereinafter referred to as the
Lexington Street property), which was rented under a long term lease to F. W.
Woolworth & Co.

On March 7, 1929, petitioners, as trustees of the Fisher estate, entered into a written
contract with the Title Guarantee & Trust Co. (hereinafter referred to as the Title Co.)
under the terms of which petitioners agreed with the Title Co. to exchange the Baltimore
Street properties, as an entirety in fee simple, for the Lexington Street property in fee
simple, subject to the outstanding lease thereon, and $33,000 in cash. The agreement
further provided that in the event the Title Co. could not obtain ownership of the
Lexington Street property by purchase, the petitioners could require the Title Co. to pay
$300,000 cash for the Baltimore Street properties in lieu of the above mentioned
exchange. The Title Co. paid $4,000 to petitioners at the execution of this contract, which
sum was to be credited to the Title Co. upon consummation of the transaction.

On March 11, 1929, the Title Co. entered into a written contract with the trustee of the
Wylie estate for the purchase of the Lexington Street property for a price of $267,000
cash. The Title Co. paid that trustee, at the execution of this contract, $1,000 to be
credited to the Title Co. upon consummation of that transaction.

On March 11, 1929, the Title Co. entered into a written contract for the sale of the
Baltimore Street property to the Emerson Hotel Co. for a price of $300,000 cash. The
Emerson Hotel Co. paid the Title Co. $5,000 upon execution of this contract, which was
to be credited to the Emerson Hotel Co. upon consummation of this transaction.

On April 15, 1929, the parties to the several contracts simultaneously executed the
following deeds of conveyance. The trustee of the Wylie estate deeded to the Title Co.
the Lexington Street property. The Title Co. deeded to the petitioners, as trustees of the
Fisher estate, the Lexington Street property. The petitioners, as trustees of the Fisher
estate, deeded to the Title Co., the Baltimore Street property. The Title Co. deeded to the
Emerson Hotel Co. the Baltimore Street property.

On the same date, April 15, 1929, pursuant to the contracts and deeds, the following
cash payments were made. The Emerson Hotel Co. issued its check payable to the Title
Co. in the sum of $294,416.67 representing the agreed purchase price of $300,000 for the
Baltimore Street property less adjustments for the $5,000 paid by Emerson Hotel Co.
upon execution of the contract of sale and rent for a half month. Such check was
deposited in the Title Co.'s bank account. The Title Co. issued its check payable to the
trustee of the Wylie estate in the sum of $265,478.42 representing the agreed purchase
price of $267,000 for the Lexington Street property, less adjustments for the $1,000 paid
by the Title Co. upon execution of the contract of sale and rent for a half month. The Title
Co. issued its check payable to the petitioner, Mercantile Trust Co., trustee of the Fisher
estate, in the sum of $28,938.25 representing that part of agreed purchase price to be paid
in cash (in addition to the deed to the Lexington Street property) for the Baltimore Street
property, that is, $33,000 less adjustments for the $4,000 paid by the Title Co. upon the
execution of the contract and rent for a half month. The petitioners paid commissions and
title fees amounting to $8,573.10, leaving the sum of $24,426.90 as the net cash received
on the transaction.

In their return for the Fisher estate for 1929, the petitioners reported a capital gain of
$24,426.90 as representing the net cash received on a transaction which was an exchange
of real property for other like property, held for investment.

The respondent disregarded the form of the transaction and determined that petitioners
sold the Baltimore Street property to the Emerson Hotel Co. for $300,000 cash and then
purchased the Lexington Street property in two separate transactions. He computed a
capital net gain of $179,621.10 as follows:

Sales Price Baltimore Street property $300,000.00


Less Commission and Title Fee 8,573.10
$291,426.90
Fair Market Value on March 1, 1913 $125,000.00
Less depreciation on value of building $41,000 at 13,194.20
2% for 15 years and 10 months $111,805,80
Capital net gain $179,621.10
Capital net gain reported 24,426.90
Increase $155,194.20
Respondent contends that while there is no imputation of fraud, 'because no deception
was practiced and means legal in themselves were used', the proposed exchange was a
sham device for tax avoidance. He further contends that the Title Co. acted purely as an
agent or dummy and not as a principal for the purchase and sale of either of the
properties; that the governing factor in the transaction was a sale of the Baltimore Street
property by petitioners to the Emerson Hotel Co. because the latter desired it, while
petitioners objected to the realization of a large taxable profit; that the transaction was
carried out in the form above outlined to prevent a straight sale of the Baltimore Street
property by petitioners to the Emerson Hotel Co. for cash; that the whole device was so
essentially fictitious,the form should be disregarded and the transaction held to be a sale
of the Baltimore Street property by petitioners for cash and then, in a separate transaction,
a purchase of the Lexington Street property by petitioners for cash.

Respondent argues that the Emerson Hotel Co. was the moving party and the Title Co.
was its agent in acquiring petitioners' Baltimore Street property. This may be true. But
even if it were, respondent's position is not helped thereby.

If the Title Co. were acting as agent for the Emerson Hotel Co., then clearly it
purchased the Lexington Street property on behalf of the Emerson Hotel Co. and,
pursuant to its agreement with petitioners, but acting for the Emerson Hotel Co.,
exchanged the Lexington Street property plus $33,000 for the Baltimore Street property.
Certainly, the Title Co. as agent for the Emerson Hotel Co. did not purchase the
Baltimore Street property for $300,000 cash as contended by respondent.

In our opinion, the respondent's position cannot be sustained unless the Title Co.
represented the petitioners as their agent, both in the transfer of the Baltimore Street
property to the Emerson Hotel Co., and in the purchase of the Lexington Street property.
The record, however, conclusively contradicts the existence of that status in either
transaction. Petitioners' only contract disclosed here was with the Title Co. alone. It was
enforceable against that company as principal. In the event the Title Co. had not been
able to secure title to the Lexington Street property, and thus comply with the exchange
provisions of the contract, petitioners could have compelled the Title Co., individually, to
pay $300,000 to petitioners for the Baltimore Street property. The Title Co. was the party
acquiring the Baltimore Street property. The consideration was to be paid by the Title Co.
and the latter did, in fact, pay to the petitioners, in its own behalf, $4,000 upon the
execution of that contract. The balance due under the exchange provisions of the contract
upon its consummation, namely, the remainder of the cash consideration and the transfer
of title to the Lexington Street property, was received by the petitioners from the Title
Co. in the performance of the individual obligation of that company.

It may be true, as urged by respondent, that the Emerson Hotel Co. desired the
Baltimore Street property and was willing to pay a price which would have netted
petitioners a large profit. In any event petitioners could have sold that property for cash,
thus incurring a tax liability, and then invested the proceeds in other property as an
investment, or, they could have effected an exchange of this investment property for
property of a like kind and thus avoided tax liability by postponing the realization of
recognized gain as provided by section 112(b)(1) and (c)(1) of the Revenue Act of 1928.
[FN1]

Respondent admits that the transaction was carried out in a legal manner, and that no
fraud was perpetrated. We cannot find that it was a mere device, essentially fictitious.
The several agreements and deeds executed, and the cash payments made by the four
interested parties were not simulated transactions. They were intended to and did
constitute juristic facts??not fictions. The agreements created fixed liabilities. The deeds
transferred legal title. The cash payments were real. Petitioners actually conveyed the
Baltimore Street property to the Title Co. They likewise received from that company, in
exchange, the Lexington Street property and $33,000. These real transactions must here
be given their normal effect. So, our single inquiry is whether these facts bring the
petitioners in the pending transaction within the scope of the quoted statutory provisions.

The obvious purpose and effect of these provisions, as well as their predecessors, in the
Revenue Act of 1921, section 202(c)(1), [FN2] (d)(1), [FN3] and (e), [FN4] and the
amendment of the Act of March 4, 1923, was to permit the postponement of recognition
of taxable gain or loss upon an exchange there described until the disposition of the
property received in the exchange. In the ultimate analysis of the present transaction, this
was all petitioners intended or accomplished.

The present exchange was not connected with a corporate reorganization. Neither in
the last?quoted provisions nor in their successors, here applicable, does there appear any
express or implied indication of a legislative intent to premise the nonrecognition of gain
or loss there provided upon any other condition than that stated specifically therein. * * *
* Nonrecognition of gain or loss does not depend here upon the impossibility of a sale of
the property by the taxpayer. The only condition precedent to that nonrecognition is the
actual exchange of property held for investment for like property to be held for
investment, with or without so?called 'boot.'

In Gregory v. Helvering, supra, the Supreme Court determined the taxable status of the
questioned transaction 'by what actually occurred '?? the receipt of the taxed stock by the
taxpayer. To sustain respondent upon the present record, we would be compelled to
ignore the exchange that actually occurred, and tax, as received by the taxpayers, money
never, in fact, received by or for them, in a sale that did not occur. We cannot here thus
substitute fiction for fact.

If petitioners' present alternative agreements to exchange or sell had been with the
trustee of the Wylie estate and the Emerson Hotel Co., separately, clearly it could not be
said that an actual exchange of petitioners' investment property with the former party was
an actual sale of it to the latter, merely because petitioners exchanged rather than sold the
property for the purpose of postponing or avoiding income taxes. Since such agreements
were with the same party, the Title Co., this admitted purpose does not convert
petitioners' actual nontaxable exchange into a taxable sale.
The above mentioned agreement of March 7 evidenced an intention to exchange the
Baltimore Street property, if certain conditions were met, and to sell it, if those conditions
were not met. Those conditions were met. The property was, in fact, exchanged. That fact
is controlling here.

We conclude that the petitioners exchanged real property held for investment, for like
property to be held for investment, plus $24,426.90 net cash. So, pursuant to section
112(b)(1) and (c)(1), supra, the recognized gain does not exceed the amount of cash
received by them in the exchange.

Judgment will be entered for the petitioners.

FN1. SEC. 112 (b)(1)


PROPERTY HELD FOR PRODUCTIVE USE OR INVESTMENT

No gain or loss shall be recognized if property held for productive use in trade or
business or for investment (not including stock in trade or other property held primarily
for sale, nor stocks, bonds, notes, chooses in action, certificates of trust or beneficial
interest, or other securities or evidences of indebtedness or interest) is exchanged solely
for property of a like kind to be held either for productive use in trade or business or for
investment. (c)(1) If an exchange would be within the provisions of subsection (b)(1), (2),
(3), or (5) of this section if it were not for the fact that the property received in exchange
consists not only of property permitted by such paragraph to be received without the
recognition of gain, but also of other property or money, then the gain, if any, to the
recipient shall be recognized, but in an amount not in excess of the sum of such money
and the fair market value of such other property.
FN2. SEC. 202 (c)(1)

When any such property held for investment, or for productive use in trade or business
(not including stock?in?trade or other property held primarily for sale), in exchanged for
property of a like kind or use.
FN3. SEC. 202 (d)(1)

Where property is exchanged for other property and no gain or loss is recognized under
the provisions of subdivision (c), the property received shall, for the purposes of this
section, be treated as taking the place of the property exchanged therefor, except as
provided in subdivision (e).
FN4. SEC. 202 (e)

Where property is exchanged for other property which has no readily realizable market
value, together with money or other property which has a readily realizable market value,
then the money or the fair market value of the property having such readily market value
received in exchange shall be applied against and reduce the basis, provided in this
section, of the property exchanged, and if in excess of such basis, shall be taxable to the
extent of the excess; but when property is exchanged for property specified in paragraphs
(1), (2), and (3) of subdivision (c) as received in exchange, together with money or other
property of a readily realizable market value other than that specified in such paragraphs,
the money or the fair market value of such other property received in exchange shall be
applied against and reduce the basis, in this section, of the property exchanged, and if in
excess of such basis, shall be taxable to the extent of the excess.

LOSSES AND DEFERRAL: HARR

Harr v. McLaughlin, a 1936 decision, was an action to determine, among other issues,
whether the transaction fell within Section 112, the 1928 predecessor of §1031.

The property had generated a loss. The taxpayer, a bank, was arguing that the property
was held primarily for resale, and therefore the loss was deductible, i.e., it did not have to
be postponed. On the other hand, the government was arguing that the property was held
as an investment,from which income was derived, and the loss could not be recognized in
the calculation of income tax under Section 112, and it had to be postponed.

The Court held that the taxpayer did not hold the real estate as an investment or for
other permanent use; therefore, the property was for resale. As such, the loss on the
property was deductible; Section 112 did not apply to postpone the loss.

HARR,
Secretary of Banking of the Commonwealth of Pennsylvania,
v.
MacLAUGHLIN.
36-2 U.S.T.C. Para. 9447 15 F.Supp. 1004 (D.C. Pa. 1936)

WELSH, District Judge.


This action is brought by the secretary of banking of Pennsylvania, in possession of the
Merion Title & Trust Company, to recover an alleged overpayment of income tax for the
year ending March 31, 1929, in the sum of $9,797.68. The parties have simplified the
issue by entering into a stipulation of agreed facts and by the elimination of a substantial
portion of the original claims, so that the issue may now be stated briefly. The Merion
Title & Trust Company was, during the years in question, a bank organized under the
laws of Pennsylvania. On October 27, 1931, under the provisions of the state law, it was
taken over by the secretary of banking, who succeeded to the rights of the bank in a claim
filed January 13, 1931, for a refund of income tax paid for the year ending March 31,
1929. The claim for refund was based principally upon a loss sustained on transactions
involving the Bryn Mawr Terrace Apartments, which, if allowed as a deduction, would
entirely wipe out the profit reported for that year and would entitle the bank, and now the
present plaintiff, to the return of the income tax paid. The statement of agreed facts
involving the transactions in question shows that the bank had advanced $96,500 to
Bowker & Houseworth for the construction of the Bryn Mawr Terrace Apartments. They
failed to complete the building, and, by virtue of their default, a mortgage foreclosure
was had in 1927 at which the bank purchased the property. It then completed the
construction and thereafter rented the apartments. During the period of operation, losses
were sustained which were added to the original cost, so that on March 1, 1929, the
books of the bank showed a total investment of $353,144.33. On that date the property
was exchanged, subject to an existing mortgage of $100,000, for three vacant lots which
were entered on the books at a valuation of $100,000, and there was at that time charged
off as a loss $153,144.33, representing the difference between the total investment and
the aggregate amount of the mortgage and the value of the lots received in exchange. A
portion of that loss was claimed as a deduction from income, and subsequently upon
review by the Commissioner of Revenue an additional loss was allowed representing a
part of the uncollected debt due by the original borrowers, Bowker & Houseworth.

For the taxable year ending March 31, 1929, the bank paid an income tax of
$17,384.44 on a reported income of $147,952.79. Upon consideration of the return and
the claim for refund, the Commissioner allowed a refund of $7,586.77, but declined to
allow the whole loss on the apartment house as claimed, and fixed the tax liability at
$9,797.68. The plaintiff contends that the entire loss on the transactions involving the
Bryn Mawr Terrace Apartments is a proper deduction from income reported March 31,
1929, and that, if the loss were allowed, it would exceed the income reported, and
therefore no tax became due. They now seek to recover the amount of tax paid and not
refunded.

The question raised is whether the loss sustained from the apartment transaction as
calculated by the plaintiff and evidenced by the testimony taken on the trial of this case is
properly deductible from the income reported for the year ending March 31, 1929.

[1] The Revenue Act of 1928, 112, 26 U.S.C.A. 112 and note, provides that upon the
sale or exchange of property the gain or loss shall be taken into account for income tax
purposes, but such gain or loss shall not be recognized if property held for productive use
or investment is exchanged for other property to be held for similar purposes. Gain or
loss on the sale or exchange of property not held for productive use or investment, but
comprising stock in trade or property held primarily for sale, must be taken into account
in the calculation of income for tax purposes.

It is contended by the plaintiff that the real estate in question was held by the bank
primarily for sale, and the loss therefrom must be deducted from income for the year in
which the loss was sustained. The defendant claims that the property in question was held
as an investment from which income was derived, and that the loss may not be
recognized in the calculation of the income tax.

CHAPTER 3
NON-TAX CONSIDERATIONS IN EXCHANGING REASONS FOR
EXCHANGING:
NON-TAX: CAVEAT
Before proceeding, it is worthwhile to emphasize that many people would argue that
exchanges, relevant to Section 1031(a), usually involve a desire to consider the tax
implications. Although this might generally be true, and therefore the reader is cautioned
to consider the limitations of what follows, there can be non-tax considerations for
exchanges.

This is not to say that this Author, the NATIONAL ASSOCIATION OF REALTORS ,
REALTORS NATIONAL MARKETING INSTITUTE , Certified Commercial Investment
Member (CCIMs), CPAs, attorneys, financial planners, and/or anyone connected with
these groups, is advocating swap and barter. It is important to recognize that although
non-tax reasons can arise, there is certainly no attempt in this material to support a
carefree swap state.

Although much has been written on 101+ reasons to exchange, the tax implications are
so important that a transaction that does not require the special tax-deferred position
under Section 1031 might well be structured as two or more different transactions, as
opposed to an exchange. The non-tax motives, although they exist, are not unique to
exchanging. One REALTOR, Al Dolby, CCIM, generally advocates with great force
structuring an item as two sales, not an exchange, in the context noted. The important
point for the reader, at this stage, is to view any transaction which does not require the
implications and the application of Section 1031 as a candidate for non-Section 1031
structuring -- if the circumstances allow and if an alternative structure produces greater
overall benefits for the parties.

WHY PEOPLE ENTER EXCHANGES:


NON-TAX CONSIDERATIONS:
VALUATION

When focusing on the non-tax considerations, one might consider the simple fact that
the transaction might not take place unless an exchange is used. The party on the other
side may seek an exchange, a roadblock may prohibit the sale for tax or other reasons,
such as a difference in opinion as to valuation, or for many other reasons. Where a party
might think the property is worth $100,000, but if the seller agreed to accept that
property, the hurdle of attempting to put a valuation on the property may be avoided. This
is one of the reasons for using the exchange form "without valuation" (see Appendix 3).
That is, we may simply structure a transaction to show the difference in equities of the
parties involved, and not structure it to show that Property A is worth so much money,
and Property B is worth so much money. It is often much "cleaner," and avoids many
controversies, to simply say that the difference between Property A and Property B is a
given amount, such as $10,000, which will be paid by one party to the other party. This
non-tax consideration allows some flexibility in situations that might not otherwise result
in a sale.

MANAGEMENT
Another reason to exchange may be to avoid additional management problems, or on
the other side, to bring in more management. A party desiring to retire may not wish to
generate gain, on the tax issue, and at the same time might desire to move from
management property to non-management property, such as a net-lease property, which
would eliminate certain personal concerns in overseeing the property. This is a non-tax
motive in support of an exchange.

PHYSICAL LOCATION

Another reason for undertaking an exchange may be a physical move. A taxpayer in


Wyoming who desires to relocate to New York might find that all of the properties
currently located at his place of business or his residence may have to be sold to allow
him the flexibility to reinvest in local properties, should he desire to oversee those
properties personally. It is obvious that the sale of a number of properties in one year
creates additional tax problems. The exchange is a potential solution, allowing the
flexibility of moving from one property to another without incurring tax liability,
assuming that it is properly structured.

TYPE OF PROPERTY: ROLLOVER

An exchange might be beneficial, non-tax-wise, to simply allow an adjustment in the


type of properties owned. An investor may be of the opinion that apartment houses are
the "up-and-coming type property," and that office buildings will not be as meritorious.
This taxpayer can use the exchange technique to move from one type of property to
another.

BAD PROPERTIES AND OTHER ALLIGATORS

Most people in the real estate business are familiar with the term "alligator," meaning
that type of property that eats at you and potentially causes tremendous cash drain.
Everyone in real estate investments, for any given period of time, has certainly faced the
potential of an alligator. It may be that where an alligator is present, greater flexibility
can come from an exchange. If A is suffering cash drain on his property at the rate of
$2,000 per month, carries a large indebtedness, and A has the chance to pick up
unimproved ground in an exchange, without a cash drain, possibly because the ground
will be leased, this may encourage him to accept this type of exchange; absent the cash
drain, A might turn up his nose at any type of exchange.

DOMESTIC ISSUES

An exchange might be favored for domestic planning considerations, as well as the


normal day-to-day routine. An exchange might be a viable alternative where a dissolution
(divorce) is involved, or custody questions, or other domestic or personal concerns, such
as a death in the family. In a dissolution, the husband may be willing to exchange his part
of an apartment building in exchange for his spouse's share of their commonly-owned
office building; an exchange may be a means for them to unwind or divide properties
which they currently own, together.

PSYCHOLOGY: THE BETTER SIDE

One of the current non-tax considerations in using exchanges deals with the
proposition that one feels one is always getting the "better side" of the bargain. This is the
typical setting in an historical swapping, such as trading one automobile for another.
Each party would try to convince himself that he received the better part of the bargain;
and if that can be done, each party is that much more inclined to accept the transaction.
The interpretation of "best side" is just that -- an interpretation -- and difficult to construe.
However, that is not the issue in this discussion. The important point is that each party
feels he is getting the best side of the transaction; and, that is what may encourage the
exchange. Each may be getting the "better side," from his or her perspective.

NON-LIKE-KIND EXCHANGE

There may be other tax and non-tax reasons for exchanges, some of which seem to pop
up at different times as the real estate field develops. One item that has been used is the
exchange of diamonds or other types of jewels for real estate.

Since this is not a like-kind exchange, it does not fit the requirements of Section 1031.
However, the parties in many instances attempt to use valuations which indicate that
there is no gain, while nevertheless attempting to assure themselves of some potential
profit. As an example, assume that X owns an office building worth $400,000; we can
also further assume, to avoid complexities, that it is free and clear. If Y offers to pay X
$200,000 in cash and gems worth a given amount, we must try to determine the value of
the gems, their fair market value at the time of the exchange, to determine whether there
is a gain, loss or break even, by the seller, X. X could have some flexibility to argue that
the cash he received, plus the gems, are equal to his basis (if he could support this
proposition). Since the nature of gems is such that there is great divergence of opinion as
to value, he may have some flexibility in arguing for a lower amount of gain, at least at
this time. Obviously, a subsequent sale by X of the gems could result in further gain or
loss.

On the other hand, if Y had traded $200,000 in cash and a listed stock on the New
York Stock Exchange, we would have little difficulty in valuing these items. We could
certainly calculate any "true gain" and recognize that taxable income would result if the
price was in excess of basis.

To reiterate, the valuation issue allows for flexibility as to gems on an exchange, which
may not be present on certain other types of properties. "Flexibility" does not mean fraud
or trickery. But because there is a degree of opinion involved as to valuation, the taxpayer
may have some support in arguing for a lower valuation. Many taxpayers find themselves
in an inconsistent position when they have appraisals made to value gems, and then use a
lower value on their tax return. Taxpayers must not commit fraud and must be consistent
in their approach; but, there is flexibility.

This concept is no different than the questions that arise when valuing real estate in the
estate of a decedent for estate tax purposes. There is frequently a great deal of variance in
the valuation of real estate in estates. It may become a battle between experts testifying as
to their opinion of value.

BENEFITS OF EXCHANGES
FOR REAL ESTATE LICENSEES

There are many advantages for real estate licensees in the exchange area. If one acts as
an agent for some third party principal, a real estate commission might be earned when an
exchange is involved, where it might not be otherwise. That is, some of the parties might
resist a sale of the property, where an exchange might not be resisted. The areas of
resistance, as discussed earlier, might include the problem of paying taxes currently, the
mental hesitation in paying those taxes, the reluctance to transfer property where one is
concerned about not receiving full value, and many other circumstances, both actual and
artificial, tax and non-tax. The agent might convince the seller to list and "sell" a property
that might not otherwise take place without an exchange.

IN SUMMARY

There are other advantages to exchanges. There may be benefits in avoiding new
financing, eliminating loan costs and other financing fees, psychological benefits of
seeing that one has received the highest price for the property, making a transaction that
might not be obtained with the transfer for money, avoiding the need to raise capital, and
so on.

There are many hidden or disguised motives for clients to accept exchanges. These
hidden or disguised motives include the psychological or non monetary considerations.
There may be a reluctance to continue owning the property, management concerns,
decreasing interest in the property, a desire to relocate or transfer, a desire to retire or
eliminate management headaches, domestic problems, including divorce, death or family
considerations, health problems, additional tax issues which affect other planning (such
as substantial profits incurred in a given year and installment sales) and other non-tax
issues.

Some properties may be transferred through an exchange that may not transfer for
other reasons. For example, a property difficult to sell may be accepted in an exchange.
Owners of properties that have tax problems because the property is fully depreciated, as
discussed subsequently, may entertain the idea of an exchange. Packaging large and small
properties in the exchange might also be acceptable to the parties, where an outright cash
sale might not be accepted .

CHAPTER 4: TAX MOTIVES


It has long been my feeling that the tax motive in a given area of the tax law is often of
crucial importance. This is not to say that the intent or motive of the parties is always
controlling. It is not. Section 1031(a) specifically provides for a tax-deferred exchange if
certain events take place, such as the exchanging of qualified property held for productive
use in trade or business or for investment for other like-kind (qualified) property. Nothing
is said as to the tax motive or intent of the parties. If the parties did not desire or intend an
exchange, if the actions met the requirements of Section 1031, the exchange rule would
apply.

Although the discussion in this Chapter stresses the importance of tax motive, one
should not proceed on the assumption that tax motive always controls the transaction. As
I mentioned in Chapter 40 of Real Estate Transactions, Tax Planning, cited earlier,
motives in tax planning can be crucial. I again stress the caveat that one cannot be so
involved in the concept of tax motive as to assume that such motives control in all
circumstances.

Taxpayers have argued, as the cases below illustrate, that they should be entitled to a
tax-deferred exchange because they intended one, even though they did not meet the
Section 1031 requirements. As an example, A sells his property to B for cash and takes
that money and buys C's property. If the parties could have structured the transaction
wherein A exchanged his property with C on a tax-deferred exchange, and C in turn sold
that property to B for cash, it might have qualified as a tax-deferred exchange for A.
However, because the transaction was not so structured, even though the intent was to
reinvest, it will not meet the requirements of Section 1031. Tax motive or tax intent does
not always control.

Nevertheless, tax motives can often be important to the exchange area.


An often-quoted Biblical passage states:

God. . . also hath made us able ministers of the New Testament; not of the letter but of the
spirit; for the letter killeth, but the spirit giveth life. (2 Cor. 3:6).

The courts have often cited this type of language to support the proposition that
although taxpayers might have met the letter of the law, they have not met the spirit. An
example might be structuring of a tax-deferred exchange in form, but with little substance
to the transaction.

To take an example of an actual case, B desires to sell his property to C. They enter a
contract. B is told that if his intent is to sell the property to C and take the money and buy
D's property, B would be much better off to simply exchange his property with D and
avoid the tax by using Section 1031.

Assume that B goes back to C and informs C that he desires to provide for an
exchange. C, having planned on acquiring the property owned by B, does not desire to
cooperate, unless there is an agreement by B and C that if B does not make the exchange
with D (so that D can eventually transfer the property to C), B will complete the sale,
under the existing contract, for cash, with C. Assume the parties agree to this. It is clear
what the parties are doing. They have restructured a transaction, that was intended as a
sale, to meet the requirements of an exchange. However, they also have a clause that if
the exchange does not take place, an actual outright sale for cash will take place. The
whole transaction was designed to postpone tax for B. Would this be allowed by the tax
law?

It is fair to say, as a result of a number of decisions and ruling by the Internal Revenue
Service, that the type of transaction described, if restructured properly, could qualify
under Section 1031. We see a great deal more flexibility with tax motive and tax intent in
the Section 1031 area than is true in many other areas. The important point is to
recognize that obviously the parties would have been better off to structure the
transaction properly in the first place, but there is some salvation to restructuring a
transaction, even though the tax motive or intent is apparent.

In the real estate exchange field the cases are as lenient as in almost any area of the
Internal Revenue Code and the laws which govern income tax treatment for taxpayers.
This is not to say that taxpayers should be careless in their drafting or their activities. It is
important to word agreements correctly in the first place, to avoid ambiguities; otherwise,
a battle may be encouraged. Obviously, the exposure to the real estate agent, attorney,
Certified Public Accountant (CPA), or other party involved in the transaction in an
advisory or other capacity might result in potential liability because of a subsequent
challenge by the Internal Revenue Service.

It is best to avoid a tax challenge by the government. We all recognize that even if the
taxpayer is successful in defending his position, there may be a great deal of lost time,
aggravation, interest, and -- yes -- money, expended to defend and support a position.

The Internal Revenue Code has the tax motive concept sprinkled throughout. The
terms "view to," "principal purpose," "primary purpose," and many others are used. These
often require interpretation as to the reasoning behind holding, selling, transferring,
exchanging or otherwise developing or utilizing the property in question. As an example,
Section 1221 defines a capital asset, a necessary item to produce capital gain, as property
held by the taxpayer, but does not include certain categories. Those categories excluded
are, among others,: "property held by the taxpayer primarily for sale to the customer in
the ordinary course of his trade or business," i.e., as a dealer. The important point of the
word "primarily" is to emphasize that one must interpret the intent or reasoning behind
holding property. This is the basis question that has been raised by tax practitioners and
real estate licensees: Is one "a dealer"? If one is a dealer, the taxpayer cannot have a
capital asset and the sale of the same would generate an ordinary gain or loss. Under
Section 1031, the point of reference for our concern, the only property that qualifies for
Section 1031 postponement or recognition of gain or loss, is property which is "held for
productive use in trade or business or for investment," and also meets other criteria. We
must interpret in this setting whether the property in question is held for productive use in
trade or business or for investment. We are looking to the activity, the use.
Intent in this setting can be judged by a number of circumstances, not simply what the
taxpayer says is his intent. The intent issue for dealership property, discussed below, is an
integral part of the exchange field.

LETTER AND SPIRIT

There are many instances where the statutes passed by Congress to regulate income
taxes have not specifically stated that a taxpayer might literally meet the requirements of
the Internal Revenue Code, that is, the letter of the law, but might not meet the intent or
spirit of the law. One example is the concept of prepaying interest. Although, generally
speaking, the deduction of prepaid interest is prohibited under today's Section 461(g),
before the passage of this section the language of the Code arguably allowed for the
deduction of interest that was paid. Arguably, the taxpayer could say that if he paid
interest, and the Code stated that interest is deductible, the taxpayer should be able to
deduct that interest, even if it was prepaid. However, first through case interpretation and
rulings, and subsequently through a change by Congress in the Code, a current deduction
for prepaid interest is not generally allowed. The cases, before the congressional change,
emphasized the importance of intent, stressing the view that although the term "interest"
was used in the Code, the intent was not to allow a deduction for prepaid interest. There
were nice mental gymnastics utilized to support this conclusion. One argument was that
prepaid interest "distorted income and expenses" of the taxpayer and should not be
allowed under other Code sections. The stress on intent was a key element in many
courts. They emphasized that Congress looked to a purpose for the section, allowing the
deduction of interest; the intent or purpose was violated by deducting prepaid interest.

I have often referred to this approach as the "pig theory." The argument is that one can
be a bear or one can be a bull (using stock market language in the tax field), but one
cannot be a pig. If one oversteps the bounds of reasonableness, even though one might
literally meet the requirements of the Internal Revenue Code section, the courts will
strike the action as a violation of what might be the "pig theory" (reasonableness theory).

The pig theory was expounded by a number of professors, including Professor Charles
S. Lyon and James S. Eustice of New York University School of Law. They emphasized
the importance of concentrating on a reasonableness approach when construing the Code.
This does not mean that some sections are not misconstrued, distorted or otherwise
warped. The general line of reasoning is that the construction of the law must be with the
spirit as well as the letter of the law.

To apply these somewhat esoteric concepts one might look to the Code section which
is our focus, Section 1031. Words or reasoning might be distorted by going too far.

Sometimes the courts have said that a given transaction or the format of a transaction is
undertaken solely because of tax motivation. Should such tax activity be recognized?
Does it have substance? In some circumstances, the courts have accepted the transaction,
even though it was structured merely for tax purposes.
Authors disagree on the issue raised. Some commentators argue that a taxpayer cannot
structure a transaction solely for tax motives; it must have a business purpose. Others
argue that this is merely a label; many transactions take place solely, to support tax
considerations. In the now famous case of Gregory v. Helvering, Judge Learned Hand
stated that, "The legal right of the taxpayer to decrease the amount that otherwise would
be his taxes, or altogether avoid them, by means which the law permits cannot be
doubted. . . ."

Many examples could be given to emphasize the practical point for most taxpayers that
they should consider the form as well as the substance of their transaction; the business
purpose involved and the economic substance as well as the tax implications are
important.

If a taxpayer was to structure a transaction solely for tax considerations, with no


economic substance whatsoever, one might find great resistance by the government. One
example, as successfully argued by the Commissioner of the Internal Revenue, was the
Hunter Manufacturing Co. case. The taxpayer, a parent company, owned stock, but not
all of it, in a subsidiary company.

The parent realized that the subsidiary company was not and would not be successful.
It realized, finally, that it must take the best route available to deduct the tax losses that it
had. It consulted a tax advisor.The tax advisor informed the parent to acquire additional
shares of stock in the subsidiary corporation, i.e., the company that was about to be
liquidated. Obviously, the board of directors of the parent corporation were very
concerned as to this tax advice, which encouraged them to acquire additional stock in a
corporation which was a "loser."

However, the tax planner had a reasonable tax basis for his thinking. He knew that,
although stock losses are usually capital losses, under a special rule the loss in question
could become an ordinary loss if the parent corporation owned a sufficient percentage of
stock to meet the requirements of Code Section 165(g). The problem was that the
taxpayer-parent corporation did not own sufficient stock to meet this requirement.
However, knowing the tax advantage of having an ordinary loss, as opposed to a capital
loss, the officers of the corporation set about acquiring additional stock. The acquisition
was successful. Other holders of the stock of the subsidiary corporation were very few.
They were delighted with the opportunity of selling their stock to the parent corporation.

When this issue was raised on audit of the parent corporation-taxpayer, the taxpayer
argued that there was nothing in the Code, under Code Section 165 or any other section,
which prohibited acquiring this stock to meet the requirements to produce an ordinary
loss in place of a capital loss. The taxpayer argued, citing language similar to that in
Gregory v. Helvering, that a taxpayer can structure his transaction in a way that will save
tax.

The government countered this position by arguing that there was no business purpose
in acquiring the stock of the subsidiary. There as an economic or dollar loss to the parent
company! The only benefit was in the form of tax savings. When the issue came before
the court, the taxpayer-parent company argued that it was qualified for an ordinary loss.
The government argued that the "tax motive" of the section of the Code was violated. The
intent of the tax law was violated, although it met the letter of the law.

This case is presented to emphasize that in some settings tax motive can be very
important. The courts have been very lenient in the exchange area, allowing a greater
degree of tax-motivated transactions, at least in my opinion. Cases such as Alderson,
Coupe, Biggs, Starker, and others which appear in this material (see Table of Cases)
emphasize the "flexibility" the courts have allowed taxpayers in this area.

Before leaving this area of tax motive and tax considerations for structuring a
transaction, the reader might consider depreciation, cost recovery, investment tax credit
and acquisitions of property to avoid taxes. A number of Code sections affect these areas,
and a number of transactions are undertaken by taxpayers in one form or another to
attempt to save tax in a given setting.

Assume for the moment that a taxpayer from the United States is on a train in Europe.
The taxpayer, a broker, is talking to another U.S. citizen, C, an investor. C is informed by
the broker that he could acquire certain property with a "fantastic loss."

The conversation is overheard by a young man from Paris who is developing his
English language proficiency. In overhearing the conversation, the young man assumes
that he must be interpreting the words incorrectly. He is confused by the term "fantastic
loss." Obviously, the loss which is "fantastic" is only valuable if we assume that the
parties are thinking of the overall tax benefits that can be received from the loss
deduction. We all know, economically, our investor would desire to have a solid
property. Hopefully, this is his first concern. If, when investing, he can acquire property
which is economically sound and which produces tax benefits, then it would be attractive.
Since much activity on the investment side is influenced by tax considerations, obviously
the only way that this conversation would have meaning to our European eavesdropper
would be if he had an understanding of the tax implications of what he overheard. It is the
line between considering the importance of tax benefits as a factor in a total transaction
as opposed to a transaction which is solely tax-motivated which must be considered. In
Hunter Manufacturing Co., the argument was that the structure was arranged solely for
tax purposes, with no business purpose; therefore, the ordinary loss treatment should be
denied.

For an application of tax motives in a tax-deferred exchange, look at the very involved
circumstances of the 1971 decision of Crenshaw, noted at the end of this Chapter. In that
case the taxpayer -- all in one day -- undertook to:

1. Terminate as a partner in a partnership and take a


distribution in liquidation of an undivided interest in real
property;
2. As administrator of the estate of her husband, and also
individually, transfer or exchange her interest in the real
estate that she received in the first step for real estate held
by the estate.
3. In her capacity as trustee, transfer the real estate that she
acquired in Step 2, which was held by the estate, to a
corporation for cash.

The corporation was created by the partners referred to in No. 1 above. The
corporation turned around and transferred the realty to the partnership -- in exchange for
the interest in the partnership previously held by the taxpayer.

If these steps seem confusing, it is because they are! The point to emphasize is that
some types of transactions will not be recognized, even though they might meet the form
or the letter of the law. This is the type of circumstance described in the Crenshaw case.

One final consideration of the tax motive area is the simple element of chance. Some
people have argued that a given transaction will qualify as a tax-deferred exchange under
Code Section 1031. One question is whether the property was held primarily for sale.
That question may be a close issue. There may also be a question as to whether a property
constitutes a real estate security. In other words, there can be some settings where there is
a question as to whether property meets the requirements under Section 1031. There can
be legitimate interpretative questions that are difficult to resolve. If the taxpayer resolves
the issue, at least at this stage, in favor of his position and treats the transaction in his
favor, the question is one of chance: What is the chance that the taxpayer might have the
issue raised in an audit? This is not to say that one should, in any way, commit fraud, or
attempt to report a transaction or treat a transaction in a way that does not comply with
the law. However, there are interpretative problems as to what qualifies under Code
Section 1031, or for that matter, under any other section of the Code, such as a sale of an
asset and whether it is a capital asset. Taxpayers may be in a position that if the issue is
not raised by an IRS agent, the matter passes.

Many taxpayers attempt to support a position or a point of view by negative inference.


For example, a taxpayer might argue that a transaction must be capital gain. Why?
Because the taxpayer filed his tax return and treated it as capital gain, and the government
never opposed it! Since we know that only a very small percentage of personal returns
are audited, generally less than 1.5 percent, this is certainly no confirmation of any
activity.

Many circumstances are left to chance. If the taxpayer commits fraud and the issue is
discovered, he is not merely liable for interest and/or penalty payments; potentially, he is
liable civilly and criminally. The key point for review in this area is to emphasize that
many transactions that might reasonably be treated as exchanges are not reviewed by the
government; therefore, many issues are not raised. Since the Treasury has indicated that it
will take a more aggressive position relative to real estate transactions, such as tax
shelters in real estate limited partnership, we may see more audit activity in a number of
these areas.
STEP TRANSACTIONS AND MOTIVE

Another important point in tax motive is the concept of step transactions. One step,
treated in the abstract, may look fine, but a series of steps that are collapsed or viewed as
a whole may create a different picture. If X exchanges his rental house for Y's rental
house, this may qualify for a tax-deferred exchange. This is the same as the
circumstances where X transfers his multi million dollar building to Y for his multi
million dollar building, assuming the properties are otherwise qualified. However, if we
learn that X occupied the house property two months after he acquired it from Y, one
could argue that the property acquired by X was not qualified property under Section
1031. In other words, we are putting together the events to see if the entire transaction
qualifies.

The process of combining or looking to a series of steps was well illustrated by


Crenshaw. Multiple party exchanges can also involve potential pitfalls for the step
transaction doctrine. (See Chapter 11.) To illustrate: If A transfers property to B, in
exchange for B transferring property to A, and A in turn takes the property he acquired
from B, which we will label B-1, and transfers B-1 to C in exchange for C transferring C-
1 to A, the argument is that A's transaction does not qualify for the tax-deferred
exchange, because B-1 has not been held as required under Section 1031(a). That is, it
must be property held for productive use in trade or business or for investment. A held
the property, B-1, with the intent to transfer it for property C-1; it does not qualify. If the
transaction was structured differently a tax-deferred exchange could be accomplished for
A, if the property otherwise qualified. The important point of this discussion is to
emphasize that when looking at the two different transfers by A, and collapsing the two
steps and looking to the essence, we may find that the transaction is disqualified because
it did not fit the requirements.

Another example of a step transaction can be where A and B desire to be partners. A


and B transfer property into a partnership in exchange for an interest in the partnership. If
A transfers a building into the partnership and immediately thereafter B and A agree that
A will receive cash from the partnership, the Regulations take the position that this can
constitute a taxable transaction to A. There are cases to the contrary; but, the point is to
emphasize the step nature of the transaction, to collapse the steps and look to the
substance of what happened. Arguably, A received cash for his building. Therefore, it
should be a sale by A, not a tax-free transfer to a partnership.

SUBSTANCE, NOT FORM: CRENSHAW

When looking to the tax implications of a transaction, the courts will often look to
interrelated steps. As noted, we sometimes label this as a collapsing of the steps; the court
may look to the essence or substance of what happened. This approach can be very
important in many areas in the tax law, including the area of exchanges. In the Fifth
Circuit decision of Crenshaw, the court focused on these issues, although not in the
context of an exchange case. The court cited the basic proposition that the tax
consequences of an interrelated series of transactions are not determined by viewing each
step in isolation, but by looking to the entire transaction.

The Crenshaw case is mentioned because it involved a very detailed set of steps
undertaken by the taxpayer to attempt to reach a tax-deferred exchange position, with the
government arguing that if you looked to the essence of intent of all of the steps, the
transaction did not meet the requirements of Section 1031. The government argued that
the ultimate consequence of the total of the steps undertaken by the taxpayer was in every
material respect equivalent to what would have resulted had there been the straight
taxable sale: The partnership continued to own the same interest in given apartments that
it had before the alleged distribution and liquidation.

The steps were intertwined: "Tax wise, taking two to tango, the transaction had to have
the equivalent of the [four steps] as an indispensable ingredient." The four steps led to a
sale, as noted earlier. The Court's conclusion was that the transaction, although appearing
to be a tax-deferred §1031 transaction, was a sale.

EMORY K. CRENSHAW,
as Executor of the Estate of Frances Wood Wilson, Deceased, Plaintiff Appellee,
v.
UNITED STATES of America, Defendant Appellant.
450 F.2d 472 (5th Cir., 1971), cert. den. 408 U.S. 923; 92 S. Ct. 2490
JOHN R. BROWN, CHIEF JUDGE:

IN THIS HOTLY CONTESTED SUIT FOR REFUND OF FEDERAL INCOME TAXES AN


INGENIOUS TAXPAYER AND A SKEPTICAL TAX COLLECTOR VIGOROUSLY DISPUTE THE
LEGAL CHARACTERIZATION OF AN IMAGINATIVE FINANCIAL MANEUVER. IF THE
ELABORATE MULTI?STAGE TRANSACTION IN QUESTION AMOUNTED TO NO MORE THAN
A 'SALE OR EXCHANGE' OF A PARTNERSHIP INTEREST UNDER 741[FN1] OF THE INTERNAL
REVENUE CODE OF 1954, THE COMMISSIONER PROPERLY ASSESSED AND COLLECTED A
$47,128.92 DEFICIENCY. ON THE OTHER HAND, IF IT WAS MERELY A 'LIQUIDATING
DISTRIBUTION' OF A PARTNERSHIP INTEREST GOVERNED BY 736(B)[FN2] THE DISTRICT
COURT CORRECTLY GRANTED TAXPAYER'S MOTION FOR SUMMARY JUDGMENT, 315
F.SUPP. 814. INITIALLY WE ENCOUNTERED SOME DIFFICULTY WITH THE FACTS BECAUSE
THE GOVERNMENT, WHILE RELYING UPON THE WELL?ENTRENCHED 'STEP TRANSACTION'
DOCTRINE, FAILED TO PROVE ALL THE STEPS. NOW, WITH THAT PROBLEM SOLVED AND
THE MATERIAL FACTS UNDISPUTED, WE REVERSE.

STEP TRANSACTIONS

LIKE MOST SOPHISTICATED SCHEMES FOR MINIMIZING TAXES, THE PLAN WAS AN
INTRICATE ONE. IT ORIGINATED IN 1962 WHILE TAXPAYER (MRS. FRANCES WOOD
WILSON) WAS THE OWNER OF AN UNDIVIDED 50/225 INTEREST IN THE PINE FOREST
ASSOCIATES PARTNERSHIP, THE REMAINING INTERESTS BELONGING TO MR. AND MRS.
LEON BLAIR. MR. BLAIR APPROACHED TAXPAYER'S ATTORNEY WITH AN OFFER TO
PURCHASE HER PARTNERSHIP INTEREST FOR CASH, AND ALTHOUGH THIS PROPOSAL
WAS NOT GENERALLY OBJECTIONABLE THE ATTORNEY RESPONDED BY POINTING OUT
THAT TAXPAYER'S GENERAL FINANCIAL POSITION SUGGESTED THE MOST APPROPRIATE
COURSE WOULD BE THE EXCHANGE OF HER INTEREST FOR OTHER INCOME PRODUCING
PROPERTY, RATHER THAN FOR CASH. MR. BLAIR DID NOT THEN OWN SUCH PROPERTY,
BUT SUBSEQUENT INVESTIGATION REVEALED THAT IT COULD BE OBTAINED FROM THE
ESTATE OF TAXPAYER'S HUSBAND. THE STAGE WAS THEN SET FOR THE FOLLOWING
PLANNED, INTEGRATED SEQUENCE OF STEPS:

(I) TAXPAYER WITHDREW COMPLETELY FROM THE


PARTNERSHIP IN EXCHANGE FOR AN UNDIVIDED 50/225
INTEREST IN A PARCEL OF REAL ESTATE (THE PINE
FOREST APARTMENTS) OWNED BY THE PARTNERSHIP.
(II) ACTING INDIVIDUALLY AND AS EXECUTRIX OF HER
HUSBAND'S ESTATE, TAXPAYER THEN EXCHANGED HER
INTEREST IN THE PINE FOREST APARTMENTS FOR
OTHER REAL PROPERTY (THE OGLETHORPE SHOPPING
CENTER) BELONGING TO THE ESTATE.
(III) ACTING SOLELY IN HER CAPACITY AS EXECUTRIX,
TAXPAYER TRANSFERRED THE ESTATE'S INTEREST IN
THE PINE FOREST APARTMENTS FOR $200,000 CASH TO
THE BLAIRS' NEWLY ERECTED CLOSELY HELD
CORPORATION (THE BLAIR INVESTMENT COMPANY).
(IV) FINALLY, THE BLAIR INVESTMENT COMPANY
TRANSFERRED ITS 50/225 INTEREST IN THE PINE FOREST
APARTMENTS TO THE PARTNERSHIP IN EXCHANGE FOR
THE PARTNERSHIP INTEREST FORMERLY OWNED BY
TAXPAYER.[FN3]

THE GOVERNMENT ARGUES THAT THE ULTIMATE CONSEQUENCE OF THESE STEPS WAS
IN EVERY MATERIAL RESPECT EQUIVALENT TO THAT WHICH WOULD HAVE RESULTED
FROM A TAXABLE SALE. THE PARTNERSHIP CONTINUED TO OWN THE SAME INTEREST IN
THE PINE FOREST APARTMENTS THAT IT HAD PURPORTED TO DISTRIBUTE IN
LIQUIDATION OF TAXPAYER'S PARTNERSHIP INTEREST, WHILE THE BLAIRS ACQUIRED
TAXPAYER'S PARTNERSHIP INTEREST IN RETURN FOR A $200,000 CASH OUTLAY. ON THE
OTHER HAND, TAXPAYER CONTENDS THAT THE ENTIRE TRANSACTION WAS NOTHING
MORE THAN A PERFECTLY LEGITIMATE TAX?FREE LIQUIDATION FOLLOWED BY AN
EQUALLY LEGITIMATE TAX?FREE EXCHANGE OF LIKE?KIND PROPERTY UNDER 1031, AND
THAT IT MUST THEREFORE BE GOVERNED BY THE LONG?ESTABLISHED RULE THAT A
TAXPAYER MAY PROPERLY TAKE ADVANTAGE OF ANY METHOD ALLOWED BY LAW TO
AVOID TAXES.

THE CRITICAL SIGNIFICANCE OF STEP (IV) GROWS OUT OF THE TWO PARALLEL
ASSERTIONS IMPLICIT IN THE GOVERNMENT'S THEORY OF THE CASE. FIRST, AS HAS
LONG BEEN RECOGNIZED, THE SUBSTANCE RATHER THAN THE FORM OF A TRANSACTION
DETERMINES ITS TAX CONSEQUENCES, PARTICULARLY IF THE FORM IS MERELY A
CONVENIENT DEVICE FOR ACCOMPLISHING INDIRECTLY WHAT COULD NOT HAVE BEEN
ACHIEVED BY THE SELECTION OF A MORE STRAIGHTFORWARD ROUTE.[FN4] 'TO PERMIT
THE TRUE NATURE OF A TRANSACTION TO BE DISGUISED BY MERE FORMALISMS, WHICH
EXIST SOLELY TO ALTER TAX LIABILITIES, WOULD SERIOUSLY IMPAIR THE EFFECTIVE
ADMINISTRATION OF THE TAX POLICIES OF CONGRESS.' COMMISSIONER OF INTERNAL
REVENUE V. COURT HOLDING CO., 1945, 324 U.S. 331, 334, 65 S.CT. 707, 708, 89 L.ED. 981, 985.
TRANSPARENT DEVICES TOTALLY DEVOID OF ANY NON?TAX SIGNIFICANCE TO THE
PARTIES[FN5] CANNOT PASS MUSTER EVEN THOUGH A LITERAL READING OF THE
STATUTORY LANGUAGE MIGHT SUGGEST OTHERWISE. * * * * THE TAX POLICY OF THE
UNITED STATES IS CONCERNED WITH REALITIES RATHER THAN APPEARANCES, AND
WHEN AN ILLUSORY FACADE IS CONSTRUCTED SOLELY FOR THE PURPOSE OF AVOIDING
A TAX BURDEN THE ASTUTE TAXPAYER CANNOT THEREAFTER CLAIM THAT A COURT IS
BOUND TO TREAT IT AS BEING A GENUINE BUSINESS ARRANGEMENT.
A COROLLARY PROPOSITION, EQUALLY WELL ESTABLISHED,IS THAT THE TAX
CONSEQUENCES OF AN INTERRELATED SERIES OF TRANSACTIONS ARE NOT TO BE
DETERMINED BY VIEWING EACH OF THEM IN ISOLATION BUT BY CONSIDERING THEM
TOGETHER AS COMPONENT PARTS OF AN OVERALL PLAN.

TAKEN INDIVIDUALLY?? OR A FEW, BUT NOT ALL, STEPS AT A TIME?? EACH STEP IN THE
SEQUENCE MAY VERY WELL FIT NEATLY INTO AN UNTAXED TRANSACTIONAL
COMPARTMENT. BUT THE INDIVIDUAL TAX SIGNIFICANCE OF EACH STEP IS IRRELEVANT
WHEN, CONSIDERED AS A WHOLE, THEY ALL AMOUNT TO NO MORE THAN A SINGLE
TRANSACTION WHICH IN PURPOSE AND EFFECT IS SUBJECT TO THE GIVEN TAX
CONSEQUENCE.

HERE THE SUCCESSFUL APPLICATION OF THESE PRINCIPLES DEPENDS UPON A SHOWING


BY THE GOVERNMENT THAT, WHILE IN FORM THESE TRANSFERS MAY APPEAR TO BE NO
MORE THAN A LIQUIDATION OF A PARTNERSHIP INTEREST FOLLOWED BY A TAX?FREE
1031 EXCHANGE,[FN6] IN SUBSTANCE THEY ARE REALLY NOTHING MORE THAN A
CAMOUFLAGED SALE OF A PARTNERSHIP INTEREST MASQUERADING AS A LIQUIDATION.
BUT IN ORDER TO REACH THIS CONCLUSION IT MUST BE SHOWN THAT THE CHARACTER
OF THE TRANSACTION IS IN EVERY RESPECT,OTHER THAN THE SUPERFICIAL AND
IRRELEVANT ONE OF FORM, A SALE, RESULTINGIN PRECISELY THOSE CONSEQUENCES
THAT WOULD HAVE OCCURRED HAD TAXPAYER SIMPLY SOLD HER INTEREST IN THE
PARTNERSHIP TO THE PARTNERSHIP OR TO THE SURVIVING PARTNERS FOR $200,000 CASH
AND THEN PURCHASED WITH THAT MONEY HER INCOME PRODUCING PROPERTY. AND IT
WOULD BE AN EQUIVALENT TRANSACTION IF THE RELATIVE POSITIONS OF THE PARTIES
FOLLOWING THIS WELL ENGINEERED SERIES OF EXCHANGES WAS FOR ALL PRACTICAL
PURPOSES SUBSTANTIALLY THE SAME AS IT WOULD HAVE BEEN HAD THEY CHOSEN THE
DIRECT RATHER THAN THE CIRCUITOUS ROUTE.

OBVIOUSLY WHAT HAPPENED HERE WAS NOT EQUIVALENT TO A SALE UNLESS THE
FINAL STEP (IV) WAS CONSUMMATED?? THAT IS, UNLESS MRS. WILSON'S UNDIVIDED
50/225 INTEREST IN THE PINE FOREST APARTMENTS ULTIMATELY FOUND ITS WAY BACK
INTO THE PARTNERSHIP NOW OWNED BY THE TWO BLAIRS. IF IT HAD NOT, TAXPAYER'S
PARTNERSHIP INTEREST WOULD HAVE BEEN 'LIQUIDATED,' IN EVERY CONCEIVABLE
SENSE OF THAT TERM, AND THE COMPLETE OBLITERATION OF IT SIMPLY COULD NOT
HAVE BEEN CHARACTERIZED AS A 'SALE' IF NONE OF IT HAD SURVIVED TO BE 'SOLD.'

HOWEVER, THE PARTNERSHIP INTEREST DID SURVIVE BECAUSE, AS THE PARTIES HAVE
STIPULATED (SEE NOTE 3, SUPRA), IT WAS TRANSFERRED TO THE BLAIR INVESTMENT
COMPANY IN RETURN FOR ITS UNDIVIDED INTEREST IN THE PINE FOREST APARTMENTS.
IN RETURN FOR ITS $200,000 CASH PAYMENT THE CORPORATION (BLAIR INVESTMENT)
RECEIVED EXACTLY THE PARTNERSHIP INTEREST IT WOULD HAVE OBTAINED BY WAY
OF A DIRECT PURCHASE FROM TAXPAYER. A SALE, NOT A 'LIQUIDATION,' OCCURRED
BECAUSE WHAT HAD FORMERLY BEEN TAXPAYER'S PARTNERSHIP INTEREST WAS
ACQUIRED BY THE BLAIRS' CORPORATE ALTER EGO AND THE RELATIVE ECONOMIC
POSITIONS OF THE PARTIES WERE THE SAME AS THEY ULTIMATELY WOULD HAVE BEEN
HAD A DIRECT SALE TAKEN PLACE.

MOREOVER, THE FACT OF THE EVENTUAL TRANSFER OF THE CORPORATION'S


UNDIVIDED INTEREST IN THE PINE FOREST APARTMENTS BACK INTO THE PARTNERSHIP
IS OF CRUCIAL EVIDENTIARY SIGNIFICANCE IN THE FINAL ANALYSIS OF WHETHER THE
ESSENCE OF THE ARRANGEMENT WAS A 'SALE' OR 'LIQUIDATION.' FOR WHILE THE
PROPER CHARACTERIZATION OF THE TRANSACTION MAY DEPEND UPON WHETHER THE
PARTICIPANTS INTENDED TO EFFECT A SALE OR A LIQUIDATION, THAT INTENTION
CANNOT BE CONCLUSIVELY PRESUMED MERELY BECAUSE THE TAX?CONSCIOUS
LITIGANT ATTACHES A PARTICULAR LABEL TO HIS ACTIONS. 'IF THE 'SALE' IS A SHAM IT
WILL BE DISREGARDED AND A TRUE SALE IS NOT MADE A LIQUIDATION BY MERE
WORDS.' MILLER V. UNITED STATES, 1967, 181 CT.CL. 331, 344, N. 3. IN SHORT, MERELY
CALLING THE SCHEME A LIQUIDATION DOES NOT MAKE IT ONE.

WHAT DOES, INSTEAD, MAKE THE TRANSACTION IN QUESTION A SALE IS THE FACT THAT
WHILE THEORETICALLY A MATTER OF INDIFFERENCE TO TAXPAYER, CONSUMMATION
OF THE STEP (IV) WAS PRACTICALLY ESSENTIAL TO ITS SUCCESS, SINCE WITHOUT IT
THERE MIGHT HAVE BEEN NO DEAL. MR. BLAIR WANTED TAXPAYER'S PARTNERSHIP
INTEREST, AND TO GET IT HE WAS WILLING TO GO ALONG WITH A SUGGESTED
ALTERNATIVE PLAN WHICH HE THOUGHT AMOUNTED TO PRACTICALLY THE SAME
THING AS A DIRECT SALE * * * * THE KEY WAS TO KEEP PINE FOREST APARTMENTS IN
THE PARTNERSHIP. FROM THE PARTNERSHIP'S STANDPOINT, THIS GOAL WOULD HAVE
BEEN FRUSTRATED BY TRANSFERRING (AND KEEPING) 50/225 OF IT IN THE SEPARATE
CORPORATE ENTITY, A RESULT WHICH MIGHT HAVE BROUGHT ABOUT SUBSTANTIAL
TAX DISADVANTAGES. FROM TAXPAYER'S STANDPOINT, SHE NEEDED (OR DESIRED)
INCOME?PRODUCING PROPERTIES WHICH SHE COULD NOT GET FROM THE PARTNERSHIP
IN A LIQUIDATING DISTRIBUTION. TO ACQUIRE SUCH PROPERTY (OGLETHORPE SHOPPING
CENTER) SHE NEEDED CASH TO PAY THE SELLER.[FN7] BUT IT WAS DISADVANTAGEOUS
FOR HER TO GET THE CASH ON DISTRIBUTION FROM THE PARTNERSHIP. THIS CASH CAME
THROUGH THE PAYMENT OF $200,000 BY THE CORPORATION FOR THE PINE FOREST
APARTMENTS INTEREST, WHICH SOON GOT BACK TO THE PARTNERSHIP EXACTLY AS IT
ALL BEGAN. AND HER PARTNERSHIP INTEREST WAS THEN OWNED BY THE BLAIRS.
TAXWISE, TAKING TWO TO TANGO, THE TRANSACTION HAD TO HAVE THE EQUIVALENT
OF STEP (IV) AS AN INDISPENSABLE INGREDIENT. THE DISTRICT COURT WAS THEREFORE
CORRECT IN HOLDING THERE TO BE NO MATERIAL ISSUE OF FACT IN CONTROVERSY,
SINCE WHETHER TAXPAYER WAS CONSCIOUS OF STEP (IV) OR NOT WAS IRRELEVANT.

OUR CONCLUSION IS NOT AFFECTED BY THE UNDISPUTED FACT THAT TAXPAYER


DISPOSED OF HER ENTIRE PARTNERSHIP INTEREST RATHER THAN A PORTION OF IT. THE
STEPS WITH WHICH WE ARE CONCERNED ARE THOSE THAT LEAD INEVITABLY TO A
RESULT IN EVERY RESPECT EQUIVALENT TO A TAXABLE SALE, EVEN THOUGH
INDIVIDUALLY ANY ONE STEP MAY HAVE THE TECHNICAL FORM OF A 736 LIQUIDATION.
A STEP TRANSACTION IS NOT MAGICALLY TRANSFORMED INTO SOMETHING ELSE
MERELY BECAUSE ONE OF THE CRITICAL STEPS WAS NOT FURTHER SUBDIVIDED INTO A
PIECEMEAL DISPOSITION OF THE PARTNERSHIP INTEREST, AND IT MAKES NO
DIFFERENCE THAT INTEREST WHATEVER. THE ENTIRE TRANSACTION ON PAPER MAY
HAVE BEEN FLAWLESS, FOLLOWING THE INITIAL TRANSFER INVOLVED IN STEP (I)
TAXPAYER OSTENSIBLY RETAINED NO BUT IT WAS NEVERTHELESS A SALE AFTER ALL
WAS SAID AND DONE.[FN8]

NOR DO WE OVERLOOK TAXPAYER'S CLEARLY CORRECT CONTENTION THAT CONGRESS,


IN ENACTING THESE PROVISIONS, HAS PROVIDED AN INDIVIDUAL WITH ALTERNATIVE
METHODS FOR DIVESTING HIMSELF OF A PARTNERSHIP INTEREST. SEE FOXMAN V.
COMMISSIONER OF INTERNAL REVENUE, 3 CIR., 1965, 352 F.2D 466; PAUL J. KELLY, 1970, 29
T.C.M. 1090; ANDREW O. STILWELL, 1966, 46 T.C. 247. TAXPAYERS HAVE A CHOICE
BETWEEN SELLING AND LIQUIDATING. BUT THEY CANNOT COMPEL A COURT TO
CHARACTERIZE THE TRANSACTION SOLELY UPON THE BASIS OF A CONCENTRATION ON
ONE FACET OF IT WHEN THE TOTALITY OF CIRCUMSTANCES DETERMINES ITS TAX
STATUS. THE MOST OBVIOUS ANSWER TO TAXPAYER'S ARGUMENT THAT THE PARTIES'
CHARACTERIZATION IS CONCLUSIVE IS THAT SUCH A RESULT WOULD COMPLETELY
THWART THE CONGRESSIONAL POLICY TO TAX TRANSACTIONAL REALITIES RATHER
THAN VERBAL LABELS. THE TAX IS REALIZEDON THE SALE OF A PARTNERSHIP INTEREST,
AND IT CANNOT BE AVOIDED BY THE SIMPLE EXPEDIENT OF CONSTRUCTING AN
ADMITTEDLY CLEVER SERIES OF SUCCESSIVE TRANSFERS, EACH NONTAXABLE IN
ITSELF, THAT TOGETHER WORK THE SAME RESULT. OTHERWISE, FORM, RATHER THAN
SUBSTANCE, WOULD INVARIABLY PREVAIL.

THE JUDGMENT OF THE DISTRICT COURT IS REVERSED AND THE CAUSE REMANDED FOR
ENTRY OF JUDGMENT IN FAVOR OF THE UNITED STATES.REVERSED AND REMANDED.

HAPTER 5:
CLASSIFICATION OF PROPERTY FOR INCOME TAX PURPOSES
INCOME TAX CLASSIFICATION OF REAL AND PERSONAL PROPERTY

OVERVIEW: It is important to classify or group types of property, whether realty or


personalty, whether tangible or intangible. Different tax treatments are allowed or
disallowed in given settings to given types, classes or uses of property.

With this in mind, we might separate or group property into:

1. Capital assets, which we sometimes refer to these, generally,


as investment property (although there can be a distinction
between capital assets and investment assets);
2. Property which is nonbusiness in nature, which we might refer
to as personal use property;
3. Property which is used for income or investment purposes;
4. Property used (employed) in the trade or business (this
category, property held for productive use in trade or business,
is referred to as Section 1231 property);
5. Property for sale to customers in the ordinary course of
business, i.e., property primarily for resale.

These classifications are important in most circumstances to determine the tax treatment.
Yes, some do overlap. See, for example, groups 3 and 4.

CAPITAL ASSETS

Code Section 1221 defines a capital asset. Unlike many definitions in the Internal
Revenue Code, Section 1221 defines in the negative: It says that "capital asset" means
property held by the taxpayer, whether or not it is connected with his trade or business,
that specifically does not include:

1. Stock in trade of the taxpayer or other property of the kind


which would properly be included in the inventory of the
taxpayer if on hand at the close of the taxable year, or
property held by the taxpayer primarily for sale to customers
in the ordinary course of his trade or business;
2. Property used in the trade or business of the taxpayer, of a
character which subject to the allowance for depreciation, or
real property used in his trade or business;
3. A copyright, literary, musical or artistic composition, letter, or
memorandum or similar property which is held by the
taxpayer who created it or someone who takes through that
taxpayer who is not a purchaser, e.g., one who acquires it by
gift;
4. Accounts or notes receivable acquired in the ordinary course
of trade or business for services rendered or from the sale of
property described in Paragraph 1;
5. A publication of U.S. government which is received from the
United States government or any agency, but not purchased
from that group and which is held by the taxpayer who
received such publication or a taxpayer who acquired it from
him. (This latter point refers to someone who acquires from
the government free publications and either holds them or
gives them away.)

Obviously, our concern for most purposes in the real property area, and particularly the
exchange area, is to focus on the assets listed in Categories 1 and 2. The other items have
been noted to complete the discussion, but the main concern will be whether property is
used in the trade or business, or whether it is property primarily for sale or otherwise not
used in the trade or business. Section 1031 property must be property used in the trade or
business or held for investment.

The "or for investment" language is intended to refer to an intent to hold income property
as opposed to a personal use house. That is, the Code is not saying that every property
qualified under Section 1031 must be income-producing. What the Code is saying is that
investment property, as that term has been construed, refers to an intent to produce
income (gain) from the property as opposed to, for example, a principal residence. Thus,
although a principal residence might be an investment, as we use that term in common
parlance, it is not the type of investment (use) that will qualify under Section 1031.

The residence of an individual might be the "best investment," but for Section 1031
treatment, the principal residence would not qualify, when used as a principal residence,
as opposed to use as rental property.

PERSONAL USE

Property which is held for personal use, such as the home, personal automobile, paintings
hanging in the home, and so forth, would fit the classification of a capital asset. This is
obvious, since the definition of a capital asset, under Section 1221, excludes five
categories, and the personal home does not fit within any one of the five; therefore, by
negative definition, it is a capital asset. But Section 1031 is concerned with use.
The distinction of a capital asset vis-a-vis other uses, e.g., property held primarily for
resale, is often litigated. The question of a capital asset versus dealer property, that is,
property held primarily for resale, is discussed in detail under Disqualified Property:
Stock, Securities, Stock in Trade, etc., later in this Chapter.

INVESTMENT PROPERTY, PROPERTY USED IN THE TRADE OR


BUSINESS, AND INVOLUNTARY CONVERSIONS:
CODE SECTION 1231

Code Section 1231(a), one of the areas of the tax law often referred to by its number, that
is, Section 1231 property, deals with property that is used in the trade or business, and
certain types of involuntary conversions. Section 1231(a) provides that if the recognized
gain on sales or exchanges of property used in the trade or business, plus certain
recognized gains from an involuntary conversion (e.g., by fire) of property used in the
trade or business and capital assets held for more than one year, are converted into
property or money, and that exceeds the losses for those types of activities, the gains and
losses shall be considered as gain and loss from the sale or exchange of capital assets held
for more than one year. This is a long-winded way of saying that if a taxpayer disposes of
Section 1231 property for a gain, the gain would be treated as long-term capital gain.
Under the law prior to the Tax Reform Act of l986, the gain would be subject to the 60
percent capital gain deduction for an individual. (That deduction no longer applied after
the Tax Reform Act of l986. The gain became fully taxable.)

Section 1231 is the "have-your-cake-and-eat-it-too" section: It allows long-term capital


gain treatment as noted. If the taxpayer had sold Section 1231 property at a loss, the loss
would have been treated as an ordinary loss, as opposed to a capital loss. The
combination is obviously more advantageous for the taxpayer.

Section 1231 provides for a specific interpretation of the term "property used in the trade
or business." That Section says that it means property which is subject to the allowance
for depreciation provided in the Internal Revenue Code, held for more than one year, and
real property used in the trade or business and held for one year, or real property used in
the trade or business held, for more than one year, which is not a type of property in any
one of the groups listed earlier.

Section 1231 property can also include timber, coal and iron ore in some settings (see
Code Section 631), and also livestock and unharvested crops in certain limited settings.
As to unharvested crops, Section 1231 provides that when an unharvested crop on land
which is used in the trade or business is held for more than one year, if the crop and the
land are sold or exchanged, or in some cases converted, involuntarily, at the same time,
and to the same person, the crop qualifies as Code Section 1231 property. It will receive
the capital gain or ordinary loss treatment.

The following reviews the term "investment property."


CARY A. EVERETT, Petitioner
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
37 T.C..M. 274,
T.C. Memo. 1978 053

MEMORANDUM FINDINGS OF FACT AND OPINION

FAY, Judge: Respondent determined a deficiency of $129,476.41 in petitioner's Federal


income tax for 1971. Due to concessions by petitioner, the sole issue remaining for
decision is whether the transfer by petitioner of certain timber rights in 1971 qualified for
nonrecognition treatment under section 1031. [FN1]

FINDINGS OF FACT

Some facts have been stipulated and are so found.

Petitioner, CARY A. EVERETT, resided in Chipley, Fla., at the time the petitioner herein
was filed. Petitioner filed his Federal income tax return for 1971 with the District
Director of Internal Revenue at Atlanta, Ga.

On August 7, 1970, petitioner purchased timber rights on approximately 5,101 acres of


land in Florida as an investment (hereinafter referred to as the Everett timber rights). The
rights thus acquired by petitioner were embodied in a timber lease covering three separate
tracts of land. The lease granted petitioner the right to remove timber from two of these
tracts for a period of six years from the date of the lease and from the third tract for a
period of 36 months. [FN2]

On January 12, 1971, W. A. McClung (McClung), a real estate broker, acquired an option
to purchase approximately 26,000 acres of property in Florida between January 25, 1971,
and September 20, 1971, from the estate of E. L. Jordan for $2,500,000. The property
consisted of land and the rights to the timber located thereon (hereinafter referred to as
the Jordan land and Jordan timber rights, respectively).

McClung did not have the money to exercise his option and therefore sought a buyer for
the property. On May 28, 1971, Jimmy Hatcher (Hatcher), a business associate of
petitioner's signed an agreement captioned 'Option Contract for Sale' in which McClung
contracted to sell and Hatcher contracted to buy some 24,468 acres of the Jordan land and
Jordan timber rights for $3,364,400. Although petitioner's name did not appear on the
contract, Hatcher signed the document on behalf of himself and petitioner as equal
partners.

In July 1971 petitioner indicated to his accountant a desire to sell the Everett timber
rights on an installment basis but also indicated that he needed cash with which to make
another investment. Petitioner's decision to sell the Everett timber rights was attributable
to his desire to acquire an interest in the Jordan land and Jordan timber rights. [FN3]
On August 9, 1971, petitioner for consideration of $10,000 granted LockhartLumber
Company (Lockhart), a 14 day option to acquire the Everett timber rights for $1,270,000.
Petitioner and Lockhart both wanted to structure the sale on an installment basis. On
August 23, 1971, the option granted Lockhart was extended until September 27, 1971.
[FN4]

Subsequent to August 23, 1971, and prior to September 17, 1971, Lockhart's attorney and
others negotiated with the First National Bank of Mobile on behalf of Lockhart for
financing the purchase of the Everett timber rights on an installment basis. [FN5] These
efforts were unsuccessful. Because Lockhart was unable to meet petitioner's requirement
regarding an installment sale, petitioner considered the sale of the Everett timber rights to
Lockhart to be at an end. At the time, Lockhart had never exercise its option to purchase
the Everett timber rights and was not legally obligated to do so.

On September 13, 1971, petitioner met with counsel and Hatcher to discuss the
alternatives. At this meeting, Hatcher suggested that petitioner consider exchanging the
Everett timber rights for other timber rights of like kind, namely, the Jordan timber rights.

Petitioner's attorney contacted McClung's attorney, William Mongoven (Mongoven),


with respect to the possibility of such an exchange. McClung, aware that Lockhart was
interested in acquiring the Everett timber rights, agreed to the exchange and authorized
Mongoven to conduct the negotiation of the exchange and his sale of the Everett timber
rights to Lockhart. Mongoven and petitioner's attorney negotiated the exchange prior to
September 17, 1971.

At the closing on September 17, 1971, the following event occurred:

(a) McClung purchased the Jordan land and Jordan timber rights from the Jordan estate
for $2,500,000

(b) Petitioner and Lockhart cancelled the option covering the Everett timber rights and
petitioner refunded the $10,000 consideration he had received for such option to
Lockhart.

(c) Petitioner and McClung exchanged timber rights. [FN6]

(d) McClung sold the Everett timber rights to Lochkart for $1,270,000.

(e) McClung sold the Jordan land (absent the Jordan timber rights for 10 year) to Chipola
Land Corporation (Chipola), a Florida corporation, which had been formed by petitioner
and Hatcher on May 26, 1971, for the purpose of serving as an investment company to
buy timber lands. [FN7]

(f) The Citizens Bank & Trust Company of Quincy, Fla., loaned $2,319,441 to Chipola.
Approximately $1,853,260 of this amount was paid directly to McClung or the Jordan
estate at the direction of McClung.
(g) Petitioner and Chipola delivered a mortgage executed by them to the Citizens Bank &
Trust Company to secure Chipola's promissory note. The bank required that the mortgage
cover both the Jordan land and timber rights.

Immediately after the closing, there was no discussion or thought of petitioner selling the
Jordan timber rights to Chipola. Petitioner's primary purpose in acquiring the Jordan
timber rights was an investment. At the time of the exchange, the Everett timber rights
and the Jordan timber rights were property of a like kind.

Respondent, in a statutory notice of deficiency, determined that the purported exchange


by petitioner of the Everett timber rights constituted a sale of such rights to Lockhart and
that the long term capital gain realized on the transaction must be recognized in the
taxable year 1971 rather than being deferred under section 1031(a).

OPINION

At issue is whether, as urged by petitioner, the September 17, 1971, transfer by petitioner
of the Everett timber rights for the Jordan timber rights constituted a tax free exchange
within the meaning of section 1031(a). [FN8]

Respondent, on brief, conceded that petitioner acquired the Everett timber rights as an
investment. Nevertheless, he maintains that during the period August 9, 1971, to
September 17, 1971, petitioner held the Everett timber rights primarily for sale and
therefore was not entitled to the nonrecognition benefits of section 1031. This is a factual
question requiring consideration of the circumstances surrounding the granting of the
opinion on August 9, 1971, as well as the exchange, the primary purpose for acquiring
and holding the property, and the nature of the property itself.

After careful consideration of these factors, we believe that the granting of the option on
August 9, 1971, did not effectuate a change in the primary purpose of petitioner in
holding the property. See Malat v. Riddell, 383 U.S. 569 (1966). We therefore conclude
that petitioner has established that the Everett timber rights were held primarily for
investment at all times relevant herein.

Next, we consider respondent's alternative argument. It is respondent's position that the


substance of the transactions involved amounted to a sale of the Everett timber rights by
petitioner to Lockhart and a reinvestment of the proceeds from such sale in the Jordan
timber rights. In support of this position, respondent attaches significance to the option
Lockhart had to purchase the Everett timber rights and asserts that McClung merely
entered into the exchange in the capacity of an agent or conduit on behalf of petitioner.

In our view, the evidence does not support respondent's position in any respect. At all
times relevant herein and prior to the exchange, petitioner held title to the Everett timber
rights. While Lockhart held an option to purchase the Everett timber rights, this option
was never exercised. [FN9] Rather, on September 17, 1971, the option was cancelled.
This is distinguishable from the situation in which the optionee has exercised the option
and paid the purchase price prior to the exchange.

Nor does the evidence support a finding that McClung acted as an agent or conduit
during the September 17, 1971, transaction. McClung was not involved in the agreement
between Lockhart and petitioner. Lockhart was not involved in the agreement between
McClung and petitioner. The mere fact that McClung might not have acquired the Everett
timber rights if he did not anticipate their immediate resale to Lockhart is immaterial.

We believe the series of events and legal documents which track the exchange cannot be
ignored. The intent of the parties involved is reflected therein and coincides with the
substance of the transactions.

On August 9, 1971, petitioner granted Lockhart an option to purchase the Everett timber
rights for cash. An installment sale with notes from Lockhart to petitioner which would
be acceptable as collateral for a loan to petitioner by a third party was an integral part of
the deal. [FN10] When petitioner's financial requirements could not be accommodated,
petitioner considered the sale to be at an end. Subsequently, an exchange of like kind
properties was negotiated and on September 17, 1971, such exchange was consummated.
On that date the Everett timber rights were transferred to McClung by petitioner, and the
Jordan timber rights were transferred by McClung to petitioner.

In Coupe v. Commissioner, we stated: It is now well settled that when a taxpayer who is
holding property for productive use in a trade or business enters into an agreement to sell
the property for cash, but before there is substantial implementation of the transaction,
arranges to exchange the property for other property of like kind, he receives the
nonrecognition benefits of section 1031. Coastal Terminals, Inc. v. United States, James
Alderson reversed on other grounds ; Carlton v. United States, Of crucial importance in
such an exchange is the requirement that title to the parcel transferred by the taxpayer in
fact be transferred in consideration for property received.

We believe the foregoing principles are applicable to this case.

Accordingly, we hold that on September 17, 1971, there was effected an exchange of like
kind property within the meaning of section 1031(a).

FN1. Unless otherwise indicated, all statutory references are to the Internal Revenue
Code of 1954, as amended, and in force during the year in issue.

FN8. SEC. 1031. EXCHANGE OF PROPERTY HELD FOR PRODUCTIVE USE OF


INVESTMENT.

(a) Nonrecognition of Gain or Loss from Exchanges Solely in Kind. No gain or loss shall
be recognized if property held for productive use in trade or business or for investment
(not including stock in trade or other property held primarily for sale, nor stocks, bonds,
notes, choses in action, certificates of trust or beneficial interest, or other securities or
evidences of indebtedness or interest) is exchanged solely for property of a like kind to be
held either for productive use in trade or business or for investment.

PRIVATE LETTER RULING 8915012

PRIVATE LETTER RULING 8915012

This Private Letter Ruling illustrates how qualified property must be used in your trade or
business or held for investment. It cannot be held for your personal residence and come
within Code §1031.

PRIVATE LETTER RULING 8915012

Section 1031 Like Kind Exchanges

Publication Date: April 14, 1989

January 5, 1988

Dear

This is in reply to your letter requesting a ruling regarding a proposed exchange of


properties.

According to the information in your letter, you presently own an eleven acre tract of
land with a house, which you rent and hold as investment property. You plan to exchange
this property for a six acre tract of land with a house and after the exchange, you plan to
use this property as your personal residence.

Section 1031(a)(1) of the Internal Revenue 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. (emphasis added).

Since you plan to use the acquired property as your personal residence after the
exchange, this exchange would not come within the provisions of section 1031 of the
Code. Accordingly, any gain or loss realized on the exchange of properties will be
recognized.

This ruling is directed only to the taxpayer who requested it. Section 6110(5)(3) of the
Code provides that it may not be used or cited as precedent.

No opinion is expressed as to the federal income tax consequences of the transaction


described above under any other provision of the Code. Sincerely yours,
STOCK IN TRADE:

PRIMARILY FOR RESALE

Property which is stock in trade of the taxpayer of property which is included in


inventory (primarily for resale) would not qualify as Section 1031 property. This
category sometimes raises an interpretive problem.

Consider a circumstance where a developer owns a great deal of property. Assume he


builds a number of homes on one-third of the acreage. Then, perhaps as a result of health
problems, changes in circumstances, zoning problems, or necessary environmental
protection approvals, he changes his mind as to the use of the property; he takes the
position that the property is now held "primarily for investment," rather than to develop
and sell. This determination may be crucial if we are talking of a sale and trying to
generate capital gain. Likewise, and often forgotten, that determination is crucial in the
exchange field, since property held "primarily for resale" is not qualified under Section
1031.

If the taxpayer-developer is approached by a buyer, who offers the taxpayer $2 million


for the property on which the taxpayer has a basis of $1 million, and the parties agree that
the transaction can be structured as an exchange, the determination as to whether the
property is held primarily for resale is paramount!

If we assume that the property is primarily for resale, not only would it not qualify for a
Section 1031 transaction, but it would also produce ordinary income. If, on the other
hand, the property would qualify as Section 1031 property, and the parties can structure it
as a proper exchange, it might be possible that no gain would be currently recognized by
a developer. This emphasizes the crucial importance of classification of the use of
property and the determination as to the category in which a given piece of property
might fit.

HELD FOR PRODUCTIVE USE OR INVESTMENT SECTION 1031(a):


GENERAL RULE: NONRECOGNITION

The nonrecognition of a gain or a loss from an exchange solely in like-kind property is


provided under Section 1031(a)(1). This Section provides:

No gain or loss shall be recognized if property held for productive use in trade or
business or for investment (if such property) is exchanged solely for property of a like-
kind to be held either for productive use in trade or business or for investment. (Emphasis
supplied.)

There are a number of key words which are developed in more detail in the subsequent
paragraphs They include, for example, such considerations as "gain or loss." That is, the
Section states that no gain or loss will be recognized. Thus, the Section, although
normally used by taxpayers to postpone gain, is also applicable to postpone losses.
Taxpayers must be very concerned with transactions which might qualify as an exchange
where the taxpayer does not desire a Section 1031 exchange, because a loss might be
generated.

Section 1031 is mandatory! The use of the word "shall" emphasizes that
"nonrecognition," meaning paying tax or taking deductions, as the term "recognition" is
defined by Code §1031 1001, will take place if the transaction falls within Code §1031.

Additional points of emphasis include the requirement that the transaction involve
property used in the trade or business, i.e., the property must be held for productive use in
trade or business or for investment. In other words, it is not "other types of property," but
is only the two groups of: (1) trade or business, or (2) investment-type property, which, if
a loss sense, we often refer to as "Code §1231 property." (The language discussed might
arguably be broader than Section 1231. Some practitioners argue against this point.)

Section 1031(a)(2) excludes certain types of property. It specifically excludes property


that is held primarily for resale. It also excludes a number of other items, such as stock or
securities. This point will become clear when we examine a number of cases, such as the
Estate of Meyer and Gulfstream.

This Section also requires an exchange. The term "exchange" has been interpreted in the
Starker cases, which emphasized that an exchange might require a "simultaneous
transaction," and not some escrow or account balance arrangement. (Starker III did not
require a simultaneous exchange.)

Section 1031(a) also provides that the exchange must be solely for property of a like-
kind. This language emphasizes the word solely; if property is exchanged and nit is not
"solely like-kind," we have a concept of "boot," meaning non-like-kind property that is
generated. This can generate tax under given settings.

The requirement that the property be transferred is emphasized in other cases; services
cannot be transferred for property. In addition, the magic label of "like-kind" has been
used. This emphasizes an interpretive problem of what constitutes like-kind property. Is it
like-kind property when one transfers an apartment house for other investment property
in the form of raw ground? The answer to this question is "yes." This and other types of
property which fit the requirement of like-kind are discussed subsequently.

26 U.S.C.A. §1031 UNITED STATES CODE ANNOTATED TITLE 26.


INTERNAL REVENUE CODE SUBTITLE A
INCOME TAXES
CHAPTER 1: NORMAL TAXES AND SURTAXES
SUBCHAPTER O GAIN OR LOSS ON DISPOSITION OF PROPERTY
PART III COMMON NONTAXABLE EXCHANGES
§1031. Exchange of property held for productive use or investment

(a) Nonrecognition of gain or loss from exchanges solely in kind.

(1) In general. 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.

(2) Exception. This subsection shall not apply to any exchange of:

(A) stock in trade or other property held primarily for sale,


(B) stocks, bonds, or notes,
(C) other securities or evidences of indebtedness or interest,
(D) interests in a partnership,
(E) certificates of trust or beneficial interests, or
(F) choses in action.

(3) Requirement that property be identified and that exchange be completed not more
than 180 days after transfer of exchanged property. For purposes of this subsection, any
property received by the taxpayer shall be treated as property which is not like kind
property if

(A) such property is not identified as property to be received in the exchange on or


before the day which is 45 days after the date on which the taxpayer transfers the
property relinquished in the exchange, or

(B) such property is received after the earlier of (i) the day which is 180 days after the
date on which the taxpayer transfers the property relinquished in the exchange, or (ii) the
due date (determined with regard to extension) for the transferor's return of the tax
imposed by this chapter for the taxable year in which the transfer of the relinquished
property occurs.

(b) Gain from exchanges not solely in kind.If an exchange would be within the
provisions of subsection (a), of section 1035(a), of section 1036(a), or of section 1037(a),
if it were not for the fact that the property received in exchange consists not only of
property permitted by such provisions to be received without the recognition of gain, but
also of other property or money, then the gain, if any, to the recipient shall be recognized,
but in an amount not in excess of the sum of such money and the fair market value of
such other property.

(c) Loss from exchanges not solely in kind.If an exchange would be within the provisions
of subsection (a), of section 1035(a), of section 1036(a), or of section 1037(a), if it were
not for the fact that the property received in exchange consists not only of property
permitted by such provisions to be received without the recognition of gain or loss, but
also of other property or money, then no loss from the exchange shall be recognized.
(d) Basis.If property was acquired on an exchange described in this section, section
1035(a), section 1036(a), or section 1037(a), then the basis shall be the same as that of
the property exchanged, decreased in the amount of any money received by the taxpayer
and increased in the amount of gain or decreased in the amount of loss to the taxpayer
that was recognized on such exchange. If the property so acquired consisted in part of the
type of property permitted by this section, section 1035(a), section 1036(a), or section
1037(a), to be received without the recognition of gain or loss, and in part of other
property, the basis provided in this subsection shall be allocated between the properties
(other than money) received, and for the purpose of the allocation there shall be assigned
to such other property an amount equivalent to its fair market value at the date of the
exchange. For purposes of this section, section 1035(a), and section 1036(a), where as
part of the consideration to the taxpayer another party to the exchange assumed a liability
of the taxpayer or acquired from the taxpayer property subject to a liability, such
assumption or acquisition (in the amount of the liability) shall be considered as money
received by the taxpayer on the exchange.

(e) Exchanges of livestock of different sexes.For purposes of this section, livestock of


different sexes are not property of a like kind.

(f) Special Rules for Exchanges Between Related Persons.

(1) In general.If:

(A) a taxpayer exchanges property with a related person,


(B) there is nonrecognition of gain or loss to the taxpayer
under this section with respect to the exchange of such
property (determined without regard to this subsection),
and
(C) before the date 2 years after the date of the last transfer
which was part of such exchange (i) the related person
disposes of such property, or (ii) the taxpayer disposes
of the property received in the exchange from the
related person which was of like kind to the property
transferred by the taxpayer, there shall be no
nonrecognition of gain or loss under this section to the
taxpayer with respect to such exchange; except that any
gain or loss recognized by the taxpayer by reason of this
subsection shall be taken into account as of the date on
which the disposition referred to in subparagraph (C)
occurs.

(2) Certain dispositions not taken into account.For purposes of paragraph


(1) (C), there shall not be taken into account any disposition

(A) after the earlier of the death of the taxpayer or the death
of the related person,
(B) in a compulsory or involuntary conversion (within the
meaning of section 1033) if the exchange occurred
before the threat or imminence of such conversion, or
(C) with respect to which it is established to the satisfaction
of the Secretary that neither the exchange nor such
disposition had as one of its principal purposes the
avoidance of Federal income tax.

(3) Related person.For purposes of this subsection, the term "related person" means any
person bearing a relationship to the taxpayer described in section 267(b).

(4) Treatment of certain transactions.This section shall not apply to any exchange
which is part of a transaction (or series of transactions) structured to avoid the purposes
of this subsection.

(g) Special Rule Where Substantial Diminution of Risk.

(1) In general.If paragraph (2) applies to any property for any period, the running of the
period set forth in subsection (f)(1)(C) with respect to such property shall be suspended
during such period.

(2) Property to which subsection applies.This paragraph shall apply to any property for
any period during which the holder's risk of loss with respect to the property is
substantially diminished by

(A) the holding of a put with respect to such property,


(B) the holding by another person of a right to acquire such
property, or
(C) a short sale or any other transaction.

(h) Special Rule for Foreign Real Property.For purposes of this section, real property
located in the United States and real property located outside the United States are not
property of a like kind.

Under the Revenue Reconciliation Act of 1990, there was a technical Amendment
under Code §1031(a)(2), amending that Section to provide that the nonrecognition under
this Section will not inhibit an exchange of an interest that is not a partnership interest.

That is, although the Code §1031 rules do not apply to exchanges of partnership
interests, there is a provision under Code §761(a) to allow parties to be excluded from the
partnership rules, if that election is properly made and applicable. If the election is
properly made, the interest will be treated as an interest in each of the assets of the
owners, and not as an interest in a partnership.

[This is a technical correction, and, therefore, it relates to transfers after 7/18/84. See
Code §1031(a)(2).]
Also, under Code §1031(a)(2), for purposes of this Section, an interest in a partnership
which has in effect a valid election under Code §761(a) to be excluded from the
participation of all of subchapter K shall be treated as an interest in each of the assets of
such partnership and not as an interest in a partnership.

PRIVATE LETTER RULING 9447008

This Private Letter Ruling illustrates the use of exchanging personalty (automobiles)
within Code §1031.

December 23, 1993


Publication Date: November 25, 1994

Dear
On behalf of Taxpayer, you have requested a private letter ruling on issues arising
under section 1031 of the Internal Revenue Code. The following facts are represented:

Taxpayer is a corporation, doing business in State A as a franchisee of Corp B.


Taxpayer owns a fleet of motor vehicles through two operating divisions. Its passenger
vehicle division engages in the business of owning and renting cars, vans, minivans and
sportutility vehicles. Its truck division owns and rents light and heavy duty trucks.
Taxpayer's total fleet ranges in number from about e to f motor vehicles at a time during
any taxable year. Taxpayer regularly disposes of these vehicles and replaces them with
new vehicles as seasonal demand and resale pricing requires. Most cars are replaced
every c to d months. All vehicles in Taxpayer's fleet are used in its trade or business.
Although Taxpayer is registered in State A as a motor vehicle dealer, none of its vehicles
are purchased merely for resale. Taxpayer depreciates all of its cars and trucks under
section 168 of the Internal Revenue Code. [FN1]

Taxpayer typically purchases its motor vehicles from manufacturers pursuant to


"manufacturers' daily rental fleet purchase programs and contracts" which are negotiated
with the manufacturers. In accordance with these contracts, Taxpayer sends purchase
orders to dealers for specifically equipped models during the year usually at a fixed
markup above such dealer's invoice from the manufacturer. Taxpayer then takes delivery
and pays the dealer. Most of the vehicles purchased for its businesses are subject to
"manufacturer's repurchase agreements" under the negotiated fleet programs. Pursuant to
these programs, the manufacturer offers to repurchase the vehicles for a minimum
amount (dependent upon length of ownership, mileage and damage).

Taxpayer typically delivers these vehicles with endorsed title certificates to the auctions
designated by the manufacturer. The vehicles are then auctioned off and the proceeds are
paid to the manufacturer. The manufacturer then pays Taxpayer the amount required by
the repurchase agreement, usually after thirty days. Taxpayer has a revolving credit
facility with a consortium of banks that includes Bank M, Bank N and Bank O. Under
this credit facility, all motor vehicles owned by Taxpayer are held under State A title
certificates with lien noted in favor of Bank M as agent for the lenders. This arrangement
permits release of the lien when the vehicle is sold or otherwise transferred by Taxpayer.
However, the amount of the credit facility available to Taxpayer depends, in part, upon
the adequate value of the vehicles pledged to Bank M.

Taxpayer has determined that, occasionally, it would be to its advantage to dispose of


and replace portions of its automotive fleet through likekind exchange arrangements
rather than continue to make replacements exclusively under its present purchase/resale
system. In view of the growth and shrinkage of its motor vehicle fleet (attributed to
seasonal fluctuations in market demand) and the frequent delays in receiving repurchase
proceeds from manufacturers, Taxpayer has determined that such exchanges should be
structured as deferred, likekind exchanges pursuant to section 1.1031(k)1 of the Income
Tax Regulations, using a qualified intermediary. Taxpayer proposes one such transaction
which it intends to enter into during the upcoming calendar year. If a favorable ruling is
obtained for this transaction, it will serve as a model for subsequent exchanges. The
following is a summary of the steps to be taken to effect the proposed likekind exchange:

PRELIMINARY STEPS

Step 1: Execution of a Master Vehicle Exchange Agreement (hereinafter the "Exchange


Agreement"). Taxpayer enters into the Exchange Agreement with Bank O. Under the
Exchange Agreement, Bank O, via its corporate trust department, is the intermediary
(hereinafter referred to as "Intermediary") for the exchange now contemplated under the
present facts and in subsequent transactions. Taxpayer intends Bank O to qualify and fill
the role of a "qualified intermediary" under the safe harbor rules of section
1.1031(k)1(g)(4) of the regulations. The agreement with Bank O was previously entered
into by Taxpayer and is dated December 31, 1992.

Step 2: Amendment of Manufacturer Agreements. Taxpayer amends the agreements


with the manufacturers from which it purchases vehicles to permit Intermediary to
acquire vehicles on Taxpayer's behalf and permit Intermediary to transfer vehicles to the
manufacturer for repurchase.

Step 3: Amendment of Credit Facility. Taxpayer amends its credit and security
agreement with the lender to permit it to exchange motor vehicles under the Exchange
Agreement.

SPECIFIC STEPS TO BE TAKEN TO EFFECT PROPOSED EXCHANGE

Step 4: Transfer of Relinquished Vehicles to Intermediary. On January 15, 1994,


Taxpayer will transfer to Intermediary 19 q cars that it originally purchased and placed in
service in its daily rental fleet in April 1993. The transfer is effected by completing a
"Relinquished Vehicle Transfer and Group Designation Form" (Exhibit E of the
Exchange Agreement), listing each of the said cars, and delivering the completed Exhibit
E to Intermediary. [FN2] Taxpayer will designate these 19 relinquished cars as the
Relinquished Vehicles for Exchange Group 1994A. Also on January 15, 1994, the
manufacturer of each relinquished vehicle (Corp H) will be advised of the assignment of
these 19 q cars and instructed to send the proceeds resulting from the sale thereof to
Intermediary. This will be effected by delivering a "Form of Assignment of Agreement
for the Sale of Vehicles" (Exhibit G of the completed Exchange Agreement) to Corp H
listing the relinquished vehicles individually. Also on January 15, 1994, upon notice from
Taxpayer, the lenders will release their security interest in the 19 q cars by signing a
release of lien on the title certificates for these vehicles.

Step 5: Sale of Relinquished Vehicles by Intermediary. On January 16, 1994, the


relinquished vehicles in Exchange Group 1994A, will be delivered to the auction house,
each with a title certificate transferring title from Taxpayer to Corp HAuction
Department. On January 18, 1994, the relinquished vehicles will be sold at auction. On or
about February 18, 1994, Corp H will pay Intermediary $i by wire transfer for the 19
vehicles comprising the relinquished vehicles of Exchange Group 1994A. Intermediary
will then deposit the proceeds into a segregated account that it maintains in its capacity as
Intermediary pursuant to the Exchange Agreement. Taxpayer will have no power or right
to receive, pledge, borrow or otherwise receive the benefits of the proceeds from the sale
of the relinquished property except as described below under the heading for Step 8.

Step 6: Identification of Replacement Vehicles. On or about February 1, 1994,


Taxpayer will send (1) a purchase order to a Corp J dealer to purchase 10 k cars with
automatic transmissions for immediate delivery and (2) a purchase order to a Corp L
dealer to purchase 6 p cars with automatic transmissions for immediate delivery. Each
purchase order lists Intermediary as the purchaser of the replacement vehicles. At the
same time, Taxpayer will complete the "Identification / Assignment Form to the
Intermediary" (Schedule F1 (alternate) of the Exchange Agreement), attaching copies of
these purchase orders, listing the 10 k cars and the 6 p cars as replacement vehicles for
Exchange Group 1994A. [FN3] This completed form will then be sent to Intermediary.
The total purchase price for the 10 k cars and the 6 p cars will approximate $q ($i +
$29,240).

Step 7: Acquisition of Replacement Vehicles. It is expected that by March 1, 1994, the


Corp J dealer will notify Taxpayer that the 10 k cars are available for delivery. On or
about March 2, 1994, Taxpayer will inspect the k cars. On or about March 3, the dealer
will deliver possession of and title to the vehicles noting a lien in favor of lenders. On or
about March 4, Intermediary will be notified by Taxpayer that all conditions for paying
for these vehicles are satisfied using a form entitled "Notification to the Intermediary"
(Schedule B1 of the Exchange Agreement). If all goes according to schedule,
Intermediary will issue a check for $r to the Corp J dealer on or about March 5, a date
that is well within the replacement period.

It is also anticipated that by March 10, 1994, the Corp L dealer will notify Taxpayer
that the 6 p cars are available for delivery. Taxpayer will inspect the 6 p cars on or about
March 12, 1994. On or about the day following, the dealer will deliver possession of and
title to the vehicles, noting the lien in favor of the lenders. On or about March 14,
Intermediary will be notified by Taxpayer that all conditions for paying for these vehicles
are satisfied using Schedule B1. Taxpayer will then deliver a check in the amount of the
balance due ($29,240) to Intermediary on or about March 15, and Intermediary will issue
a check for $s (the remaining balance on the total purchase price $q) to the Corp L dealer
on or about the same date.

Step 8: Disbursement of Funds by the Intermediary. If replacement vehicles with


respect to a group of relinquished vehicles are not identified within 45 days of the first
transfer of a car or truck included in such group of relinquished vehicles, the exchange
agreement directs Intermediary to disburse funds from the proceeds of the sale of such
group to Taxpayer by depositing them into an account at Bank M in behalf of Taxpayer.
If the proceeds of the sale of a group of relinquished vehicles exceed the amount
expended by the Intermediary to acquire replacement vehicles, the Exchange Agreement
directs Intermediary to deposit such excess funds to an account of Taxpayer at Bank M
within three business days following either Taxpayer's receipt of the last identified
replacement vehicle with respect to such group of relinquished vehicles or the expiration
of the exchange period which ever first occurs. [FN4]

Taxpayer will enter into the exchange with the intent that Intermediary will utilize
proceeds from the sale of the relinquished vehicles to purchase the replacement vehicles.
Taxpayer will make its identification of replacement vehicles for the group of
relinquished vehicles within 45 days after the first relinquished vehicle in the group is
transferred. Taxpayer will not identify replacement vehicles for an exchange group with
an aggregate fair market value exceeding 200% of the aggregate fair market value of the
relinquished vehicles for such group.

Taxpayer will fully complete and transmit all forms and schedules for the exchange
group, as required by the Exchange Agreement. The form of notification to be given to
manufacturers will specifically advise manufacturers that Intermediary is acting as a
qualified intermediary pursuant to the Exchange Agreement with respect to purchases
and sales of vehicles under the Exchange Agreement. All notifications to dealers,
including purchase orders, will advise the dealer that Intermediary is acting as a qualified
intermediary pursuant to the Exchange Agreement. The Exchange Agreement will govern
all exchanges of vehicles made by Taxpayer.

Under these facts, Taxpayer requests the Service issue the following rulings:

1. Taxpayer's transfer of each group of relinquished vehicles and Taxpayer's


corresponding receipt of designated replacement vehicles in accordance with the
Exchange Agreement will each constitute a separate and distinct exchange transaction for
federal income tax purposes.

2. Intermediary, acting in accordance with the Exchange Agreement, will be treated as


acquiring and transferring both the relinquished vehicles and replacement vehicles for
purposes of section 1031 of the Code.

3. Taxpayer will not be in constructive receipt of any money or other property held by
Intermediary unless and until such items are actually payable to or received by Taxpayer,
on the condition that the requirements of the Exchange Agreement, representations in this
ruling request and other conditions of the safe harbor test are in fact met.

4. The exchange pursuant to the Exchange Agreement of each group of relinquished


vehicles for properly identified and received replacement vehicles will constitute a
nontaxable exchange to the extent no cash or other nonlike kind property is received by
Taxpayer, assuming that only motor vehicles from the same general asset class are
involved in such exchange. If Taxpayer does receive cash or other nonlikekind property
as defined in section 1031(b) in the exchange, the gains will be recognized in an amount
not in excess of such cash or other property.

Section 1031(a)(1) 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 for
productive use in a trade or business or for investment. Paragraph (a)(2) adds that this
subsection does not apply to any exchange of stock in trade or other property held
primarily for sale.

Accordingly, when a taxpayer disposes of an asset, there are three general requirements
for nonrecognition treatment under section 1031: (1) there must be an exchange; (2) the
properties exchanged must be of like kind; and (3) the property transferred and the
property received must be held for productive use in a trade or business, or for
investment.

Taxpayer's ruling request presents a proposed deferred exchange of multiple units of


tangible, depreciable property, for which the general requirements for nonrecognition
under section 1031(a) of the Code are the same. To simplify the monitoring of the
exchange in the present case (and in subsequent transactions), and insure the proposed
transaction qualifies as an exchange, Taxpayer plans to group its vehicles by general asset
classes and exchange them only for groups of assets of the same general asset class. This
approach is consistent with the one adopted in the regulations. Section 1.1031(j)1(a)(2) of
the regulations generally provides that the amount of gain recognized in an exchange of
multiple properties is computed by first separating the properties transferred and the
properties received by the taxpayer in the exchange into exchange groups in the manner
described in paragraph (b)(2) of that section. The separation of properties transferred and
properties received in the exchange into exchange groups involves matching up
properties of a like kind or like class to the greatest extent possible. Paragraph (b)(2)(i) of
that section provides, in part, that each exchange group consists of the properties
transferred and received in the exchange, all of which are of a like kind or like class. In
the present case Bank O, as Intermediary under the Exchange Agreement, has assumed
the responsibility of keeping specific accounts tracking the cash proceeds, interest earned
and disbursements relative to each group of relinquished vehicles. The transfer of a group
of relinquished vehicles to receive identified replacement vehicles of like kind or class in
accordance with an Exchange Agreement may constitute a transaction that is separate and
distinct from others for federal income tax purposes. Therefore, based upon Taxpayer's
representations, the proposed transaction constitutes an exchange.
The second requirement, that the properties exchanged be of likekind, has reference to
the nature or character of the property and not to its grade or quality. To qualify for
likekind exchange treatment, one kind or class of property may not be exchanged for
property of a different kind or class. See section 1.1031(a)1(b). In the context of a
multiple asset exchange, an exchange group may consist of all exchanged properties that
are in the same "general asset class" or the same "product class" as defined in section
1.1031(a)2(b). This latter provision lists categories of "automobiles," "buses," "light
general purpose trucks" and "heavy general purpose trucks" as being among the different
general asset classes that are recognized.

However, when an exchange transaction is deferred rather than simultaneous, even if


Taxpayer trades property for other property of the same asset class, the second
requirement (that the exchanged properties be of like kind) will not be satisfied if the
replacement property is not timely identified or received or if Taxpayer actually or
constructively receives property that is not of like kind before receiving the likekind
property intended. Section 1031(a)(3) of the Code provides that for purposes of this
subsection, any property received by the taxpayer shall be treated as property which is
not of like kind if(A) such property is not identified as property to be received in the
exchange on or before the day which is 45 days after the date on which the taxpayer
transfers the property relinquished in the exchange, or (B) such property is received after
the earlier of (i) the day which is 180 days after the date on which the taxpayer transfers
the property relinquished in the exchange, or (ii) the due date (determined with regard to
extension) for the transferor's return of the tax imposed by this chapter for the taxable
year in which the transfer of the relinquished property occurs.

PRIVATE LETTER RULING 9627014

This Ruling addressed the use of Code §1031 for exchanging of automobile fleets. It
also emphasized the requirements of a nonsimultaneous exchange and the use of an
intermediary in such case.

The Ruling is a good summary of the requirements necessary to comply with Code
§1031 in this setting, with personalty.

Internal Revenue Service (I.R.S.)


PRIVATE LETTER RULING 9627014
1996 WL 374432 (I.R.S.)
Issue: July 5, 1996
April 5, 1996

This responds to your letter of December 12, 1994 (and supplemental submissions
dated February 7, 1995, April 3, 1995, January 24, 1996 and March 8, 1996) requesting a
private letter ruling on issues arising under section 1031 of the Internal Revenue Code.
The following facts are represented: Taxpayer operates a car rental agency under a
franchise from Corporation B.
Taxpayer has rental locations in various towns situated in Territory A. Taxpayer owns a
fleet of vehicles ranging from c to d automobiles which are used in its rental business as
daily rental vehicles.

Taxpayer generally orders and purchases its vehicles from manufacturers through local
dealerships pursuant to manufacturer' daily rental fleet programs. The vehicles are
purchased from the local dealers at a fixed markup over dealer invoice cost for each
automobile.

Most of the vehicles purchased for its businesses are subject to "manufacturer's
repurchase agreements" under the negotiated fleet programs. Pursuant to these programs,
the manufacturer offers to repurchase the vehicles for a minimum amount (dependent
upon length of ownership, mileage and damage). Under this program, Taxpayer typically
delivers these vehicles with endorsed title certificates to the auctions designated by the
manufacturer. The vehicles are then auctioned off and the proceeds are paid to the
manufacturer. The manufacturer then pays Taxpayer the amount required by the
repurchase agreement. The amount that the manufacturer receives from the auction and
the amount that the manufacturer is required to pay Taxpayer are not related.

Taxpayer's vehicles are financed through commercial paper secured with a letter of
credit from Bank E and through lines of credit from several other banks (collectively
referred to as "Lender"). These financing arrangements are secured by vehicles with liens
noted on the initial title certificates in favor of Lender and by receivables from the
manufacturers for repurchased vehicles. Liens are released upon sale or transfer of a
vehicle by Taxpayer.

Taxpayer has determined that it would be advantageous to exchange a portion of its


automotive fleet rather than continue the sale/purchase process currently used. Due to
seasonal variances in fleet size and the inability to trade in used vehicles to the sellers of
new vehicles, the proposed exchanges must be structured as deferred likekind exchanges
using a qualified intermediary pursuant to s 1.1031(k)1 of the Income Tax Regulations.

A large portion of Taxpayer's rental fleet consists of vehicles manufactured by


Corporation X. As Corporation X does not have the systems in place to properly
segregate payments for nonexchange vehicles and payments for vehicles designated as
exchange vehicles, Corporation X has entered into a Master Deposit Agreement with
Deposit Bank. Under that agreement, Deposit Bank will serve as Corporation X's agent
responsible for properly segregating the payments for exchange and nonexchange
vehicles which Corporation X has purchased under a repurchase agreement. Taxpayer
will send copies of each Notice of Assignment and Notice of Rescission to Deposit Bank
so that Deposit Bank will have the information necessary to properly segregate and
disburse the funds it receives from Corporation X. Within two business days of receipt of
the funds, Deposit Bank will forward the money relating to the vehicles designated as
exchange vehicles to a designated qualified intermediary. Funds relating to nonexchange
vehicles will be paid by Deposit Bank to Taxpayer or to Taxpayer's lenders.
Taxpayer proposes one such transaction to be completed in the following steps in the w
taxable year:

PRELIMINARY STEPS (To All Exchanges by Taxpayer)

Step 1: Execution of a Master Vehicle Exchange Agreement (hereinafter the


"Exchange Agreement"). Taxpayer enters into the Exchange Agreement with Bank O.
Under the Exchange Agreement, Bank O, via its corporate trust department, is the
intermediary (hereinafter referred to as "Intermediary") for the planned exchange. The
Exchange Agreement provides that Taxpayer has no rights to receive, pledge, borrow, or
otherwise obtain the benefits of money or other property held by Intermediary before the
end of the exchange period, the receipt of all identified replacement property, or the
expiration of the identification period if no replacement vehicles are identified. Taxpayer
intends Bank O to qualify and fill the role of a "qualified intermediary" under the safe
harbor rules of section 1.1031(k)1(g)(4) of the regulations. Bank O performs no services
for Taxpayer other than in its capacity as the qualified intermediary.

Step 2: Amendment of Manufacturer Agreements. Taxpayer amends the agreements


with the manufacturers from which it purchases vehicles to permit Intermediary to
acquire vehicles on Taxpayer's behalf and permit Intermediary to transfer vehicles to the
manufacturer for repurchase. These amendments will permit Taxpayer to complete the
exchanges through Intermediary.

Step 3: Amendment of Credit Facility. Taxpayer amends its credit and security
agreement with Lender to permit it to exchange vehicles under the Exchange Agreement.

SPECIFIC STEPS TO BE TAKEN TO EFFECT PROPOSED EXCHANGE

Step 4: Transfer of Relinquished Vehicles to Intermediary. On Date Z, Taxpayer will


transfer to Intermediary two fs (FMV $g) for exchange pursuant to the Exchange
Agreement. On Z+1, Taxpayer will transfer to Intermediary four more fs, also for
exchange pursuant to the Exchange Agreement. These transfers will be effected by
completing a "Relinquished Vehicle Transfer and Group Designation Form" (Form A of
the Exchange Agreement), listing each of the said vehicles, and delivering the completed
Form A to Intermediary. [FN1] Taxpayer designates these relinquished automobiles as
the Relinquished Vehicles for Exchange Group 10. Also on Date Z and on Z+1,
Taxpayer, using another standard form authorized by the Exchange agreement (Form B),
will notify Corporation X ("manufacturer") of its assignment of the six relinquished
vehicles to Intermediary. The manufacturer will be directed to send the proceeds from
those vehicles to Intermediary acting in its capacity as qualified intermediary under the
Exchange Agreement. A copy of each Form B (which lists each vehicle assigned to
Intermediary during each day) will be sent to Deposit Bank, so Deposit Bank will have
information available to properly identify the proceeds from the manufacturer/purchaser.
On the day each vehicle is assigned to Intermediary, Lender will release its security
interest in the relinquished vehicles by signing a release of lien on the respective
certificates of title.
Step 5: Sale of Relinquished Vehicles by Intermediary. The six relinquished vehicles
constituting Exchange Group 10 will be delivered to the auction house with the title
certificates transferring title from Taxpayer to manufacturer on the dates listed above. On
or about Z+5, the vehicles will be sold by the auction house. On or about Z+26, Deposit
Bank will receive a check from manufacturer in the amount of $q. This amount
represents the total payment of $m for the six fs relinquished on Date Z and on Z+1
("exchange funds") plus $r for nonexchange vehicles ("nonexchange funds"). By Z+28,
Deposit Bank will forward $m to Intermediary and $r to Taxpayer. Intermediary will
deposit the $m exchange funds in an account segregated for Exchange Group 10 pursuant
to the Exchange Agreement.

Step 6: Identification of Replacement Vehicles. On or about Z+36 (but before 45 days


after Date Z), Taxpayer will identify three ts with a total cost of $u (an amount exceeding
$m by $v) as replacement vehicles for Exchange Group 10. This is accomplished by
completing a standard form of the Exchange Agreement (Form CD) which identifies the
vehicles and assigns Taxpayer's purchase rights in such vehicles to Intermediary.

PRIVATE LETTER RULING 9431025

This Ruling involved an attempted exchange by the Taxpayer of property that was held
for investment, certain adjoining land or lots, and another lot in which the Taxpayers held
their house.

They were approached by a party who wished to undertake the acquisition of all the
property. The Taxpayer desired a tax-deferred exchange on the entire property, under the
theory of Code §1031.

Although the lots held for investment qualified under Code §1031 for the exchange,
assuming other requirements of Code §1031 were met, the Ruling held that a qualified
exchange would not apply to the extent of the gain involving the portion of the residence
that was being transferred, as it did not come within the meaning of the Code §1031
definition of "trade or business or investment property".

PRIVATE LETTER RULING 9431025


Publication Date: August 5, 1994

Dear

This is in reply to your letter of August 26, 1993, and subsequent correspondence,
requesting a ruling under section 1031 of the Internal Revenue Code on the anticipated
EXCHANGE of certain real estate and the replacement of that property, on your behalf.

You have made the following representations:

You, Individuals A and B, are a married couple. You hold a fee interest in Lot 1, 1.8
acres, and Lot 2, 1.9 acres, in Town T, State S. Back in 1969, you purchased Lot 1 for
your home and Lot 2 for investment or other use. You now have your family home on
Lot 1 and a pair of frame sheds on Lot 2. Recently, a developer, Individual D, has
proposed to acquire the north .5 acre of Lot 1 and all of Lot 2 from you in EXCHANGE
for 2 townhouses to be built by him on land acquired from your neighbor, Individual E.
Individual D needs 3 acres for a planned unit development and will build 4 townhouses
on that land. Two of the buildings resulting are intended to be acceptable to you in a
simultaneous EXCHANGE under section 1031 of the Code. You and Individual E and
his spouse have joined with the developer, Individual D, to get the properties rezoned,
with no change in title until the rezoning is completed.

You offered Lot 2 to developers from 1979 until the present, with a sign on the
property. You received more than 5 letters and 50 phone calls on it before making the
agreement with Individual D. However, your house is on Lot 1, which was not offered for
sale or EXCHANGE until Individual D insisted that he needed more land. While you
have represented that you hold Lot 2 for productive use for investment, you have not
represented that you hold Lot 1 for investment.

You expect to hold the replacement property as a fee interest and as an investment,
renting out the two townhouses for income.

You have requested that the Service rule that:

The EXCHANGE of the 2.4 acres of land currently known as Lot 2 and .5 acres of Lot
1 for the two townhouses to be built by Individual D will qualify as an EXCHANGE of
property of a like kind held for productive use in a trade or business or for investment
within the meaning of section 1031(A)(1) of the Code.

Section 1031(A)(1) of the Code provides that, in general, 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 a like kind
which is to be held either for productive use in a trade or business or for investment.

Section 1.1031(A) 1 (B) of the Income Tax Regulations provides, in part, that the
words "like kind" have reference to the nature or character of property and not to its
grade or quality.

You have represented that the replacement townhouses would be held as an investment
similar to the way you now hold Lot 2, for the production of rental income. Accordingly,
based on the facts presented and the representations made, we rule that:

The EXCHANGE of the 1.9 acres of land currently known as Lot 2 for the two
townhouses to be built by Individual D will qualify as an EXCHANGE of property of a
like kind held for productive use in a trade or business or for investment within the
meaning of section 1031(A)(1) of the Code. However, gain or loss must be recognized on
the .5 acres of Lot 1, which you do not represent to be investment property.
This ruling is directed only to the taxpayer who requested it. Section 6110(j)(3) of the
Internal Revenue Code provides that it may not be used or cited as precedent.

No opinion is expressed as to the tax treatment of the transaction under the provisions
of any other sections of the Code and regulations which may be applicable thereto, or the
tax treatment of any conditions existing at the time of, or effects resulting from, the
transaction which are not specifically covered by the above ruling. Sincerely yours,
Assistant Chief Counsel (Income Tax & Accounting)

PERSONALTY:
PRIVATE LETTER RULING 8946068
Exchanging personalty (cellular phone rights) can come within Code §1031.
See the following Private Letter Ruling 8946068.
PRIVATE LETTER RULING 8946068

Section 1031 Like Kind Exchanges


Publication Date: November 17, 1989 * * * *
August 24, 1989

Dear

This is in response to the letter dated August 4, 1989 in which rulings were requested
on behalf of A concerning the federal income tax consequences of a proposed exchange
of similar businesses under Section 1031 of the Internal Revenue Code. Information
relating to the transaction was also received in a letter dated February 23, 1989.

According to the information submitted, A is a limited partnership which owns the


Federal Communications Commission (FCC) nonwireline cellular telephone license for
and operates the system for the market in State 1 and State 2. A has owned this FCC
license since date P, began construction of the cellular telephone system on date Q, and
began operating the business on date R.

B is a corporation which owns 100 percent of the stock of C, which in turn owns 100
percent of the stock of D. D's only asset is the sole general partnership interest in A, and
C's only asset is the majority limited partnership interest in A. The owners of B desire to
dispose of their interests in A by selling their stock in B.

W is an unrelated holding company which owns subsidiaries X and Y. X is a cellular


telephone operating company which owns an FCC license for and operates a nonwireline
system in State 3. Y owns minority interests in numerous cellular telephone entities, one
of which is a 71/2 percent limited partnership interest in A. W negotiated to acquire a
majority ownership interest in A indirectly by acquiring B.

E, an entity unrelated to any of the other parties, desires to acquire the market owned by
X.
Negotiations led to these transactions being consolidated. E will acquire all the stock of
B and consequently will indirectly acquire the ownership interests in A held by C and D.
E will also acquire Y's ownership interest in A and will attempt to acquire all other direct
interests in A. Subsequent to these transactions, A will exchange all of its assets with X.

A proposes to exchange its nonwireline telephone license and operating assets for the
market in State 1 and State 2 for he non wireline cellular telephone license and operating
assets owned by X for the market in State 3. The assets to be exchanged include all of the
assets connected with the business and operations of A and X and include assets in the
following categories:

a. REAL PROPERTY A and X will exchange all real property


used in the operation of their respective systems, including any
leases, leasehold improvements, or any other interests in real
property used.
b. TANGIBLE PERSONAL PROPERTY A and X will exchange
all fixed and tangible assets used in the operation of the
respective systems including the cellular telephone system
equipment, office furniture and fixtures, office materials,
supplies, and other tangible personal property.
c. INTANGIBLE PROPERTY A and X will exchange all licenses
issued by the FCC, agreements, and miscellaneous other
intangible property used in connection with their operations.
d. OTHER PROPERTY In addition to the property noted above,
A and X will exchange additional property including accounts
receivable, prepaid expenses, telephone inventory, and cash.

A has represented that the property received in the exchange will be held by A for
productive use in a trade or business.

A has requested rulings that the exchange described above will constitute a likekind
exchange of property and therefore, no gain or loss shall be recognized on the exchange
by A, pursuant to section 1031(a)(1) of the Code, except to the extent of cash received,
the excess of liabilities transferred over liabilities assumed by the transferor, and any
other assets described in section 1031(a)(2) that are received in the exchange.

Section 1031(a) of the Code provides that no gain or loss shall be recognized if
property held for productive use in a trade or business or for investment (not including
stock in trade or other property held primarily for sale, stocks, bonds, notes, choses in
action, interests in a partnership, certificates of trust or beneficial interest, or other
securities or evidences of indebtedness or interest) is exchanged solely for property of
likekind which is to be held either for productive use in trade or business or for
investment.

Section 1.1031(a)1(b) of the Income Tax Regulations provides, in part, that the words
'like kind' have reference to the nature or character of the property.
Section 1031(b) of the Code provides, in part, that if an exchange would be within the
provisions of section 1031(a) of the Code, if it were not for the fact that the property
received in exchange consists not only of property permitted by such provision to be
received without the recognition of gain, but also of other property or money, then the
gain, if any, to the recipient shall be recognized, but in an amount not in excess of the
sum of such money and the fair market value of such other property.

Revenue Ruling 85135, 19852 C.B. 181, holds that where the assets of two television
stations were exchanged for the assets of another television station, the transfer and
receipt of the assets qualify for nonrecognition of gain or loss treatment as an exchange
of likekind property under section 1031(a) of the Code. Under the facts of that revenue
ruling, the property exchanged did not include stock in trade or other property held
primarily for sale, stocks, bonds, notes, choses in action, certificates of trust or beneficial
interest or other securities or evidences of indebtedness or interest.

Accordingly, based on the facts and representations submitted, it is concluded that

(1) The nonwireline cellular telephone licenses to be exchanged


constitute likekind property under section 1031(a)(1), and
(2) No gain or loss will be recognized by A on the exchange of
property with X pursuant to section 1031(a)(1) of the Code
except to the extent of cash received, the excess of liabilities
transferred over liabilities assumed by A in the transaction, and
any other assets described in section 1031(a)(2) that are received
in the exchange.

This ruling letter is based on representations made by A and assumes that the property
received in the exchange will be held for productive use in a trade or business or for
investment by A, and specifically, that A has no present intention to dispose of the
property received in the exchange by merger, dissolution, or otherwise.

No opinion is expressed as to the tax treatment of this transaction under the provisions
of any other sections of the Code and regulations, or the tax treatment of any conditions
existing at the time of, or effects resulting from, the transaction which are not specifically
covered by this ruling. Further, no opinion is expressed as to whether any particular asset
in the exchange comes within the assets described in section 1031(a)(2) of the Internal
Revenue Code.

A copy of this letter should be attached to the federal income tax return for the year in
which the transactions in question are consummated. This ruling letter is directed only to
the taxpayer who requested it. Section 6110(j)(3) of the Code provides that it may not be
used or cited as precedent.

This ruling will be modified or revoked by adoption of temporary or final regulations,


to the extent the regulations are inconsistent with conclusions in this ruling. See Section
16.04 of Rev. Proc. 891, 19891 I.R.B. 8, 19. However, when the criteria in Section 16.05
of Rev. Proc. 891 are satisfied, a ruling is not revoked or modified retroactively, except in
rare or unusual circumstances. Sincerely yours,

Assistant Chief Counsel


REGALS REALTY

The issue in the Regals case focused on whether property in an exchange was acquired
with the intent to hold that property for investment or whether it was acquired with the
intent to transfer it. The requirement is to hold the property for investment, not to sell or
retransfer the property.

BLACK

The Court was faced with the issue as to whether the taxpayer's actions were such that
the property was acquired for investment purposes or whether it was acquired with the
intent to resell.

The taxpayer was a real estate broker. The taxpayer acquired the property by
exchanging her desert land, held for investment, in consideration of acquiring residential
property, a mortgage and cash.

The taxpayer moved into the property to undertake work on the property. After fixing
up the property, it was sold. The taxpayer claimed this fell within the tax-deferred area.
The Court disagreed.

ETHEL BLACK, PETITIONER,


v.
COMMISSIONER OF INTERNAL REVENUE, RESPONDENT. 35 T.C. 90

In August 1955, petitioner exchanged desert land she was holding for investment
purposes for residential property, a mortgage, and cash. She painted the house and made
some repairs, moving from a place she was renting into the newly acquired residence to
do the work. When the work had been completed she listed the house for sale with a real
estate agent, and in April 1956, it was sold for $7,500, the amount at which it had been
included in the exchange. Petitioner claimed nonrecognition of gain to the extent of the
value of the residential property. Respondent determined that the entire gain realized by
petitioner from the exchange was to be recognized and was taxable income. Held, that the
residential property received in exchange for the old property was other property held
primarily for sale and did not come within the non recognition of gain provisions of
section 1031(a) of the Internal Revenue Code of 1954.

The respondent determined a deficiency in income tax against the petitioner for the year
1955 in the amount of $687.12. The only question presented is whether residential
property received by petitioner as partial consideration in exchange for unimproved
desert land was property to be held by her for investment within the meaning of section
1031(a) of the Internal Revenue Code of 1954, to the end that the gain realized on the
exchange to the extent represented by the residential property was not to be recognized.

FINDINGS OF FACT.

Petitioner is a single person, and a resident of Phoenix, Arizona. She filed an individual
income tax return and two amended returns for the year 1955 with the district director of
internal revenue for Arizona.

Prior to July 29, 1955, and from 1940, petitioner owned 200 acres of unimproved desert
land situated in Maricopa County, Arizona. She was not employed. She resided in a
rented 'court' at 2627 North Central Avenue in Phoenix.

On July 29, 1955, petitioner, as seller, and Philo C. Carter, a real estate broker of
Glendale, Arizona, as buyer, entered into escrow agreement No. 9248, upon the closing
of which she would exchange her desert land for a total consideration of $19,500, to
consist of residential property at a value of $7,500, a purchase money mortgage in the
amount of $11,000, and $1,000 in cash. On the same date, Carter, as seller, and
petitioner, as buyer, entered into escrow agreement No. 9247, upon the closing of which
petitioner would acquire the residential property as a stated value of $7,500 as a 'credit by
trade' of the property covered by escrow agreement No. 9248. The closing under each
escrow agreement was contingent on the concurrent closing of the other. The cost to
petitioner of the desert land was $2,035 and her cost in making the exchange was
$147.91, resulting in a net gain to her of $17,317.09.

Under escrow agreement No. 9248 covering transfer by petitioner of the desert
property, the $11,000 purchase money mortgage was payable as follows:

In annual installments of $2,200.00 or more on or before the 1st of September of each


and every year, beginning 9/1/56, with interest on all unpaid principal at the rate of 5%
per annum from 9/1/55, payable annually and in addition to the payments of principal.

On August 10, 1955, Carter authorized and directed the escrow agent to show Arizona
Rochester Development Corporation, an Arizona corporation, as nominee. Petitioner had
no dealings with that corporation.

The escrows were closed on an undetermined date, probably between August 10 and
August 31, 1955. At some undetermined time, either prior to or shortly after the closing
of the escrows, the persons who had been occupying the residence vacated it. It appeared
to petitioner that the property 'needed fixing up,' and she wanted to do the work herself.
The property was situated about 6 miles from where she was living and to reach it she
was required to go by public transportation, make a transfer, and then walk about a mile
and a half. The trips back and forth would absorb some substantial portion of the time she
desired to devote to the work, and it was more economical as well as more convenient for
her to live on the property. Accordingly, on or about August 31, 1956, she moved into the
house and had her mailing address changed to that location. Included in the work done
was the painting of the outside of the house, which took considerable time. When she had
completed the work she listed the property for sale with a real estate agent. She was
living in the residence when it was sold in April 1956. She received $7,500 for the
property. At all times after acquisition of the property she had held it primarily for sale.

In her original income tax return for 1955, filed on April 16, 1956, petitioner listed her
address as 3214 West Northview Avenue, Phoenix, which was the address of the property
in question. The only income reported was in the amount of $5,926.04, which was shown
as longterm capital gain realized from the disposition of her desert property. Attached to
the return was a computation reflecting $17,317.09 as the amount of gain realized,
$11,852.09 as the amount of the gain to be recognized, and $5,926.04 as 'longterm' gain,
the amount taken into account for tax purposes. The $11,852.09 represented the mortgage
of $11,000 and cash of $852.09 ($1,000 cash received less $147.91, cost of the
exchange). At the bottom of the computation sheet was the following reference: 'per Sec.
351, 356, 371, 1031, I.R.C.1954,' followed by 'Sec. 112c I.R.C.1939.' With a standard
deduction in the amount of $592.60 and a personal exemption of $600, the taxable
income reported was shown as $4,733.44, and the tax thereon as $1,030.69.

On June 15, 1956, petitioner filed an amended return for 1955. At that time, her address
was given as 4136 North 19th Street, Phoenix. In a computation attached to the return,
the market value of the $11,000 mortgage was stated to be $8,800, which resulted in a
showing that there was realized a gain of $15,117.09, a recognized gain of $9,652.09, and
a taxable 'longterm' gain of $4,826.05. The tax liability was reported as $783, and an
overpayment of the tax was shown as $247.69.

On October 2, 1956, petitioner filed a second amended return for 1955. In this return,
she was shown to have elected to report the gain from the sale or exchange on the
installment basis, the basis therefor being that the $11,000 was payable at the rate of
$2,200 per year for 5 years, commencing September 1, 1956. The computation showed a
realization of longterm capital gain of $1,000, an exclusion of longterm capital gain of
$500 and income of longterm capital of $500, resulting in the reporting of 'No Tax' due
and an overpayment, described as 'Paid on original return,' of $40, refund of which was
requested.

Respondent determined that the longterm capital gain to be recognized from the
exchange was $17,317.09, and not $11,852.09, as reported by petitioner.

At the time of the exchange petitioner acquired the new property as other property to be
held primarily for sale.

OPINION

TURNER, Judge:

The question presented is whether upon the disposition by petitioner of her desert
property the gain realized to the extent of the fair market value of the residential property
received in exchange is not, under section 1031(b) of the Internal Revenue Code of
1954,[FN1] to be recognized. Respondent has determined that the exchange does not
meet the statutory requirements for nonrecognition of the gain in question. Both parties
have accepted $7,500 as the fair market value of the residential property received.

In section 1031(a) of the Code,[FN1] it is provided that '(n)o gain or loss shall be
recognized if property held for productive use in trade or business or for investment (not
including stock in trade or other property held primarily for sale * * * ) is exchanged
solely for property of a like kind to be held either for productive use in trade or business
or for investment.' If, however, the property received in exchange includes money or
property other than property permitted under subsection (a) to be received without
recognition of gain, then under subsection (b) the gain is to be recognized to the extent of
'the sum of such money and the fair market value of such other property.'

According to section 1.10021(b) of the Income Tax Regulations, exceptions to the


general rule, including the exceptions provided in section 1031 of the Code, 'are strictly
construed and do not extend either beyond the words or the underlying assumptions and
purposes of the exception.' According to subsection (c) of that section, '(t)he underlying
assumption of these exceptions is that the new property is substantially a continuation of
the old investment still unliquidated.'

Similar language has been used in regulations extending back to those promulgated
under the Revenue Act of 1934.

With respect to the exception provided in section 1031 of the Code, the definition of
'like kind' is stated in section 1.1031(a)1(b) of the Income Tax Regulations, as follows:

As used in section 1031(a), the words 'like kind' have reference to the nature or
character of the property and not to its grade or quality. One kind or class of property
may not, under that section, be exchanged for property of a different kind or class. 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.
Unproductive real estate held by one other than a dealer for future use or future
realization of the increment in value is held for investment and not primarily for sale.

That the desert land was held for investment appears to be accepted by both parties, and
according to the regulations there is an underlying assumption that residential property
received in exchange was substantially a continuation of the old investment still
unliquidated. That is not to say, however, that the exceptions are not to be given full force
and effect even though they are to be strictly construed and do not extend either beyond
the words or the underlying assumptions and purposes of the exceptions. Our inquiry
accordingly must be directed to the exceptions, and to whether or not the residential
property is covered thereby.

Admittedly, the desert property, the property exchanged, was not property held for
productive use, and though at the trial there was some reference to a possible holding of
the residential property for rent, the petitioner makes no claim that it was ever so held,
but rather, contends that within the meaning of the statute it was property of a like kind to
be held for investment.

From a reading of the wording of the exception, it is apparent, we think, that if the
exception did cover the property in question it was because it was either stock in trade or
other property held primarily for sale. On the facts here, we may pass the stock in trade
category without any detailed discussion, since it is patent on the record before us that
petitioner was not engaged in a business of buying and selling real estate or in any other
business during the pertinent period, and thus the residential property acquired could not
have been, as to her, stock in trade. We are of the view, however, that on the evidence the
property when acquired was 'to be held' and was in fact held by petitioner primarily for
sale. It was petitioner's testimony that she accepted Carter's offer for her desert property
which called for part payment in the residential property because she thought it was the
best 'deal' she could get. An while on direct testimony she did testify that in acquiring the
property she was undecided whether to rent, sell, or just hold it and after acquiring it she
had thought of renting it, she later testified on crossexamination that she was at all times
attempting to sell the property and when she had finished her painting and other work she
placed it in the hands of a real estate agent for sale, the sale being effected very shortly
while she was still residing in the house. We are accordingly convinced that petitioner did
not acquire the property to be held as an unliquidated continuation of the old property and
for investment, but that at all times it was held primarily for sale, and we hold that the
gain represented thereby falls within the exception to 1031(a) and must be recognized.

To support her position that the property was not held primarily for sale within the
meaning of section 1031(a), petitioner cites and relies on Loughborough Development
Corporation, 29 B.T.A. 95, and Atlantic Coast Realty Co., 11 B.T.A. 416. Neither case is
in point. In the Atlantic Coast Realty case, the question was whether a corporation
engaged in buying and selling land was entitled to have its income determined by the use
of inventories. The question here and the applicable statutory provision are wholly
different.

In Loughborough Development Corporation, the question was whether gain from the
sale of real estate by a corporation which under its charter was authorized to engage in
the real estate business was capital gain under the capital gains provisions of the statute
or ordinary income, the basis for the latter being that the gain on the real estate was on
the sale of property 'held by the taxpayer primarily for sale to customers in the ordinary
course of his trade or business.' It was there found on the evidence that the property sold
had not been so held, and it was held that it made no difference that the taxpayer was
authorized by its charter to engage in the business of buying and selling real estate and
that the particular real estate was not brought within the exception to the capital gains
statute if in fact the real estate was not held primarily for sale to customers in the ordinary
course of the taxpayer's business.

In the instant case, we are dealing with an entirely different statute, namely, section
1031, and as to that section the words 'for sale to customers in the ordinary course of' the
taxpayer's trade or business are quite conspicuous by their absence. For the exception in
section 1031 to apply, there is no requirement that the taxpayer be conducting a trade or
business, or that the property in question be held 'for sale to customers in the ordinary
course of' a trade or business carried on by the taxpayer. There can be no question, we
think, that had it been intended that the scope of the exception in section 1031 should be
so limited, language comparable to that used in the capital gains provisions, and which
was in question in Loughborough Development Corporation, would likewise have been
used in section 1031. The only requirement for applicability of the exception in 1031 is
that the property received in exchange be 'held primarily for sale.' The record shows that
the residence was so held, and we accordingly hold that the nonrecognitionofgain
provisions of that section does not apply.

Decision will be entered for the respondent.

FN1. SEC. 1031.


EXCHANGE OF PROPERTY HELD FOR PRODUCTIVE USE OF
INVESTMENT.

(a) NONRECOGNITION OF GAIN OR LOSS FROM EXCHANGES SOLELY IN


KIND.
No gain or loss shall be recognized if property held for productive use in trade or
business or for investment (not including stock in trade or other property held primarily
for sale, nor stocks, bonds, notes, choses in action, certificates of trust or beneficial
interest, or other securities or evidences of indebtedness or interest) is exchanged solely
for property of a like kind to be held either for productive use in trade or business or for
investment.

(b) GAIN FROM EXCHANGES NOT SOLELY IN KIND.


If an exchange would be within the provisions of subsection (a), of section 1035(a), of
section 1036(a), or of section 1037(a), if it were not for the fact that the property received
without the recognition of gain, but also of other property or money, then the gain, if any,
to the recipient shall be recognized, but in an amount not in excess of the sum of such
money and the fair market value of such other property. Tax Court, 1960.

REVENUE RULING 79-143

Exchanging bullion or coins used for financial investments will not qualify for
nonrecognition under Code §1031. The following Rev. Rul. 79-143 supports this.

REVENUE RULING 79143


19791 C.B. 264

ISSUE
Does an exchange of numismatictype coins held for investment for bulliontype coins
held for investment qualify for nonrecognition of gain under section 1031 of the Internal
Revenue Code of 1954

FACTS

An individual taxpayer who is not a dealer in foreign or domestic coins purchased


United States $20 gold coins as an investment. After the coins had appreciated in value,
the taxpayer exchanged them for South African Krugerrand gold coins of equal total fair
market value. A gain was realized by the taxpayer as a result of the exchange. The
taxpayer will hold the South African Krugerrand gold coins as an investment.

The United States $20 gold coins exchanged by the taxpayer are numismatictype coins.
The value of numismatictype coins is determined by their age, number minted, history,
art and aesthetics, condition, and metal content. The South African Krugerrand gold coins
received by the taxpayer are bulliontype coins. The value of bulliontype coins is
determined solely on the basis of their metal content.

LAW AND ANALYSIS

Section 1031(a) of the Code provides that no gain or loss is recognized upon an
exchange of property (not including evidences of indebtedness) held for productive use in
trade or business or for investment for property of a like kind to be held either for
productive use in trade or business or for investment.

Section 1.1031(a) 1 (b) of the Income Tax Regulations provides that as used in section
1031(a) of the Code, the words 'like kind' have reference to the nature or character of the
property and not to its grade or quality. One kind or class of property may not, under that
section, be exchanged for property of a different kind or class .

Section 1031(e) of the Code provides that the exchange of livestock of one sex for
livestock of the other sex is not an exchange of property of like kind for purposes of the
nonrecognition provision of section 1031(a), because, as the committee report cited
below points out, the different sexes of livestock represent investments of different types,
in one case an investment for breeding purposes, in the other an investment in livestock
raised for slaughter. Section 1031(e) was enacted to clarify what was considered to be the
correct interpretation of section 1031(a). See S. Rep. No. 91552, 91st Cong., 1st Sess.
102 (1969), 19693 C.B. 423, 488489.

Similarly, in this case, although the coins appear to be similar because they both
contain gold, they actually represent totally different types of underlying investment, and
therefore are not of the same nature or character. The bulliontype coins, unlike the
numismatictype coins, represent an investment in gold on world markets rather than in
the coins themselves. Therefore, the bulliontype coins and the numismatictype coins are
not property of like kind.
HOLDING

The exchange of United States $20 gold coins for South African Krugerrand gold coins
does not qualify for nonrecognition of gain under section 1031(a) of the Code.

Rev. Rul. 76214, 19761 C.B. 218, which holds that the exchange of Mexican 50peso
gold coins for Austrian 100corona gold coins, both of which are official government
restrikes, qualifies for nonrecognition of gain under section 1031(a) of the Code, is
distinguishable because that Revenue Ruling involves only the exchange of bulliontype
coins for bulliontype coins.

PRIVATE LETTER RULING 8508095

In this Private Letter Ruling, the Service addressed the question as to whether there
could be a tax-deferred exchange of land for a house.

The Service held that the exchange came within Code §1031 only to the extent that the
house to be received is to be held for productive use in trade or business or for
investment, not for personal use.

PRIVATE LETTER RULING 8508095

This is in reply to a request for a ruling dated July 26, 1984, submitted on your behalf
by your authorized representative, concerning the federal income tax consequences under
section 1031 of the Internal Revenue Code of a proposed exchange of land for a house.

Y Corporation recently constructed a ranch house which it currently rents to you. The
house contains a separate office for you. It is expected that this office will meet the
requirements of section 280A(c) of the Code dealing with the deduction for a home office
when the ranch house is conveyed to you. In return for the house you will deliver to Y
Corporation land lying under the X Building, plus certain contiguous parking areas, and a
portion of your ranch. The total fair market value of the properties to be transferred to Y
Corporation by you will be the same as the fair market value of the house to be
transferred to you. It is represented that the property which underlies the X Building,
together with the parking areas, is rental property which has been held by you, for
investment, for many years; furthermore, that portion of the ranch which you will deliver
to Y Corporation as part of the proposed exchange has been held and used by you for a
number of years, both for productive use in the ranching business, and for investment.

Section 1031(a) of the Code provides that no gain or loss shall be recognized if
property held for productive use in trade or business or for investment (not including
certain enumerated property) is exchanged solely for property of a like kind to be held
either for productive use in trade or business or for investment.

Section 1031(b) of the Code provides that if an exchange would be within the
provisions of section 1031(a) of the Code (as well as certain other sections), if it were not
for the fact that the property received in exchange consists not only of property permitted
by such provisions to be received without the recognition of gain, but also of other
property or money, then the gain, if any, to the recipient shall be recognized, but in an
amount not in excess of the sum of such money and the fair market value of such other
property.

Based upon the information submitted and representations made, we conclude that from
your standpoint the proposed exchange will constitute an exchange under section 1031 of
the Code only to the extent that the house to be received by you from Y Corporation in
the exchange is, after the exchange, to be held by you for productive use in trade or
business or for investment.

CLEMENTE, INC.

In the Clemente, Inc. case, 1985 Tax Court position, the Court was asked to address the
question as to whether there would be tax-deferred treatment under Code Section 1031
with regard to an exchange involving an 8-acre piece of ground for the right to remove
gravel from another piece of property.

The Government argued that the exchange did not come within Code Section 1031
inasmuch as the properties were not like-kind, and there was not a simultaneous
exchange.

The Court held that the exchange in question was not within Code Section 1031.

CLEMENTE, INC., Petitioner


v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

GREGGO & FERRARA, INC., Petitioner


v.
COMMISSIONER OF INTERNAL REVENUE, Respondent T.C. Memo. 1985367

MEMORANDUM FINDINGS OF FACT AND OPINION


SWIFT, JUDGE:

In a statutory notice dated May 29, 1979, respondent determined Federal income tax
deficiencies against petitioner Greggo & Ferrara, Inc. ('Greggo & Ferrara '), in the
amounts of $114,944.99 and $31,224.35 for its taxable years ending September 30, 1973
and September 30, 1974, respectively. In a statutory notice dated January 7, 1977,
respondent determined a Federal income tax deficiency of $42,480 against petitioner
Clemente, Inc. ('Clemente') for its taxable year ending September 30, 1973. The separate
petitions filed by each petitioner herein have been consolidated for purposes of trial,
briefing, and opinion.
After certain concessions by the parties, the issues for decision are: * * * * , and (3)
whether Clemente is entitled to taxfree treatment under section 1031 [FN2] with respect
to the EXCHANGE of an 8acre parcel of land for the right to extract gravel from another
parcel of land.

FINDINGS OF FACT

Some of the facts have been stipulated and are found accordingly.

Greggo & Ferrara was organized as a corporation pursuant to the laws of Delaware in
1948. During the years in issue, Greggo & Ferrara was engaged in the business of
excavation and road construction in and about New Castle County, Delaware, where it
was one of the major road construction firms. In its road construction business, Greggo &
Ferrara required large quantities of gravel and therefore it owned a number of parcels of
land from which it extracted gravel.

Clemente was organized as a corporation pursuant to the laws of Delaware in 1952.


During the years in issue, Clemente was engaged in the business of operating a bus stop
and restaurant adjacent to land owned by Greggo & Ferrara. condition when acquired and
required extensive renovation and repairs before they could be rented out.

Having reviewed the record, we hold that Greggo & Ferrara has failed to establish that
the buildings were placed in service by September 30, 1973, and Greggo & Ferrara is
therefore not entitled to a depreciation deduction with respect to its taxable year ending
on that day.

III. SECTION 1031 ISSUE

The final issue concerns the tax treatment to Clemente of the EXCHANGE entered into
between Greggo & Ferrara and Clemente, pursuant to the June 27, 1973, contract. Under
that contract, Greggo & Ferrara acquired the right to remove all of the gravel contained in
the Clemente Bank in EXCHANGE for Greggo & Ferrara's promise to transfer the
residual interest in 8 excavated acres of light industrial land from the Gulf Tract to
Clemente. The Clemente Bank was estimated to contain 47,000 cubic yards of gravel, but
Greggo & Ferrara was entitled to remove all of the gravel actually contained therein,
provided it did not extract gravel below the depth of Clemente's adjoining land
(approximately 2025 feet deep).

The issue herein is whether that EXCHANGE qualifies as a taxfree EXCHANGE


pursuant to section 1031. Respondent asserts that it does not qualify because the
properties exchanged were not of 'likekind' and because the EXCHANGE was not
simultaneous. [FN11]

Section 1031(a) provides for nonrecognition of gain or loss where property held for
productive use in a trade or business or for investment is exchanged solely for property of
a like kind to be held for similar uses. As used in section 1031(a), the words 'like kind'
have reference to the nature or character of the property, and not to its grade or quality.
For example, the fact that some of the real estate in an EXCHANGE is improved and
other real estate is unimproved is not material for that fact relates only to the grade or
quality of the property and not to its kind or class. Sec. 1.1031(a)1(b), Income Tax Regs.

The underlying rationale for allowing nonrecognition of gain or loss is the concept that
the taxpayer's economic situation after the EXCHANGE is fundamentally the same as it
was before the transaction. This is expressed in the Committee Report to the predecessor
statute to section 1031 as follows:

If the taxpayer's money is still tied up in the same kind of property as that in which it
was originally invested, he is not allowed to compute and deduct his theoretical loss on
the EXCHANGE, nor is he charged with a tax upon his theoretical profit. * * * (H. Rept.
704, 73d Cong., 2d Sess. (1934); 19391 C.B. (Part 2), 554, 564.)

See also Biggs v. Commissioner, 69 T.C. 905, 913 (1978), affd. 632 F.2d 1171 (5th Cir.
1980). The underlying assumption of section 1031(a) is that the new property is
substantially a continuation of the old investment still unliquidated. Commissioner v.
P.G. Lake, Inc., 356 U.S. 260, 268 (1958).

Therefore, under section 1031(a), a comparison of the properties exchanged is


appropriate in order to determine whether or not their nature or character is substantially
alike. In so doing, consideration must be given to the respective interests in the physical
properties, the nature of the title conveyed, the rights of the parties, the duration of the
interests, and any other factor bearing on the nature or character of the properties as
distinguished from their grade or quality. Significantly, as the standard for comparison,
section 1031(a) refers to property of a likenot an identicalkind. The comparison should be
directed to ascertaining whether the taxpayer, in making the EXCHANGE, has used his
property to acquire a new kind of asset or has merely exchanged it for an asset of like
nature or character. (Koch v. Commissioner, 71 T.C. 54, 65 (1978).)

In Commissioner v. Crichton, 122 F.2d 181, 182 (5th Cir. 1941), affg. 42 B.T.A. 490
(1940), the Fifth Circuit held that the EXCHANGE of an overriding royalty interest in
minerals for a city lot qualified as a likekind EXCHANGE.

See also Rev. Rul. 68331, 19681 C.B. 352, which held that the EXCHANGE of an oil
producing lease for a fee simple title to a ranch qualified as a likekind EXCHANGE.

In Fleming v. Commissioner, 24 T.C. 818, 823824 (1955), affd. sub nom.


Commissioner v. P.G. Lake, Inc., 356 U.S. 260 (1958), revg. 241 F.2d 78 (5th Cir. 1957),
we held that an assignment of carvedout oil payment rights and a fee interest in real estate
were not likekind properties although the applicable state law characterized the oil
payment rights as an interest in real estate.

In Koch v. Commissioner, 71 T.C. 54, 65 (1978), we explained the difference between


the holdings of Crichton and Fleming as follows:
The main distinction between the two transactions is the duration of the interestsan
overriding royalty interest continues until the mineral deposit is exhausted whereas a
carvedout oil payment right terminates usually when a specified quantity of minerals has
been produced or a stated amount of proceeds from the sale of minerals has been
received.

We conclude that the EXCHANGE between Clemente and Greggo & Ferrara resembles
the facts of Fleming more than it does the facts of Crichton, and therefore we conclude
that the EXCHANGE does not qualify as a likekind EXCHANGE. While it is true, as
Clemente points out, that Greggo & Ferrara was not limited to extracting only the 72,000
cubic yards of gravel that the Clemente Bank was estimated to contain, it is also true that
Greggo & Ferrara did not receive the right to extract an unlimited quantity of gravel from
the Clemente Bank. Rather, Greggo & Ferrara was limited to extracting gravel ONLY
from the elevated bank designated, and Greggo & Ferrara was required to adhere to a
grading plan which prohibited the extraction of gravel in the Clemente Bank below the
level of the adjoining land. This restriction limited the amount of gravel that could be
removed. Therefore, Greggo & Ferrara's interest is not similar to the unlimited
'overriding royalty interest' present in Crichton, but is similar to the limited 'carvedout'
royalty interest in Fleming.

A comparison of the respective positions of Clemente and Greggo & Ferrara after the
EXCHANGE transaction is relevant. After the transaction, Clemente ended up with (1)
its original land, at a lower elevation (due to the gravel extracted) and with grading
services completed, thereby bringing the elevation to the same level as the adjoining
property, and (2) a new 8acre tract of land which adjoined its original land. Greggo &
Ferrara, however, ended up with approximately 72,000 cubic yards of gravel which had,
by that time, been carried away and used in one or more of its many construction
projects. In effect, Clemente sold gravel and bought land; Greggo & Ferrara sold land and
bought gravel. It is apparent to us that there was no continuity of investment in the
manner contemplated by section 1031(a).

It follows that Clemente must recognize gain upon its EXCHANGE of the gravel in the
Clemente Bank, in an amount equal to the amount realized as determined herein (namely
8 acres of land at $3,500 per acre), less Clemente's adjusted basis in the gravel under
section 1011.

In accordance with the foregoing resolution of the issues.

FN11 In light of our resolution of the like-kind argument, it is not necessary to address
respondent's contention that the exchange was not simultaneous.

PRIVATE LETTER RULING 8515012

This Private Letter Ruling assumes a tax-deferred treatment on an exchange under


Code §1031. Therefore, with that assumption, it follows and addresses the issue as to
adjustments to basis when there is a §1031 treatment.
PRIVATE LETTER RUL. 8515012

This is in reply to a letter of August 22, 1984 from your authorized representative,
requesting rulings under section 1031 of the Internal Revenue Code. In a letter dated
January 7, 1985 we ruled that the exchange of Property a for Property b qualifies as a like
kind exchange under section 1031(a)(1) of the Internal Revenue Code. It was understood
that we would address at a later time the bases of the properties held by the taxpayers
after the exchange.

The information submitted indicates that X owns Property a for the production of rental
income. A and B, noncorporate shareholders of X, jointly own and rent Property b to X
for use in the trade or business of X. Property a and Property b consists of unencumbered
real property. An independent appraiser hired by the taxpayers concluded that the fair
market value of Property a is $19x, while the fair market value of Property b is $18x.
$19x is a greater amount than $18x.

Section 1031(a)(1) 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.

Section 1031(d) of the Code provides, in part, that if property was acquired on an
exchange described in this section, then the basis shall be the same as that of the property
exchanged, decreased in the amount of any money received by the taxpayer and increased
in the amount of gain or decreased in the amount of loss to the taxpayer that was
recognized on such exchange.

Section 301(a) of the Code provides that, except as otherwise provided, a distribution
of property made by a corporation to a shareholder with respect to its stock shall be
treated in the manner provided in subsection (c). Section 301(b) provides that for
noncorporate distributees, the amount of any distribution shall be the amount of money
received, plus the fair market value of the other property received. Section 301(c)
provides generally that if there is a distribution to which subsection (a) applies, then the
portion of the distribution which is a dividend (as defined in section 316) shall be
included in gross income. Section 301(d) provides that for noncorporate distributees, the
basis of property received in a distribution to which subsection (a) applies shall be the
fair market value of such property.

Section 316(a) states that the term "dividend" generally means any distribution of
property made by a corporation to its shareholders out of the corporation's earnings and
profits.

Section 1.3011(j) of the Income Tax Regulations provides, in part, that if property is
transferred by a corporation to a shareholder which is not a corporation for an amount
less than its fair market value in a sale or exchange, such shareholder shall be treated as
having received a distribution to which section 301 applies in an amount equal to the
difference between the amount paid for the property and its fair market value.

Provided that $19x and $18x reflect the fair market values of Property a and Property b,
it is held as follows:

(1) For purposes of the exchange subject to section 1031, the basis
of Property a after the exchange shall equal the basis of
Property b prior to the exchange and the basis of Property b
after the exchange shall equal the basis of Property a prior to
the exchange.
(2) A and B will be treated upon the exchange described above as
having received a distribution from X of property to which
section 301(a) of the Code applies. The distribution will consist
of the amount by which the fair market value of Property a
exceeds the fair market value of Property b (section 1.301 1(j)
of the regulations).
(3) The basis of the property received in the distribution will be the
fair market value of such property (section 301(d))

PRIVATE LETTER RUL. 8810034

The following Ruling involves the exchange of timberland for other timberland within
Code §1031. The Ruling also emphasized the fact that if there is an alternative tax
position, it does not vitiate the exchange, assuming the exchange takes place.

PRIVATE LETTER RUL. 8818034

This is in reply to a letter dated August 5, 1987, submitted on behalf of the Partnership,
requesting rulings that a proposed transaction qualifies as a likekind exchange under
Section 1031 of the Internal Revenue Code.

The information submitted indicates that Partnership holds interest in a parcel of real
estate and several multiunit apartment buildings located on the real estate. The apartment
buildings are owned by the Partnership under two forms of ownership: (1) some of the
land and apartment units are owned in a fee simple, and (2) some of the land and
apartment units are part of a stock cooperative organized under the laws of State X
known as the 'Cooperative'.

At the time the Cooperative was created, it entered into proprietary leases for a term of
ninetynine (99) years (the 'Leases') with each of its shareholders. Each of the leases has in
excess of 92 years remaining in the term, and all of the leases, representing all of the
units owned by the Cooperative, have been assigned to the Partnership by the previous
owners. In addition, the Partnership owns all of the membership shares in the
Cooperative.
In order to obtain refinancing more readily, and to ease the administrative difficulties
encountered in operating the units, the Partnership proposes to exchange its ownership
interest in the cooperative apartment units for direct ownership of the real estate in a
condominium form or as a fee simple interest. The exchange would occur through the
liquidation of the cooperative and the exchange of the Partnership's cooperative stock and
interest in the proprietary leases for the condominium interest received in liquidation.

Section 1031(a) of the Code provides that no gain or loss shall be recognized if
property held for productive use in trade or business or for investment (not including
stocks, bonds, notes, choses in action, certificates of trust or beneficial interest and
certain other types of property not here pertinent) is exchanged solely for property of a
like kind to be held either for productive use in a trade or business or for investment.

Section 1.1031(a) 1 (c) of the Income Tax Regulations provides, in part, that no gain or
loss is recognized if a taxpayer who is not a dealer in real estate exchanges a leasehold of
a fee with 30 years or more to run for real estate.

Rev. Rul. 55749, 19552 C.B. 295, holds that where, 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 under section 1031(a) of
the Code provided the requirements of that section as to holding for productive use in a
trade or business or for investment are satisfied.

Given the unique nature of tenantstockholder's interest, consisting of leasehold rights


linked with stock ownership, it is an oversimplification to regard the tenantstockholder as
merely a stockholder with an interest in the realty (see 15A Am Jur 2d, Condominiums
and Cooperative Apartments, section 78 (1976)), and it is, therefore, incorrect to regard a
tenantstockholder's interest as falling within the parenthetical language of section 1031(a)
excluding stocks, choses in action, certificates of beneficial interest, etc. from favorable
treatment under that provision. In the present case, because the tenantstockholder's
interest includes a lease the term of which exceeds 30 years (See section 1.1031(a)1(c) of
the regulations, supra) and because this interest is characterized as a real property interest
under state law (See In re Pitts' Estate, 218 Cal. 184, 22 P. 2d 694 (Cal. 1933), cited with
approval in California Coastal Commission v. Quanta Investment Corporation, 170 Cal.
Rptr. 263, 113 Ca. App. 3d 579 (Cal. Ct. of Appeal 1980)) the tenant stockholder's
interest should be characterized as a real property interest for purposes of section 1031.
See Rev. Rul. 55749, supra, as to the effect of state law in characterizing property
interests for purposes of section 1031. Compare Rev. Rul. 8640, 19661 C.B. 227, in
which the Internal Revenue Service relied on New York law in holding that the interest
held by a taxpayer in a New York cooperative apartment is not considered real property
for purposes of section 2515(a) of the Code. Moreover, the California statute (West's
Ann. Cal. Civ. Code, Section 783) and Rev. Rul. 77 423, 19772 C.B. 352, treat a
condominium interest as the ownership of real property.

Section 1250(a) of the Code provides for ordinary income treatment with respect to a
portion of the gain from the disposition of certain depreciable real property. For purposes
of section 1250, a leasehold of land is considered real property. Section 1.12501(e)(3) of
the regulations.

Section 1250(d)(4) of the Code provides, in part, that where property is disposed of and
gain is not recognized in whole or in part under section 1031, then the amount of gain
treated as ordinary income under section 1250(a) shall not exceed the greater of (i) the
amount of gain recognized on the disposition, increased by the amount determined under
section 1033(a)(2)(A) or (ii) the excess of the gain taken into account under section
1250(a) over the fair market value of the section 1250 property acquired in the
transaction.

The partnership's presently held interest as tenantstockholder, and the 'condominiums'


to be received in the exchange, are both real property interests representing the same
physical property. Therefore, the surrender of Partnership's stock in Cooperative in
exchange for a condominium interest in the same property constitutes a nontaxable
exchange of properties of a likekind under section 1031(a), provided that the properties
are held for productive use in a trade or business or for investment.

The basis in the 'condominiums' received by Partnership will be determined under


section 1031(d) of the Code. The holding period of the 'condominiums ' received by
Partnership will include Partnership's holding period in the stock of cooperative held as
tenant stockholder, provided Partnership's interest as a tenantstockholder was a capital
asset or property described in section 1231. See section 1223(1) of the Code.

Because Partnership will not recognize gain under section 1031 of the Code,
Partnership will not treat any gain as ordinary income under section 1250(a) of the Code.
See section 1250(d)(4).

This ruling is directed only to the taxpayer who requested it. Section 6110(j)(3) of the
Code provides that it may not be used or cited as precedent. Except as specifically ruled
on above, no opinion is expressed as to the federal tax consequences of the transaction
described above under any other provision of the Code. Sincerely yours,

LIKE-KIND PROPERTY: PERSONALTY OR REALTY BEELER

This case examined many of the principles involved in the Code §1031 transaction.
Factually, many of the issues surrounded an interpretation of whether the taxpayer was
transferring only real estate under a Code §1031 transaction, or whether the taxpayer also
transferred personalty, in the form of sand, permits for operation, goodwill and other
property.The Court concluded that the transfer involved, for the most part, real estate;
therefore, it qualified under Code §1031.

See also Beeler v. Commissioner, T.C. Memo 1998-44, 1998 WL 44099 (U.S. Tax Court,
1998.)
Larry L. BEELER and Cynthia J. Beeler, Petitioners
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent.
No. 1605294.

United States Tax Court.


T.C. Memo. 199773
1997 WL 52498 (U.S.Tax Ct.)
Feb. 10, 1997.

MEMORANDUM FINDINGS OF FACT AND OPINION

COLVIN, Judge:

Respondent determined a deficiency of $266,375 in petitioners' income tax for 1991.

After concessions, the issue for decision is whether petitioners may defer recognition of
all of the gain that they received for an exchange involving real property in 1991 under
section 1031, as petitioners contend, or only part of the gain, as respondent contends. Our
decision on this issue depends on whether we decide, as respondent contends, that
petitioners exchanged, in addition to real estate, assets which do not qualify under section
1031, such as property held for sale (i.e., sand), certain business operating permits,
goodwill, and goingconcern value, or whether we decide, as petitioners contend, that
petitioners exchanged only property that qualifies under section 1031. [FN1] We agree
with petitioners, and hold that all of the gain they received in the exchange qualifies
under section 1031.

FN1. Respondent determined in the notice of deficiency that petitioners could not defer
any gain under sec. 1031 for their exchange of property in 1991. Respondent conceded at
trial and in the posttrial brief that the land qualifies for likekind exchange treatment.

Section references are to the Internal Revenue Code as in effect for the relevant periods.
Rule references are to the Tax Court Rules of Practice and Procedure.

FINDINGS OF FACT

A. Petitioners

Petitioners are married and lived in Port Richey, Florida, when they filed the petition in
this case.

B. The Real Property

Petitioners owned a mobile home park called Brentwood Estates in Pasco County,
Florida. On April 25, 1984, they paid $766,808.78 to buy about 76.5 acres of vacant land
zoned for a mobile home park (the 76.5 acres) next to Brentwood Estates so they could
expand their mobile home park. This was their primary purpose in buying and holding
the land until they listed the property for sale or exchange (described below at par. D1).

The 76.5 acres had natural mounds of sand on it. Petitioners bought the 76.5 acres on
the condition that they could obtain a Pasco County permit to mine sand from it. Their
contract with the seller required that petitioners pay the seller $.75 per cubic yard of sand
that they removed.

D. Petitioners' Exchange of the 76.5 Acres

1. Listing the Property for Sale

Petitioners listed the 76.5 acres with a realtor to sell as a mobile home park, sand mine,
or construction and demolition debris dump. There was a large demand for construction
and demolition debris dumps in Pasco County when petitioners listed the 76.5 acres for
sale. David Gilmore (Gilmore) was petitioners' attorney. He represented them in the
exchange of the 76.5 acres.

Petitioners did not have a construction and demolition debris dump permit when they
listed the 76.5 acres for sale. Petitioners applied to Pasco County for a construction and
demolition debris dump permit. They stated on their application that they ultimately
intended to use the 76.5 acres as a mobile home park. The B.C.C. approved
petitioners'application. Potential buyers became more interested in the property after
petitioners obtained a construction and demolition debris dump permit.

The Pasco County permit was not the only permit petitioners needed to operate a
construction and demolition debris dump on the 76.5 acres. They did not operate a dump
while they owned the 76.5 acres, and they did not have all the permits required to do so.

A prospective buyer of the76.5 acres retained Triggs, Catlett & Associates in June 1990
to estimate the value of the land and various values and costs related to the prospective
buyer's operation of a sand mine on the 76.5 acres. Frank A. Catlett (Catlett), a real estate
appraiser, estimated that the value of the land was $1,163,000, before taking into account
any costs of equipment or other assets required to operate a sand mine or any
goingconcern value of petitioners' sand mine. Catlett's client did not buy the 76.5 acres or
petitioners' sand mine business.

2. The Buyers

Dakic and Fontana (the buyers) wanted to buy a construction and demolition debris
dump site in Pasco County. They had one landfill that was nearly full.

Operating a construction and demolition debris dump was more profitable to the buyers
than operating a sand mine. The sand on the 76.5 acres had no value to the buyers. The
buyers would have preferred to have obtained land with a hole in the ground.
The buyers did not want to acquire petitioners' sand mine business. They did not ask to
see petitioners' sand mine business records. Petitioners did not show their business
records to the buyers.

Initially, Dakic negotiated for the buyers. Later, attorney Robert C. Burke (Burke)
represented the buyers to help them acquire the 76.5 acres and Pasco County permits. The
only item or property that petitioners conveyed was the 76.5 acres. Petitioners did not
have a customer list, trucks, or other equipment. The buyers did not want those items and
did not obtain them from petitioners.

Gilmore negotiated the exchange of the 76.5 acres for petitioners. The subject of
conveying petitioners' business was not discussed during the negotiations.

3. Contract for LikeKind Exchange

On October 3, 1990, petitioners signed a contract entitled "Real Estate Contract for
LikeKind Exchange" (the contract) to convey the property to the buyers. An addendum to
the contract gave the buyers 30 days after signing the contract to perform field tests to see
whether the 76.5 acres was suitable for use as a landfill and sand mine. The buyers could
have their deposit returned only if they decided that the 76.5 acres was not suitable for
use as a construction and demolition debris dump and sand mine, or if they did not obtain
construction and demolition debris dump and sand mine permits from Pasco County.

The addendum allowed petitioners to operate the sand mine until the transfer to the
buyers closed. This benefitted the buyers, who wanted sand to be removed. The buyers
had the right to review petitioners' records to verify that petitioners did not jeopardize the
property, e.g., create liens.

The addendum provided that if the buyers obtained new permits and then defaulted on
the contract, the buyers agreed to pay petitioners' expenses to obtain the permits that
petitioners had obtained before signing the contract.

On November 9, 1990, the parties extended the closing date under the contract because
the buyers did not know if Pasco County would permit them to deposit debris from
outside the county in a dump on the 76.5 acres. The buyers had the right to cancel the
contract if they could not do so.

Petitioners transferred the 76.5 acres to the buyers by warranty deed on October 16,
1991. The buyers paid $1.2 million for the 76.5 acres. Petitioners mined about 130,000
cubic yards of sand from the 76.5 acres during the time the contract was executory. The
buyers did not request any price adjustment.

Florida had a bulk sale law when petitioners exchanged the 76.5 acres with the buyers
that required parties to a transfer of a business to list all equipment, materials, and stock
in trade to avoid the presumption that the transfer is a fraudulent conveyance. Fla. Stat.
Ann. secs. 676.101109 (West 1993) (repealed by 1993 Fla. Laws ch. 9377, sec. 3). Burke
did not try to comply with the bulk sale law because he believed petitioners exchanged
real estate, not a business with equipment or stock in trade. The buyers did not receive a
bill of sale for any chattels. Burke obtained land title insurance and paid for real estate
documentary stamps based on the $1.2 million contract price.

The 76.5 acres remained zoned for a mobile home park during the time petitioners held
it.

In exchange for the 76.5 acres, petitioners received title to the Mosquito Control
Building, Palm Coast Storage, and a bank building (the acquired properties). The
acquired properties were rental properties. Petitioners identified the acquired properties
within 45 days of October 16, 1991. They received title to the acquired properties within
180 days of October 16, 1991. The acquired property was real property held for
productive use in a trade or business or for investment.

4. Permits for the Buyers

Burke obtained new permits from Pasco County for the buyers to operate a sand mine
and a construction and demolition debris dump at the 76.5 acres. He obtained all of the
permits that the buyers would need to operate a construction and demolition debris dump,
including permits from the Florida Department of Natural Resources. The buyers paid
more than $100,000 to their attorneys, engineers, and to Pasco County to obtain the
permits. The buyers gave sand away from the 76.5 acres.

The buyers incorporated their business as Sunset Sand Mine, Inc. and transferred the
76.5 acres to it.

E. Pasco Lakes, Inc.

In 1989, Larry Gilford (Gilford) owned 50 percent of the stock of Pasco Lakes, Inc.
(Pasco Lakes). In September 1989, Pasco Lakes paid $675,000 for vacant land zoned for
agricultural use. Pasco Lakes obtained permits to mine sand from the land. Gilford sold
the stock of Pasco Lakes to Environmental Capital Holdings, Inc. (Environmental) on
September 19, 1991. Environmental bought stock instead of the land because it wanted
the permits and an operating business. Otherwise it would have been required to apply to
Pasco County and follow the rigorous procedure to obtain permits for itself.

F. Petitioners' Income Tax Returns

Petitioners filed a joint income tax return for 1991. They reported on Form 4797, Sale
of Business Property, that they exchanged for $1.2 million sand mine property that they
bought in 1984. They attached a statement to the return which was entitled, "Exchange of
Sand Mine for Like Business Real Estate." In their statement they reported that they took
depletion deductions from 1984 to 1991 totaling $712,317.14.

OPINION
A. Contentions of the Parties and Background

A taxpayer may defer recognition of gain or loss from qualifying exchanges of likekind
property. Sec. 1031(a)(1). A likekind exchange occurs if property held for productive use
in a trade or business or for investment is exchanged solely for property of like kind that
is to be held either for productive use in a trade or business or for investment. Sec.
1031(a)(1). A taxpayer recognizes gain in a likekind exchange under section 1031 to the
extent of the fair market value of any nonqualifying property exchanged. Sec. 1031(b).

Petitioners contend that the only property they exchanged was the 76.5 acres, and that
they may defer recognition of the gain from the $1.2 million exchange price for the 76.5
acres under section 1031. Respondent concedes that petitioners may defer the gain under
section 1031 to the extent that it relates to the land. However, respondent contends that
petitioners exchanged certain business operating permits, goodwill, goingconcern value,
and property held for sale (i.e., sand), which are nonqualifying properties under section
1031.

B. What Petitioners Transferred to the Buyers

1. Whether Petitioners Transferred Tangible Property Other Than Land

Petitioners contend that they transferred only land to the buyers. Respondent contends
that petitioners exchanged land and other assets. We agree with petitioners.

Mrs. Beeler, Dakic, Burke (the buyers' attorney), and Gilmore (petitioners' attorney)
testified that the only asset petitioners transferred was real property. The deed conveying
the 76.5 acres states that petitioners conveyed land to the buyers; it does not state that
petitioners conveyed anything else. There are no other documents conveying title from
petitioners to the buyers for any other property. The parties treated the land as the only
property transferred for title insurance and real estate transfer tax purposes. There were
no bills of sale for any chattels. There is no evidence to support respondent's contention
that petitioners exchanged an office, a fence, vehicles, equipment, or anything other than
land.

Respondent contends that we should give no weight to the testimony of Mrs. Beeler,
Dakic, Burke, and Gilmore because it was selfserving and unbelievable. We disagree. We
may not arbitrarily disregard unimpeached, competent, and relevant testimony. Conti v.
Commissioner, 39 F.3d 658, 664 (6th Cir.1994), affg. 99 T.C. 370 (1992) and T.C.
Memo.1992614; Loesch & Green Constr. Co. v. Commissioner, 211 F.2d 210, 212 (6th
Cir.1954), revg. a Memorandum Opinion of this Court. Mrs. Beeler, Dakic, Burke, and
Gilmore testified in a manner fully consistent with the documents related to the
transaction at issue and with each other's testimony. Respondent produced no evidence to
the contrary.

We conclude that petitioners transferred land and no other tangible property to the
buyers.
2. Whether Petitioners Exchanged Their Mining and Construction and Demolition Debris
Dump Permits

Respondent contends that petitioners exchanged their Pasco County sand mining and
construction and demolition debris dump permits with the 76.5 acres. We disagree.

The parties to the exchange and their attorneys testified that petitioners did not
exchange their Pasco County permits. The documents conveying property in the
exchange did not list the permits.

Cynthia Jolly (Jolly) was the Code Enforcement Director for Pasco County at the time
of trial. She was very knowledgeable about Pasco County permit procedures. Respondent
relies on the fact that Jolly answered in the affirmative when asked, "Is a permit
transferrable" Respondent misses the point made clear by Jolly's other testimony, that a
permit may be transferred only by Pasco County, and not by a permit holder. Jolly
testified clearly that petitioners could not transfer their Pasco County permits and that the
B.C.C. must independently approve issuance of a permit to a new permittee. Thus,
petitioners could not sell or exchange their Pasco County sand mine or construction and
demolition debris dump permits.

Respondent contends that Pasco County permits are analogous to easements, grazing
rights, FCC licenses, and liquor licenses, which are generally transferrable. E.g., In re
Atlantic Bus. and Community Dev. Corp., 994 F.2d 1069, 1075 (3d Cir.1993); Ward v.
Commissioner, 58 F.2d 757 (9th Cir.1932); Osborne v. Commissioner, 87 T.C. 575
(1986); Uecker v. Commissioner, 81 T.C. 983 (1983), affd. 766 F.2d 909 (5th Cir.1985);
Radio Station WBIR, Inc. v. Commissioner, 31 T.C. 803, 813 (1959); Tube Bar, Inc. v.
Commissioner, 15 T.C. 922 (1950). Respondent's argument does not apply because
petitioners did not transfer their Pasco County permits.

Respondent called Catlett as an expert witness to appraise the 76.5 acres as of June
1990. He testified that the 76.5 acres would be worth $1,163,000 with permits and
$710,000 without permits. Respondent contends that this shows that petitioners
transferred the permits. We disagree. The $1.2 million exchange value is consistent with
Catlett's appraisal of the 76.5 acres because it was contingent on issuance by Pasco
County of the needed permits to the buyers, not because petitioners transferred their
permits to the buyers. The effect on the value of the land of a seller having Pasco County
permits is analogous to the effect of receipt of a favorable zoning classification. The
existence of both depends on governmental action. Both can add value to the land. A new
buyer may expect that zoning will not change and may pay more for property because of
that expectancy. Similarly, a buyer of land, the seller of which has a Pasco County
permit, may expect that his or her application for a new permit will be approved, and may
pay more for the land because of that expectancy. However, a seller cannot sell either a
permit or a zoning classification.

We conclude that petitioners did not sell their Pasco County permits.
3. Whether Petitioners Conveyed Goodwill or Going Concern Value

Respondent contends that petitioners transferred $37,000 of goodwill or going concern


value with the 76.5 acres. Respondent points out that petitioners called their sand
business the "Sunset Sand Mine," and the buyers formed a corporation named "Sunset
Sand Mine, Inc." Respondent contends this shows that petitioners sold goodwill and a
goingconcern to the buyers. Respondent points out that petitioners had a good business
location and customers and that the contract for exchange required petitioners to operate
and maintain their business.

LIKE-KIND PROPERTY: PERSONALTY OR REALTY

BEELER

In Beeler v. Comm., T. C. Memo 1998-44, 1998 WL 44099 (U.S. Tax Court), the parties
had argued for a tax-deferred exchange and were successful.

The case at hand was an argument that they were entitled to an award of administrative
litigation costs against the Internal Revenue Service. The Court held that the taxpayers
were entitled to such relief.

Larry L. BEELER and Cynthia J. BEELER, Petitioners


v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

No. 1605294.
United States Tax Court.
T.C. Memo. 199844
1998 WL 44099 (U.S.Tax Ct.), 75
T.C.M. (CCH) 1699, T.C.M. (RIA) 98,044
Feb. 5, 1998.

MEMORANDUM OPINION

COLVIN, Judge:

This case is before the Court on petitioners' motion for an award of administrative and
litigation costs, as amended and supplemented, under section 7430 and Rule 231.

The parties have submitted affidavits and memoranda supporting their positions. We
decide the motion based on the memoranda, affidavits, and exhibits attached to the
affidavits. The parties do not dispute the material facts in the affidavits or the authenticity
of the exhibits attached to the affidavits. Respondent did not request a hearing. Although
petitioners requested a hearing, we conclude that a hearing is not necessary to properly
decide the motion. Rule 232(a)(3).
Background

Petitioners are married and lived in Florida when they filed their petition in this case.

The primary issue in the underlying case, Beeler v. Commissioner, T.C. Memo.199773,
was whether petitioners' disposition of 76.5 acres of land in Pasco County, Florida,
qualified for treatment as a likekind exchange under section 1031. Respondent
determined in the notice of deficiency and contended throughout the case that some or all
of the gain realized by petitioners from the exchange of the 76.5 acres did not qualify for
nonrecognition under section 1031 because petitioners exchanged assets other than land;
i.e., certain business operating permits issued by Pasco County, goodwill, goingconcern
value, and sand. We found that petitioners did not exchange assets other than the 76.5
acres of land. The parties to the transaction testified and the documents relating to the
transaction showed that petitioners transferred no assets other than land. Pasco County
did not allow permit holders to transfer their permits to buyers of their land. We held that
petitioners' transfer of the land qualified as a likekind exchange under section 1031.

Discussion

A. Motion for Administrative and Litigation Costs

Generally, a taxpayer who has substantially prevailed in a Tax Court proceeding may
be awarded reasonable administrative and litigation costs. Sec. 7430(a), (c). To be
entitled to an award, the taxpayer must:

1. Exhaust administrative remedies. [FN1] Sec. 7430(b)(1).


Respondent concedes that petitioners meet this requirement.
FN1. This requirement does not apply to an award for
reasonable administrative costs. Sec. 7430(b)(1).
2. Substantially prevail with respect to the amount in controversy.
Sec. 7430(c)(4)(A)(ii)(I). Respondent concedes that petitioners
meet this requirement.
3. Be an individual whose net worth did not exceed $2 million, or
an owner of an unincorporated business, or any partnership,
corporation, etc., the net worth of which did not exceed $7
million, when the petition was filed. Sec. 7430(c)(4)(A)(iii); 28
U.S.C. sec. 2412(d)(2)(B) (1988). Respondent concedes that
petitioners meet this requirement.
4. Show that they did not unreasonably protract the proceedings.
Sec. 7430(b)(4). Respondent concedes that petitioners meet this
requirement.
5. Show that the position of the United States in the action was not
substantially justified. Sec. 7430(c)(4)(A)(i) Respondent
contends that petitioners do not meet this requirement.
6. Establish that the amount of costs and attorney's fees claimed by
the taxpayers is reasonable. Sec. 7430(a), (c)(1) and (2).
Respondent does not dispute the number of hours of legal
services or other costs claimed by petitioners. Petitioners
initially claimed that they were entitled to more than $75 per
hour adjusted for inflation. Respondent disputed that contention.
Petitioners now claim that they are entitled to $75 per hour
adjusted for inflation. Thus, the amount of costs is not in
dispute.

B. Whether the Position of the United States Was Substantially Justified

The sole issue for decision is whether respondent's position in this case was
substantially justified. A taxpayer has the burden of proving that he or she meets this
requirement before the Court may award administrative and litigation costs under section
7430. Rule 232(e). [FN2]

FN2. The provisions of the Taxpayer Bill of Rights 2, Pub.L. 104168, sec. 701, 110 Star.
1452, 14631464 (1996), which amended sec. 7430, are effective for proceedings begun
after July 30, 1996. The provisions of the Taxpayer Bill of Rights 2 do not apply here
because petitioners filed the petition in this case on Sept. 6, 1994. See Magpie
Management Co. v. Commissioner, 108 T.C. 430, 441 (1997).

1. Position of the United States

The position of the United States is the position taken by respondent: (a) In the judicial
proceeding, and (b) in the administrative proceeding as of the earlier of: (i) the date the
taxpayer receives the notice of the decision of the Internal Revenue Service Office of
Appeals, or (ii) the date of the notice of deficiency. Sec. 7430(c)(7). Respondent
determined in the notice of deficiency and contended in the answer that petitioners
transferred assets other than land. Thus, that is respondent's position for both the
administrative and the judicial proceedings.

2. Substantially Justified Standard

A taxpayer must establish that the position of the United States in the litigation was not
substantially justified to be entitled to an award for administrative and litigation costs.
Sec. 7430(c)(4)(A)(i). The substantially justified standard requires that the Government's
position be justified to a degree that would satisfy a reasonable person. Pierce v.
Underwood, 487 U.S. 552, 565 (1988); Rickel v. Commissioner, 900 F.2d 655, 665 (3d
Cir.1990), affg. in part and revg. in part on other grounds 92 T.C. 510 (1989). That
standard applies to motions for litigation costs under section 7430. Rickel v.
Commissioner, supra. Powers v. Commissioner, 100 T.C. 457, 470, 473 (1993), affd. on
this issue and revd. in part and remanded on other issues 43 F.3d 172 (5th Cir.1995).

To be substantially justified, the Commissioner's position must have a reasonable basis


in both law and fact. Pierce v. Underwood, supra; Hanover Bldg.. Matls.,.. Inc. v.
Guiffrida, 748 F.2d 1011, 1015 (5th Cir.1984); Powers v. Commissioner, supra. For a
position to be substantially justified, there must be substantial evidence to support it.
Pierce v. Underwood, supra at 564565; Powers v. Commissioner, supra at 473.

The fact that the Commissioner eventually loses or concedes the case does not in itself
establish that a position is unreasonable. Wilfong v. United States, 991 F.2d 359, 364 (7th
Cir.1993); Hanson v. Commissioner, 975 F.2d 1150, 1153 (5th Cir.1992). However, it is
a factor to be considered. Estate of Perry v. Commissioner, 931 F.2d 1044, 1046 (5th
Cir.1991); Powers v. Commissioner, supra at 471.

LIKE-KIND PROPERTY:
PRIVATE LETTER RULING 8938045

Under this Ruling, the Treasury held that it was proper to exchange under Code §1031
a commercial building for commercial condominium, when that new condominium was
newly constructed. In other words, this could qualify as like-kind property.

PRIVATE LETTER RULING 8938045

Dear

This is in reply to your letters dated March 14 and June 2, 1989, submitted on behalf of
X and Y, in which you requested a ruling on the applicability of section 1031 of the
Internal Revenue Code to a transaction.

X currently owns a commercial building from which it operates its business. Y is


presently developing a combination office and warehouse building.

X and Y are owned by related parties.

X and Y propose to exchange the commercial building for a commercial condominium


in the newly constructed building. It is represented that the fair market value of both
properties will approximately equal $V.

X represents that it is not a dealer in real property. Additionally, the property


exchanged by X has been held for use in a trade or business or for investment. Similarly,
X intends to hold the property to be received for investment or use in a trade or business.
Further, the exchange will not involve any assumption of liabilities on any of the
properties by either party.

Based on the above facts and representations, X requests a ruling as follows:

No gain or loss will be recognized by X under 1031 of the Code on the exchange of the
commercial building for the commercial condominium offices.

Section 1031(a)(1) of the Code provides, in general, 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.

Section 1031(a)(2) of the Code lists the exceptions to the types of property to which the
general rule of recognition will not apply. These types include: stock in trade or other
property held primarily for sale; stock, bonds, or notes; other securities or evidences of
indebtedness or interest; interests in a partnership; certificates of trust or beneficial
interests; and choses in action.

Under section 1031(b) of the Code, if the exchange would be within the provisions of
section 1031(a) if it were not for the fact that property other than property permitted
under section 1031(a) is received, then the gain, if any, to the recipient shall be
recognized, but in an amount not in excess of the sum of such money and the fair market
value of such other property.

Pursuant to section 1031(c) of the Code, if the exchange would be within the provisions
of section 1031(a), if it were not for the fact that the property received in exchange
consists not only of the property permitted by such provisions without the recognition of
gain or loss, but also of other property or money, then no loss from the exchange shall be
recognized.

Section 1031(d) of the Code provides if property was acquired on an exchange


described in this section, then the basis shall be the same as that of the property
exchanged, decreased in the amount of any money received by the taxpayer and increased
in the amount of gain or decreased in the amount of loss to the taxpayer that was
recognized on such exchange.

Under section 267(a)(1) of the Code, no deduction for losses are allowed with respect
of any loss from the sale or exchange of property, directly or indirectly, between persons
specified under section 267(b). Section 267(b)(3) includes as such persons two
corporations which are members of the same controlled group.

In Rev. Rul. 72151, 19721 C.B. 225, an exchange of rental property for farm property
between a corporation and its sole shareholder was held to constitute a qualifying like
kind exchange. Additionally, any loss under section 1031(b) of the Code from the
inclusion of other property or money not permitted under section 1031(a) would not be
recognized pursuant to sections 1031(c) and 267(a)(1).

Based on the above facts and representations, we therefore hold:

No gain or loss will be recognized by X under section 1031 of the Code on the
exchange of the commercial building for the commercial condominium offices.

The above ruling is conditioned on the existence of a common interest in the underlying
land being a part of the condominium articles. And it is further conditioned on the
absence from the exchange of money or any property referred to in section 1031(a)(2) of
the Code. No opinion is expressed as to the tax treatment of the transaction herein under
the provisions of any other sections of the Code and regulations which may be applicable
thereto, or the tax treatment of any condition existing at the time of, or effect resulting
from, the transaction except as specifically covered by the above ruling.

This ruling is directed only to those taxpayers who requested it. Section 6110(j)(3) of
the Code provides that it may not be used or cited as precedent. Sincerely yours,

SIMULTANEOUS EXCHANGE: APPRAISALS:


VALUE ISSUES:
PRIVATE LETTER RULING 9535028

This Ruling involved a simultaneous tax-deferred exchange under Code §1031, with
the parties agreeing to utilize appraisals to value the property relative to the exchange.
This involved the exchange of real property subject to a portion of the existing mortgage
for an exchange of real estate subject to an existing mortgage. Absent debt relief, the
transaction qualified for a tax-deferred exchange, also assuming no additional
consideration was received, aside from the like-kind property.

PRIVATE LETTER RULING 9535028

Section 1031 EXCHANGE of Property Held were determined by independent


appraisal to which all parties agreed to be bound. The parties utilized such appraisals to
determine that the fair market values of the properties to be EXCHANGED were
approximately equal, taking into account the amounts of any mortgages to which such
properties are subject.

Section 1031(A)(1) of the Internal Revenue 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.

Section 1031(B) of the Code provides, in part, that if an EXCHANGE would be within
the provisions of subsection (a) if it were not for the fact that some property received in
the EXCHANGE consists not only of property permitted by such provisions to be
received without the recognition of gain, but also of other property or money, then the
gain, if any, to the recipient shall be recognized, but not in excess of the sum of such
money and the fair market value of such other property.

Section 1031(D) of the code provides, in part, that if property was acquired on an
EXCHANGE described in this section, then the basis shall be the same as that of the
property EXCHANGED, decreased in the amount of any money received by the taxpayer
and increased in the amount of gain or decreased in the amount of loss to the taxpayer
that was recognized on such EXCHANGE. It further provides that where as part of the
consideration to the taxpayer another party to the EXCHANGE assumed a liability of the
taxpayer or acquired from the taxpayer property subject to a liability, such assumption or
acquisition (in the amount of the liability) shall be considered as money received by the
Taxpayer on the EXCHANGE.

Section 1.1031(B) 1 (C) of the Income Tax Regulations provides, in part, that
consideration received in the form of an assumption of liabilities (or a transfer subject to
a liability) is to be treated as "other property or money," for purposes of section 1031(B).
Where on an EXCHANGE described in section 1031(B), each party to the EXCHANGE
either assumes a liability of the other party or acquires property subject to a liability,
then, in determining the amount of "other property or money" for purposes of section
1031(B), consideration given in the form of an assumption of liabilities (or a receipt of
property subject to a liability) shall be offset against consideration received in the form of
an assumption of liabilities (or a transfer subject to a liability). See s 1.1031(D)2,
example (2).

In this case, Taxpayer is simultaneously EXCHANGING real property held for


investment solely for other real property to be held for investment. Hence, this
transaction involves likekind property within the meaning of section 1031(A) of the
Code. The simultaneous transfers of likekind properties, of approximately equal value, is
treated as an EXCHANGE.

In the proposed EXCHANGE the parties will be transferring real property subject to a
share of an existing mortgage and receiving real property subject to a share of an existing
mortgage. Under section 1031(D) of the Code and the related regulations cited above, the
relief of liability on a mortgage, whether by its assumption by another party or by transfer
of property subject to a mortgage, equates to the receipt of cash or other property for
which gain must be recognized. Furthermore, the relief of liability as to Taxpayer, A
Corp, is offset by the amount of any liability to which the property it receives is subject.

Therefore, Taxpayer will recognize no gain or loss in its EXCHANGE with the Marital
Trust in connection with the Settlement Agreement except to the extent required by
application of section 1031(B) of the Code relating to the receipt of money or other
property, including relief from mortgage debt, in connection with the EXCHANGE. As
to the mortgage debt, no gain will be recognized with respect to such transfers except to
the extent of the excess, if any, of liabilities transferred over liabilities assumed by the
Marital Trust. The scope of this ruling is limited to the land, buildings and fixtures
constituting real property under local law and has no application to the transfer of
tangible personal property, if any, located in or on the real properties to be transferred,
where such tangible personal property does not constitute a fixture under local law.

No opinion is expressed as to the tax treatment of this item(s) (or transaction(s)) under
the provisions of any other section of the Code or regulations which may be applicable
thereto, or the tax treatment of any conditions existing at the time of, or effects resulting
from, the item(s) (or transaction(s)) described which are not specifically covered in the
above ruling. Moreover, the amount of mortgage liability to which T10 may be subject is
not clear as of the date of this letter. Therefore, we express no opinion as to what extent,
if any, Taxpayer may experience net gain as a result of its transfer and receipt of
mortgage encumbered property or of how Taxpayer's basis in its remaining property may
be affected by its transfer of b% of T10 subject to the mortgage.

If it is later determined that the values of the properties EXCHANGED are not
approximately equal, there may be a basis for holding that part of the consideration for
the EXCHANGE was the receipt of nonlikekind property or may have involved an
EXCHANGE of a chose in action, a relinquishment of a chose in action or be taxable as
some other form of income. We express no opinion on the factual question of the relative
values of the EXCHANGE properties. In this connection, we note that section
1031(A)(2)(F) of the Code states that section 1031 shall not apply to any EXCHANGE of
a chose in action.

SALE OR EXCHANGE
EAST LAKE CREEK RANCH, LLP
V.
BROTMAN,
STATE BOARD OF LAND COMMISSIONERS, 1999 WL 569335 (Colo. App.)

The East Lake Creek Ranch case examined the question as to whether the transaction
involved a tax-deferred exchange or a sale. The court concluded that the transaction
constituted a sale.

FOR EDUCATIONAL USE ONLY


Copr. © West 1999 No Claim to Orig. U.S. Govt. Works
NOTICE: THIS OPINION HAS NOT BEEN RELEASED FOR PUBLICATION IN THE PERMANENT
LAW REPORTS. A PETITION FOR REHEARING IN THE COURT OF APPEALS OR A PETITION
FOR CERTIORARI IN THE SUPREME COURT MAY BE PENDING.
EAST LAKE CREEK RANCH, LLP,
A Colorado limited liability partnership, Plaintiff Appellee and Cross Appellant,
V.
Robert BROTMAN,
State Board of Land Commissioners, and the State of Colorado, Defendants Appellants
and Cross Appellees.
Colorado Court of Appeals.
1999 WL 569335 (Colo.App.)
Aug. 5, 1999.

Appeal from the District Court of the City and County of Denver
Honorable Edward A. Simons, Judge No. 97CV2586

Opinion by JUDGE PLANK

In this action for declaratory and injunctive relief, defendants, Robert Brotman, State
Board of Land Commissioners (Board), and the State of Colorado, appeal from the trial
court's injunction barring Brotman and the Board from completing their "land exchange"
agreement. The Board also appeals the trial court's ruling which acknowledged the
standing of plaintiff, East Lake Creek Ranch (ELCR), as a taxpayer to challenge that
exchange. Plaintiff crossappeals the court's denial of standing on the basis of its right as
owner of adjacent property. We affirm.

We first address the issue of whether ELCR has standing to challenge the Board's
agreement with Brotman by which he would acquire a patent to certain state school land.

The Board contends that the trial court erred in relying on McCroskey v. Gustafson,
638 P.2d 51 (Colo.1981) to find that ELCR had standing as a taxpayer to bring this suit.
Instead, the Board argues that principles of trust law should govern and, as thereunder
ELCR is at most an incidental beneficiary of the school land trust, it lacks standing. We
are not persuaded.

Our de novo review, see Brown v. Board of County Commissioners, 720 P.2d 579
(Colo.App.1985), leads us to reach the same result as the trial court, though for different
reasons. Thus, we do not disturb its ruling. See Utah International, Inc. v. Board of Land
Commissioners, 41 Colo.App. 72, 579 P.2d 96 (1978).

We agree with the Board that McCroskey specifically sets forth a test by which to
determine taxpayer standing to bring a representative action on behalf of a municipal
corporation. And, we decline to extend McCroskey to reach the facts here.

The McCroskey test was formulated precisely because the standing requirements set
forth in Wimberly v. Ettenberg, 194 Colo. 163, 570 P.2d 535 (1977) for taxpayer actions
against the state were determined not functional in the context of a taxpayer suit on
behalf of a municipality. See McCroskey v. Gustafson, supra.

Thus, here, because defendant Board is a state agency, see Sunray Mid Continent Oil
Co. v. State, 149 Colo. 159, 368 P.2d 563 (1961), we conclude that Dodge v. Department
of Social Services, 198 Colo. 379, 600 P.2d 70 (1979) is the more appropriate basis for a
determination of ELCR's standing.

The Dodge court reaffirmed Wimberly, which announced that the proper inquiry in
determining standing is whether a plaintiff has suffered an injury infact to a legally
protected interest as contemplated by statutory or constitutional provisions. In applying
that test to the facts in Dodge, our supreme court found that the second criterion was met
by plaintiff's averment that acts by the state defendant had violated the Colorado
Constitution and exceeded the department's statutory authority.

In its consideration of the first component of the Wimberly test, the Dodge court then
determined that an injuryinfact may be found in the absence of direct economic injury.
See Howard v. City of Boulder, 132 Colo. 401, 290 P.2d 237 (1955) (although proposal
to amend city charter had no adverse economic effect on plaintiff, he had standing
because of his interest that the form of government under which he lived be in accord
with the state constitution); see also Colorado State Civil Service Employees Ass'n v.
Love, 167 Colo. 436, 448 P.2d 624 (1968) (petitioners state a justiciable controversy
because they claim violation of the state constitution).
Similarly, here, ELCR alleged in its complaint that the Board acted ultra vires in
exercising its statutory and constitutional authority by entering this real estate agreement.
Specifically, ELCR argued that defendants' "exchange" was in reality a sale of property,
which did not adhere to the requirements of Colo. Const. art. IX, § 10, or § 36124,
C.R.S.1998. ELCR further alleged that the appraised value of the parcel was far below
the fair market price and, thus, that the Board had effectively made a donation to
Brotman in violation of Colo. Const. art. XI, § 2.

These allegations are sufficient under Dodge to confer taxpayer standing on ELCR to
bring this action against a state agency.

B.

Our review of the facts in the context of trust principles does not, in our view, negate
ELCR's standing.

Through the Colorado Enabling Act, Congress conveyed land to the state for support of
the common schools. The language of the Act has been found sufficient to indicate the
settlor's intent "to create a fiduciary obligation for the state of Colorado to manage the
school lands in trust for the benefit of the state's common schools." Colorado Enabling
Act § 7; Branson School District RE82 v. Romer, 161 F.3d 619, 634 (10th Cir.1998).

Colorado's 1876 Constitution met the obligation by creating a state agency to manage
all of the federal lands that had been granted under the Act. Colo. Const. art IX, § 10
(State Land Board has duty to provide for location, protection, sale or other disposition of
all lands under such regulations as may be prescribed by law). The Board has been
characterized as a managing landlord. Harrah v. People, 125 Colo. 420, 243 P.2d 1035
(1952).

In doing so, the state did not relinquish its trusteeship to the state agency. See Walpole
v. State Board of Land Commissioners, 62 Colo. 554, 163 P. 848 (1917) (The Board does
not in any sense stand in the position of an owner. It is an agent, with a duty to do no less,
and power to do no more, respecting the disposition of State lands under its control, than
is statutorily provided).

We further note that the composition and structure of the Board, its allocation of school
funds, management principles, and the scope of its duties are subject to determination by
Colorado voters. See Branson School District RE82 v. Romer, supra.

The state holds the school trust lands "in a perpetual, intergenerational public trust for
the support of public schools, which should not be significantly diminished." Colo.
Const. art. IX, § 10(1) (emphasis added). Accordingly, the members of the public at
large, through the institution of the public schools, are the intended beneficiaries of the
trust. See 89 C.J.S. Trusts § 19 (1955); 67 C.J.S. Officers and Public Employees § 3
(1978).
Thus, we cannot say that ELCR is a mere "incidental beneficiary" precluded from
bringing an action in regard to the operation of the state's trust.

Finally, because we have determined on other grounds that ELCR has standing to bring
this action, we do not address its crossappeal, which asserted standing as an adjacent
property owner.

Both Brotman and the Board contend that the trial court erred in its finding that the
agreement was the "functional equivalent of a sale." In support of this contention,
defendants argue that the agreement constituted an exchange of real estate, which was not
defeated by the $l,800,000 appraisal value assigned or by any delayed acquisition of
replacement property. We are not persuaded.

The decision to grant or deny injunctive relief lies within the sound discretion of the
trial court. See City of Colorado Springs v. Blanche, 761 P.2d 212 (Colo.1988).
However, interpretation of a written contract is a question of law subject to de novo
review. Hence, we need not defer to the trial court's interpretation of the agreement upon
which the court's injunction was based. See Bertrand v. Board of County Commissioners,
872 P.2d 223 (Colo.1994).

While it is our duty to interpret a contract in a manner which effectuates the manifest
intention of the parties at the time the contract was signed, see Roemmich v. Lutheran
Hospitals & Homes Society, 934 P.2d 873 (Colo.App.1996), we also note that an
unambiguous contract should be enforced according to the express provisions, with the
words given their plain and generally accepted meaning. Humphrey v. O'Connor, 940
P.2d 1015 (Colo.App.1996).

A longstanding test for determining whether a transaction constitutes a sale or exchange


is whether there is a fixed value at which the exchange is to be made; if there is a fixed
value, it is a sale. See Fain Land & Cattle Co. v. Hassell, 163 Ariz. 587, 790 P.2d 242
(1990); see also Gill v. Eagleton, 108 Neb. 179, 187 N.W. 871 (1922)(if the bargain is
made and the value of the land parted with is measured in money terms and the land is
paid for in money or in something the parties agree to treat as having a fixed and definite
value in money, the transaction is a sale).

Admittedly, the mere fact that a price is placed on the properties involved in an
exchange does not render the transaction a sale where the price fixed is evidently for the
purpose of constituting a basis on which the exchange may be made. However, where the
price is determined for the purpose of fixing definitely the value of the respective
properties involved in the purported exchange, that determination is conclusive that a
sale, not an exchange, has occurred. 33 C.J.S. Exchange of Property § 2(b) (1998); see
Higbie v. Johnson, 626 P.2d 1147 (Colo.App.1980); see also Hamburger v. Berman, 203
Mich. 78, 168 N.W. 925 (1918)(contract held to be exchange of two properties where
values fixed by the respective parties upon the properties were mere estimates and were
merely for the purpose of effecting an exchange).
Here, defendants agreed upon an appraiser and the $l,800,000 appraised value of the
school land. That value also established the maximum price of the land or lands to be
later acquired by the Board as replacement property.

Further, Brotman's only immediate obligation under the agreement was to tender four
irrevocable deposits amounting to the $l,800,000 appraisal value plus appraisal costs.
Once he met this obligation, the agreement granted him possession and control as well as
the authority to initiate condemnation proceedings for a private way of necessity.

Finally, and contrary to Board policy in effect at the time, Brotman was in control of
when he would receive the state patent. The transaction closing could occur on the date of
Brotman's final deposit or upon his sixtyday prior written notice to the Board.

Hence, we find that defendants' appraisal determined the fixed value of the transaction
and, thus, the agreement constituted a sale of real estate.

The fact that the agreement restricted the Board's eventual expenditure of the escrow
funds for only replacement property does not bring the transaction within the definition
of an exchange.

Our determination is supported by the Colorado constitutional amendment passed by


Colorado voters in November 1996, which specifically authorized and detailed guidelines
for the Board's participation in nonsimultaneous land exchanges. Contrary to the
openended agreement here, that amendment clearly requires that "the purchase of lands to
complete such an exchange shall be made within two years of the initial sale or
disposition." Colo. Const. art. IX, § 9(7) (emphasis supplied).

Further, we note that Internal Revenue Code criteria, established for purposes of
distinguishing taxable sales of land from exchanges, also preclude purely openended
transactions

The Code is flexible in accommodating situations, as advanced here by the Board,


wherein the buyer of lands may not have at the time of transfer a replacement property
desired by the seller. However, to qualify as an exchange under the Code, both parcels of
property involved must be identified and the exchange completed within specified time
frames. See 26 U.S.C. § 1031 (1995)(exchanges may be nonsimultaneous, but
replacement property must be identified within a 45day time frame and the exchange
completed not more than 180 days after the transfer of the initial parcel); see also 14 R.
Powell, Powell on Real Property § 83A.04(8)(b) (1995).

Here, while defendants' agreement required the simultaneous exchange of "any deed(s)
conveying the Replacement Property" at the time of closing, the parties did not state a
deadline for, or make Brotman's receipt of the patent contingent upon, any such
acquisition. That this terminology did not mandate a title exchange of some or all of the
replacement property at closing is supported by later provisions detailing the manner in
which the Board would direct the expenditure of remaining escrow funds.
Further, while Brotman agreed to cooperate, if requested, in the acquisition and
conveyance of replacement property, that acquisition was within the sole discretion and
control of the Board. His attendance at an escrow closing of the replacement property
was only upon the Board's request.

Thus, because we find that the agreement constituted a sale of school land transacted in
violation of § 361124, C.R.S.1998, we need not address defendants' remaining
contentions on appeal.

Accordingly, the injunction is affirmed.

SALE OR EXCHANGE: YOUNG

The Young case typifies the distinction between an exchange and a sale with a
reinvestment. The latter does not qualify for Code §1031 treatment. This point was made
clear to the taxpayer in the Young case.

ROBERT G. YOUNG, Petitioner


v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent T.C. Memo. 1985221
MEMORANDUM FINDINGS OF FACT AND OPINION

PARKER, JUDGE:

Respondent determined a deficiency in petitioner's 1978 Federal income tax and an


addition to tax under section 6653(a) [FN1] in the amounts of $19,291.00 and $964.55,
respectively. The issues [FN2] for decision are:

(1) The amount of gain petitioner realized on the sale or exchange


of real property, which depends on petitioner's adjusted basis
in the property at the time of the transaction;
(2) Whether petitioner must recognize such gain in 1978 or can
defer recognition of the gain in this transaction as a likekind
exchange under section 1031; and
(3) Whether petitioner is liable for the addition to tax under
section 6653(a)
FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The first and second
stipulation of facts and the exhibits attached thereto are incorporated herein by this
reference. Petitioner resided in Virginia Beach, Virginia, at the time he filed his petition
in this case.

Petitioner timely [FN3] filed his 1978 Federal individual income tax return (Form
1040) with the Internal Revenue Service Center in Memphis, Tennessee. His filing status
was that of a married person filing a separate return. Petitioner is a native of Floyd
County, Virginia, which is located in the rural Blue Ridge Mountain region of Virginia.

Petitioner's formal education included the sixth grade; he entered but did not complete
the seventh grade. Sometime before 1953, petitioner moved from Floyd County to
Virginia Beach, Virginia. In Virginia Beach petitioner worked as a carpenter, building
houses primarily.

Sometime during the first half of 1953, petitioner decided to buy some land in Floyd
County in case he wanted to move back there some day. Petitioner told an acquaintance
in Floyd County, Dock Dickerson (Dickerson), that if he could find some property there
that petitioner could buy, he would give Dickerson part of it 'for his trouble.' Soon
thereafter, Dickerson reported to petitioner that he had located a parcel of real estate that
petitioner might be interested in. As soon as he could, petitioner traveled to Floyd
County, inspected the property, and discussed with the owner the purchase of the land.

Petitioner bought this property, consisting of approximately 164.5 acres in the Court
House Magisterial District of Floyd County, Virginia (the Virginia property). He
acquired the property by a deed dated June 19, 1953, from Edd S. Rakes and Catherine
M. Rakes (the Rakes) to petitioner and his wife, Jean D. Young, as tenants by the
entirety. [FN4] Petitioner paid the Rakes $10,000 cash and a promissory note in the
amount of $14,900. The note was cosigned by Dickerson, but it was not otherwise
secured or recorded as a lien against the property. Only the $10,000 cash payment was
recited in the deed as the consideration therefor.

Petitioner also owned a house located in an area known as Elizabeth River Shores,
which is now within the city limits of Virginia Beach, Virginia. Sometime after petitioner
purchased the land in Floyd County, he sold the Virginia Beach house and used the
proceeds from that sale to pay in full the $14,900 note he had given to the Rakes.
Dickerson did not pay any portion of the note.

Shortly after paying off the note petitioner transferred to Dickerson 44.1 acres [FN5] of
the Virginia property as a finder's fee or broker's commission for locating it. Petitioner
received no additional consideration from Dickerson for this parcel.

Sometime during 1963 petitioner sold approximately 15 acres of the Virginia property
to the Floyd County School Board for $5,400. [FN6] Shortly thereafter petitioner made a
number of capital improvements to the remainder of the Virginia property. These
improvements included leveling off a portion of the property as well as putting in an
access road, drainage ditches, and drainage pipes. Petitioner paid the contractor who did
the work $6,900, consisting of the $5,400 petitioner received from the Floyd County
School Board plus an additional $1,500 of petitioner's separate funds.

Sometime during 1978 petitioner had an accident with a chain saw that injured his foot
and precluded him from continuing to work as a carpenter. After his convalescence from
this accident, petitioner decided to try to support himself by cutting and selling firewood.
The Virginia property was heavily wooded with timber suitable for firewood. However,
petitioner did not think he could profitably exploit that timber because the property was
too far away, some 300 miles from Virginia Beach, his best potential market. Petitioner
decided to trade the Virginia property for similar real estate located closer to Virginia
Beach so that he could profitably sell firewood from such timberland.

Shortly after reaching this conclusion, petitioner found a parcel of suitable land in
Currituck County, North Carolina (the North Carolina property). Currituck County is just
across the North Carolina State line, approximately eight miles from petitioner's
residence. Petitioner called the owners of the North Carolina property, James H. Ferebee,
Sr., and James H. Ferebee, Jr. (the Ferebees), to inquire if the land was for sale. The
Ferebees referred petitioner to Mary Louise Chappell (Chappell), the real estate agent
who was handling the sale of their land. Petitioner contacted Chappell during the summer
of 1978 and asked her if she thought the Ferebees would be interested in trading the
North Carolina property for his Virginia property. After discussing petitioner's proposal
with the Ferebees, Chappell told petitioner that they would not trade properties because
the Virginia property was too far away and they were interested in selling land, not
buying land.

Sometime before September 7, 1978, petitioner again spoke with Chappell about a
possible trade of his Virginia property for the Ferebees' North Carolina property.
Chappell repeated their refusal to trade. After further negotiations during that
conversation, petitioner agreed to offer to purchase the North Carolina property for
$100,000. At that time petitioner signed an offer to purchase and contract (the offer to
purchase and contract), reflecting the offer and gave Chappell a $5,000 earnest money
deposit. [FN7] Pursuant to the offer to purchase and contract, petitioner's $5,000 earnest
money deposit was to be credited against the $100,000 purchase price. The balance was
to be paid at the closing, $80,000 by cash and $15,000 by a secured promissory note
payable June 1, 1979. However, petitioner made it clear to Chappell, and she agreed, that
petitioner's offer was conditioned on his selling his Virginia property and using the
proceeds of the sale to make the purchase. In response to petitioner's inquiry during the
negotiations, Chappell told petitioner that it was her understanding that his sale of the
Virginia property and immediate use of the proceeds to buy the North Carolina property
would be tax free because, as she saw it, petitioner was essentially exchanging timberland
in Virginia for timberland in North Carolina.

Pursuant to a contract (the sales contract) dated September 7, 1978, petitioner agreed to
sell his Virginia property [FN8] to the Turmans, husband and wife, for $90,000, and
received an earnest money deposit in the amount of $5,000. On October 10, 1978, the
sale [FN9] was closed and petitioner received a check for the net settlement proceeds in
the amount of $84,242.63 (the sale proceeds). At the closing, petitioner asked the closing
attorney, Warren G. Lineberry (Lineberry), what the tax consequences of his sale of the
Virginia property and reinvestment of the sale proceeds in the North Carolina property
would be. Lineberry responded that the transactions should be tax free.
On October 26, 1978, the Ferebees accepted petitioner's offer to purchase the North
Carolina property for $100,000. The purchase was consummated on November 27, 1978.
At the closing petitioner delivered the check for the sale proceeds he received for the
Virginia property to Chappell as part of the payment required by the offer to purchase
and contract. [FN10] In response to petitioner's inquiry, the closing attorney, a Mr.
Brumsey, told petitioner that his real estate transactions would be tax free. From the
outset petitioner intended that his sale of the Virginia property followed by his purchase
of the North Carolina property qualify for taxfree treatment and he would not have
entered into those transactions if he had known they did not.

During 1978, petitioner and his counsel, Allen J. Gordon (Gordon), were partners in a
partnership that owned a sixunit apartment building. Despite their partnership, petitioner
was in contact with Gordon infrequently during 1978. Petitioner did not seek Gordon's
advice about the tax consequences of petitioner's 1978 real estate transactions until after
he had met with respondent's agent regarding the deficiency herein.

On his 1978 return petitioner reported only a loss from the partnership with Gordon in
the amount of $710.42. The return contained no information regarding petitioner's 1978
real estate transactions.

In his statutory notice of deficiency dated October 28, 1982, respondent determined that
petitioner realized and should have recognized a capital gain on the sale of the Virginia
property in the amount of $79,712, determined as follows:

Amount realized $90,000


Less: cost basis $10,000
selling expenses 288
10,288
Capital gain $79,712

Respondent also determined that petitioner was liable for the negligence addition
provided by section 6653(a).

OPINION
I. GAIN REALIZED ADJUSTED BASIS OF THE VIRGINIA PROPERTY

Under section 1001(a), 'gain from the sale or other disposition of property shall be the
excess of the amount realized therefrom over the adjusted basis provided in section 1011
for determining gain.' Section 1001(b) provides that '(t)he amount realized from the sale
or other disposition of property shall be the sum of any money received plus the fair
market value of the property (other than money) received.' Generally, the adjusted basis
for determining gain or loss from the sale or other disposition of property is the cost of
the property adjusted as provided in section 1016. Secs. 1011(a) and 1012. Section
1016(a)(1) requires that proper adjustment be made for expenditures, receipts, losses, or
other items, properly chargeable to capital account, including the cost of improvements
and betterments made to the property. Sec. 1016(a)(1); sec. 1.10162(a), Income Tax
Regs. Petitioner bears the burden of proof in this proceeding. Welch v. Helvering, 290
U.S. 111 (1933); Rule 142(a).

The parties agree that the amount petitioner realized on the sale of the Virginia property
was $90,000. Sec. 1001(b). They disagree on petitioner's adjusted basis in the property at
the time of sale. Petitioner argues that his adjusted basis was $26,900, calculated as
follows:

(1) Cost basis of $24,900, consisting of the $10,000 cash petitioner paid the Rakes and
the $14,900 promissory note petitioner gave the Rakes and later paid off with the
proceeds from the sale of the Virginia Beach property;

PLUS:

(2) $2,000 for the amount of cash petitioner allegedly paid out of his own pocket for
capital improvements made on the Virginia property in 1963.

On the other hand, respondent contends that only the $10,000 cash petitioner paid for
the Virginia property, which was the only consideration recited in the deed, should be
included in his adjusted basis. Respondent concedes, however, that petitioner's gain on
the sale should also be reduced by selling expenses in the amount of $288. After carefully
considering the evidence of record as a whole and the parties' arguments, we have
determined that petitioner's adjusted basis in the Virginia property at the time of the sale
to the Turmans was $28,697.85, as set forth and explained below.

Petitioner testified that he paid the Rakes $10,000 in cash and gave them an unsecured,
unrecorded, but cosigned promissory note in the amount of $14,900 for the Virginia
property. Petitioner further testified that shortly thereafter he sold his Virginia Beach
house and used the sale proceeds to pay off the promissory note. Respondent's primary
argument is that petitioner's bare testimony does not satisfy petitioner's burden of proof.
However, we found petitioner to be a candid and forthright, if somewhat inarticulate
witness, and we found his testimony wholly worthy of belief.

Petitioner's testimony was essentially uncontradicted. [FN11] Respondent suggests that


petitioner's failure to offer documentary evidence of the conveyance of the Virginia
Beach property petitioner sold to pay off the promissory note is EVIDENCE that no such
conveyance took place, citing Wichita Terminal Elevator Co. v. Commissioner, 6 T.C.
1158 (1946), affd. 162 F. 2d 513 (10th Cir. 1947), and Pollack v. Commissioner, 47 T.C.
92 (1966), affd. 392 F. 2d 409 (5th Cir. 1968). Those cases state that the normal inference
to be drawn from a party's failure to present the testimony of a readily available witness
or other evidence in his possession is that such evidence would have been unfavorable.
Pollack v. Commissioner, supra, 47 T.C. at 108; Wichita Terminal Elevator Co. v.
Commissioner, supra, 6 T.C. at 1165. That rule does not apply in this case.

During respondent's cross examination of petitioner, petitioner's counsel offered


respondent's counsel a copy of the conveyance if the latter desired to offer it into
evidence. While it is unfortunate that petitioner's counsel did not think it useful to offer
the document into evidence, we think his obvious willingness to allow respondent's
counsel to do so and petitioner's credibility are sufficient to overcome the usual inference
that we may draw from a party's failure to present readily available evidence. The
evidence in this instance was readily available to both parties. Thus, we draw no negative
inference from petitioner's failure to introduce the conveyance into evidence, and do not
consider it, as respondent suggests, EVIDENCE that no such conveyance took place.
[FN12] We reach a similar conclusion as to the conveyance to Dock Dickerson of a
portion of the land acquired in 1953. Furthermore, we think the informality of these 1953
transactions in Floyd County, Virginia, as described by petitioner, is entirely consistent
with the rural setting and practices of perhaps a bygone day in that area of Virginia. Thus,
based on the record as a whole, we find that petitioner had a cost basis in the Virginia
property of $24,900. [FN13]

Apparently to attack petitioner's credibility, respondent asserts that '(i)f, in fact, the
petitioner paid $24,900 for the (original Virginia property), he evaded Virginia Recording
Taxes by fraudulently stating in the deed that the consideration paid for the property was
$10,000.' Respondent refers to Virginia Code sections 5854 and 5854.1 (1974), [FN14]
which impose a state recordation tax and an additional tax on the recording of deeds, the
amounts of which are determined with reference to 'the consideration of the deed or the
actual value of the property conveyed, whichever is greater.' Respondent does not cite nor
have we found any authority holding that the failure to recite the full consideration in the
deed constitutes fraudulent evasion of the Virginia recordation taxes. Moreover, the
measure for the tax is the consideration stated in the deed OR the actual value of the
property conveyed. Thus, the statute on its face contemplates the possibility that the tax
would be based on an amount other than the consideration recited in the deed. Suffice it
to say, our opinion of petitioner's credibility is unswayed by respondent's unsupported
attack.

Respondent also argues on brief that the parol evidence rule 'prohibits the petitioner
from claiming that he paid * * * (the Rakes) more than the $10,000 recited in the deed.'
We find this argument somewhat curious in view of the fact that respondent did not raise
a parol evidence rule objection to petitioner's testimony at any time during the trial. In
any event, respondent contends that we must apply the Virginia parol evidence rule and
that under that rule petitioner's testimony is inadmissible because it is inconsistent with
the deed's recital, citing Estate of Craft v. Commissioner, 68 T.C. 249 (1977) (Court
reviewed), affd. per curiam 608 F. 2d 240 (5th Cir. 1979), and Davis v. Marr, 200 Va.
479, 106 S.E. 2d 722 (1959), respectively.

In Estate of Craft, we stated (68 T.C. at 260261) that we have followed two approaches
in applying the parol evidence rule in this Court. Under the 'thirdparty to the instrument
rule' we have held that 'because respondent was not a party to the instrument involved,
neither he nor petitioner may successfully rely on the rule to exclude extrinsic evidence
offered by the other.' Estate of Craft v. Commissioner, supra, 68 T.C. at 260, and cases
cited therein. We have at other times 'looked to and followed the applicable State law
regarding the admissibility of extrinsic evidence.' Estate of Craft v. Commissioner, supra,
68 T.C. at 261, and cases cited therein. After enunciating these two rules, we held (68
T.C. at 262263) that when the issue involved requires a determination of legal rights and
property interests under state law we must look to the state's parol evidence rule because
that term is a misnomer; 'the rule is one of substantive law and not one of evidence. '
(Citations omitted.)

Nevertheless, we acknowledged in Estate of Craft, supra, 68 T.C. at 263, the continuing


vitality of the 'thirdparty to the instrument rule' in cases that did not involve 'a
determination of legal rights or property interests under State law but rather concerned
the proper allocation (or character) of amounts paid under a contract' or, stated otherwise,
in cases 'not concerned with ownership of the property interest but with the true reasons
for and behind its receipt by the owner.' (Citations omitted.) This rule has been invoked
to admit extrinsic evidence in cases decided since Estate of Craft. See e.g., Smith v.
Commissioner, 82 T.C. 705, 716 n. 12 (1984); Ellison v. Commissioner, 80 T.C. 378,
393394 (1983); Weisbart v. Commissioner, 79 T.C. 521, 534535 (1982). We think that a
determination of the true consideration petitioner paid for the original Virginia property is
more akin to a determination of the allocation or character of payments made under a
contract than to a determination of his legal rights or property interests under state law.
Thus, under Estate of Craft, we must follow the 'thirdparty to the instrument rule' and
admit extrinsic evidence of the amount of consideration petitioner actually paid for the
Virginia property. [FN15] We have admitted the evidence and have found as a fact that
petitioner paid $24,900 for the Virginia property.

We have also found as a fact that petitioner transferred approximately 44.1 acres
[FN16] of the Virginia property to Dock Dickerson as a finder's fee or broker's
commission for locating the property for petitioner. [FN17] Normally, if a portion of a
tract of land is disposed of, the basis of that portion is no longer included in the basis of
the remaining tract. In other words, normally the basis of the remaining tract is reduced
by the portion of the basis allocable to the transferred property. Cf. Fasken v.
Commissioner, 71 T.C. 650 (1979). However, the amount of a finder's fee or broker's
commission paid in connection with the acquisition of property is included in or added to
the basis thereof. E.g., Woodward v. Commissioner, 397 U.S. 572, 575 (1970). If a
finder's fee or broker's commission is paid out of the property acquired, the purchase
price allocable to the transferred property is included in the cost basis of the property
retained. Silberberg v. United States, 174 F. Supp. 31 (S.D. Cal. 1959). Thus, petitioner's
$24,900 basis in the Virginia property was not affected by his payment of a portion of the
acreage as a finder's fee or broker's commission to Dickerson. In essence, petitioner
actually paid the $24,900 purchase price for 120.4 acres of land. [FN18]

In 1963 petitioner sold approximately 15 acres of the original Virginia property to the
Floyd County School Board. He used the proceeds of the sale ($5,400) plus an additional
$1,500 [FN19] to pay for various capital improvements made to the Virginia property.
[FN20]

II. GAIN RECOGNIZED SECTION 1031


Section 1001(c) provides in general that 'the entire amount of the gain * * * on the sale
or exchange of property shall be recognized.' Section 1031(a) creates an exception to this
general rule by providing that no gain shall be recognized if property held for productive
use in a trade or business or for investment is EXCHANGED solely for property of a like
kind. 'Ordinarily, to constitute an exchange, the transaction must be a reciprocal transfer
of property, as distinguished from a transfer of property for a money consideration only.'
Sec. 1.10021(d), Income Tax Regs. [FN21]

Petitioner argues that as evidenced by his clear intent and his admonition to Chappell
that he would not purchase the North Carolina property unless he first sold the Virginia
property, the sale and subsequent purchase were components of a single integrated plan
the substance of which constituted an exchange of the Virginia property for the North
Carolina property. Therefore, continues petitioner, he is relieved of recognizing his gain
on the sale by section 1031(a). Respondent counters by pointing out that a sale of
property for cash and reinvestment of the cash in similar property does not constitute an
exchange. Thus, continues respondent, petitioner did not meet the exchange requirement
of section 1031(a) and must recognize his gain. We agree with respondent.

Petitioner begins by quoting the following passage from Rev. Rul. 57469, 19572 C.B.
521, 522:

A fundamental principal (sic) of taxation is that substance and not form governs in tax
matters.

In determining the substance of a transaction, the situation as it existed in the beginning


and at the end of a series of steps and the object sought to be accomplished should be
considered. In the instant case, since the sale was only a necessary step in reaching the
ultimate desired exchange, the transaction was an exchange within the provisions of
section 1031 of the Code.

Petitioner also considers the following language from Redwing Carriers, Inc. v.
Tomlinson, 399 F. 2d 652, 658 (5th Cir. 1968) relevant:

Equally well established is the corollary that an integrated transaction may not be
separated into its components for the purposes of taxation by either the Internal Revenue
Service or the taxpayer. Roebling Securities Corp. v. United States, 1959, D.C. N.J., 176
F. Supp. 844, 847. In Kanawha Gas & Utilities Co. v. Commissioner of Internal Revenue,
5 Cir. 1954, 214 F. 2d 685, 691, our Court through Judge Rives said:

In determining the incidence of taxation, we must look through form and search out the
substance of a transaction. * * * *cases cited) This basic concept of tax law is particularly
pertinent to cases involving a series of transactions designed and executed as parts of a
unitary plan to achieve an intended result. Such plans will be viewed as a whole
regardless of whether the effect of so doing is imposition of or relief from taxation. The
series of closely related steps in such a plan are merely the means by which to carry out
the plan and will not be separated.
From these statements petitioner distills support for his contention that looking at his
sale of the Virginia property and purchase of the North Carolina property in the
aggregate, we must conclude that they were not a sale and a purchase, but merely
components of a single integrated plan that constituted an exchange even though the
conduit for accomplishing the exchange was the receipt and disbursement of cash.
Petitioner attempts to bolster his analysis by arguing that the sales contract (with the
Turmans) and the offer to purchase and contract (with the Ferebees) were interdependent
because petitioner conditioned his offer to purchase the North Carolina property on the
sale of the Virginia property.

We agree with petitioner that ordinarily the substance and not the form of a transaction
should govern the tax consequences thereof. Commissioner v. Court Holding Co., 324
U.S. 331 (1945); Biggs v. Commissioner, 69 T.C. 905, 914 (1978), affd. 632 F. 2d 1171
(5th Cir. 1980). However, the touchstone of section 1031 is the requirement that there be
an EXCHANGE of likekind properties rather than a cash sale of property followed by a
reinvestment of the proceeds in other property. Barker v. Commissioner, 74 T.C. 555,
560561 (1980). As we stated in Barker, 74 T.C. at 561:

The 'exchange' requirement poses an analytical problem because it runs headlong into
the familiar tax law maxim that the substance of a transaction controls over form. In a
sense, the substance of a transaction in which the taxpayer sells property and immediately
reinvests the proceeds in likekind property is not much different from the substance of a
transaction in which two parcels are exchanged without cash. Bell Lines, Inc. v. United
States, 480 F. 2d 710, 711 (4th Cir. 1973). Yet, if the exchange requirement is to have
any significance at all, the perhaps formalistic difference between the two types of
transactions must, at least on occasion, engender different results. Accord, Starker v.
United States, 602 F. 2d 1341, 1352 (9th Cir. 1979).

See also Swaim v. United States, 651 F. 2d 1066, 1070 (5th Cir. 1981), quoting and
applying our language. In short, the conceptual distinction between a section 1031
exchange and a sale and reinvestment is largely one of form. Barker v. Commissioner,
supra, 74 T.C. at 566. Other courts have also acknowledged that transactions that take the
form of a sale and reinvestment cannot, in substance, constitute an exchange for purposes
of section 1031. Bell Lines, Inc. v. United States, 480 F. 2d 710, 713 (4th Cir. 1973);
Carlton v. United States, 385 F. 2d 238, 241 (5th Cir. 1967) and cases cited therein;
Coastal Terminals, Inc. v. United States, 320 F. 2d 333 (4th Cir. 1963).

There simply was no exchange of properties in this case. Petitioner dealt only with the
Turmans in selling his Virginia property to them for cash; he dealt only with the Ferebees
(or their agent) in purchasing their North Carolina property for cash. The Turmans and
the Ferebees apparently never met or had any dealings together at all.

Petitioner received cash from the Turmans for his Virginia property. This precludes the
application of section 1031(a) which requires that the property be 'exchanged solely for
property of a like kind.' As the Court of Appeals for the Fifth Circuit stated in Carlton v.
United States, supra, 385 F. 2d at 242:
The very essence of an exchange is the transfer of property between owners, while the
mark of a sale is the receipt of cash for the property. * * * Where, as here, there is an
immediate repurchase of other property with the proceeds of the sale, that distinction
between a sale and exchange is crucial. * * * (Citations omitted.)

Petitioner's arguments concerning the interdependency of the sales contract and the
offer to purchase and contract are inapposite. Here, in substance and in form, there was a
sale of petitioner's Virginia property for cash and a separate and unrelated purchase of the
North Carolina property for cash. There was no interdependency between petitioner's
sales contract with the Turmans and his later offer to purchase and contract with the
Ferebees. The only relationship between the two transactions was the fact that if
petitioner did not sell his Virginia land, he was not going to have the money to buy the
North Carolina land. That does not suffice to convert a sale and reinvestment of the
proceeds into an exchange of likekind properties.

Petitioner may very well have thought that his transactions amounted to his exchange of
his timberland in Virginia for other timberland in North Carolina. However, petitioner's
subjective intention or desire that his real estate transactions qualify for nonrecognition
treatment does not alter our conclusion. Tax consequences must be determined by what
actually takes place and not by what was intended or hoped for. See Weiss v. Stearn, 265
U.S. 242, The fact that two attorneys and a real estate agent told petitioner that his
transactions would be tax free does not make them so. [FN22]

In conclusion, petitioner's sale and reinvestment do not constitute an exchange of


likekind properties, and petitioner must recognize all of the gain realized on the sale.
While this result may seem harsh to petitioner, it is necessary if the exchange requirement
in section 1031(a) is to have any meaning. See Carlton v. United States, supra, 385 F. 2d
at 243. Deferral or nonrecognition of gain is the exception to the normal rule, and a
taxpayer must bring himself within the terms of the exception. The Congress has
provided for such nonrecognition of gain on the sale of a taxpayer's principal residence if
he sells the old residence and reinvests the proceeds in a new residence within a certain
time period. Sec. 1034. However, in the case of business or investment property, such as
is involved here, the Congress has imposed a strict exchange requirement for the taxpayer
to obtain such nonrecognition. Sec. 1031.

III. NEGLIGENCE ADDITION

Section 6653(a) imposes an addition to tax if any part of an underpayment of tax 'is due
to negligence or intentional disregard of rules and regulations (but without intent to
defraud).' Petitioner bears the burden of proving that he is not liable for the addition.
Catalana v. Commissioner, 81 T.C. 8, 17 (1983), affd. without published opinion sub
nom. Knoll v. Commissioner, 735 F. 2d 1370 (9th Cir. 1984); Foster v. Commissioner,
80 T.C. 34, 237 (1983); Bixby v. Commissioner, 58 T.C. 757, 791792 (1972).

Petitioner argues that his knowledge of tax law is limited. He was told by two attorneys
and a real estate agent that his sale and purchase transactions would be 'taxfree.'
Petitioner claims that he did not report his gain from the sale because he relied in good
faith on the advice he was given by individuals he considered knowledgeable on the
subject. He perceived no real distinction between a trade of properties and a sale of
property and reinvestment of the proceeds in other property. Respondent, on the other
hand, contends that petitioner's testimony is not credible. He also relies on petitioner's
failure to mention the sale on his 1978 return and his failure to report any other income
on the return [FN23] as supporting imposition of the negligence addition.

As discussed above, we found petitioner's testimony wholly worthy of belief and have
accepted it in making our findings of fact. We have also acknowledged that while the
distinction between an exchange and a sale and reinvestment is necessary in the proper
application of section 1031(a), it is nonetheless somewhat formalistic and has generated
much litigation. Most importantly, the fact that three individuals whose advice petitioner
reasonably relied upon assured him that his sale of the Virginia property would be taxfree
weighs heavily in his favor. Although there is no affirmative obligation to seek tax
advice, Yelencsics v. Commissioner, 74 T.C. 1513, 1533 (1980), reasonable reliance on
such advice may relieve a taxpayer from the negligence addition. Industrial Valley Bank
& Trust Co. v. Commissioner, 66 T.C. 272, 283 (1976). So may a good faith
misunderstanding of the law. Yelencsics v. Commissioner, supra, 74 T.C. at 1533. After
reviewing all of the facts and circumstances * * * * from his failure to report the gain on
his sale of the Virginia property was not due to negligence or intentional disregard of
rules and regulations. Accordingly, petitioner is not liable for the 6653(a) addition.

To reflect the foregoing, decision will be entered under Rule 155.

FN1 Unless otherwise indicated, all section references are to the Internal Revenue Code
of 1954, as amended and in effect during the taxable year in issue, and all Rule references
are to the Tax Court Rules of Practice and Procedure.

FN2 That portion of the deficiency attributable to the section 56 minimum tax is an
automatic computation based on 15 percent of the total tax preference items that exceed
the greater of $10,000 or onehalf of the 'regular tax deduction' (as defined in section
56(c)). Since petitioner filed his return as a married person filing separately, it would
seem that the figure of $5,000 should be substituted for the $10,000 figure (see
sec.58(a)), but the statutory notice used $10,000 in the minimum tax computation. Since
respondent has raised no issue in that regard, the Court will not address the matter. In his
reply brief, respondent 'surmises' that petitioner has conceded the first and third issues if
we hold for respondent on the second issue because petitioner did not address them in his
opening brief. A careful reading of petitioner's opening brief reveals that he did in fact
discuss the basis question. Moreover, petitioner clearly addressed both the basis and
negligence addition issues in his reply brief. Thus, these issues are contested and have not
been conceded by petitioner.

FN3 Petitioner filed his 1978 return on July 15, 1979, prior to the expiration of an
extension of time for filing the return granted by respondent. See sec. 6081(a). The Court
has accepted the parties' stipulation as to the date of filing of the return but the face of the
Form 1040 bears a stamp indicating receipt by the Internal Revenue Service on June 22,
1979.

FN4 Petitioner and his wife were divorced some time after the filing of the 1978 return.
Petitioner testified and on brief requested that we find as a fact that despite the clear
terms of the deed his wife had no ownership interest in the original Virginia property and
that he was the sole owner thereof. We note that his wife's name was also on the land
contract of September 7, 1978 whereby the Virginia property was sold to John Michael
and Wanda A.Turman (the Turmans). Because this question is immaterial to the issues
before the Court and contrary to the deed and land contract, we decline to find such a
fact. It is undisputed that petitioner alone received the proceedsfrom the sale of the
Virginia property to the Turmans and that he alone purchased the North Carolina
property. There has been no suggestion that the wife is liable for any part of the tax
deficiency in this case. Her ownership rights in the Virginia property, if any, is a matter
between petitioner and his exwife, and is not before this Court.

FN5 In his opening statement, petitioner's counsel suggested that the parcel transferred
to Dickerson consisted of between 25 and 30 acres. However, no evidence to this effect
was submitted. We determined the stated figure by subtracting from the 164.5 acres
indicated in the original deed the acreage involved in subsequent transactions described
below, as to which sufficient evidence was provided. See n. 8, infra.

FN6 This price represents three acres at $600 per acre ($1,800) plus 12 acres at $300
per acre ($3,600). FN7 The offer to purchase and contract indicates that petitioner's offer
was made on October 26, 1978. However, petitioner testified that he actually signed the
document before he contracted to sell the Virginia property, which he did on September
7, 1978. Petitioner's testimony is supported by Chappell's affidavit (which the parties
stipulated to) and his own further testimony that petitioner's offer was conditioned upon
his first selling the Virginia property. Such a contingency would have been unnecessary if
petitioner had actually made his offer on October 26, 1978, because petitioner had
already closed the sale of the Virginia property on October 10, 1978. Furthermore, the
offer to purchase and contract indicates that the Ferebees accepted petitioner's offer on
October 26,1978. We think it highly unlikely that petitioner's offer was accepted the same
day it was made, given the overwhelming evidence that after his initial phone call to the
Ferebees petitioner dealt only with Chappell and never directly with the Ferebees. Thus,
we conclude that the date of petitioner's offer was inserted into the offer to purchase and
contract not when petitioner actually signed the document, but only after it had been
accepted by the Ferebees. Consequently, we accept petitioner's testimony and find that he
made the offer before contracting to sell the Virginia property. Our finding is not at
variance with the parties' stipulation that '(o)n October 26, 1978, the petitioner contracted
to buy * * * (the North Carolina property).' Regardless of when it was made, petitioner's
offer was not accepted until October 26, 1978. Thus, there was no contract until that date.

FN8 The sales contract called for the sale of approximately 103 acres. However, a U.S.
Department of Housing and Urban Development Settlement Statement for the sale
indicates that the Virginia property consisted of approximately 105.4 acres at the time of
sale. We have used the latter figure to determine the number of acres petitioner
transferred to Dickerson. See n. 5, supra.

FN9 The sales contract suggests that petitioner was to retain four acres of the Virginia
property. However, respondent calculated the deficiency in the statutory notice and both
parties have proceeded throughout this case as if petitioner sold the entire Virginia
property. The record is devoid of any other evidence to the contrary. Therefore, we find
as a fact * * * * earnest money deposit. If petitioner used the sales proceeds check in the
amount of $84,242.63 to make the cash payment which, under the offer to purchase and
contract, was only required to be $80,000, then obviously some adjustment had to be
made in the $15,000 promissory note. We are not satisfied that petitioner in fact used the
entire $84,242.63 check as his cash payment, as he testified, but whether he did or not is
not determinative of any issue in this case.

FN11 On brief respondent contends that petitioner's testimony was contradicted by the
deed's recital that the consideration given for the original Virginia property was $10,000
cash. The deed does not state that the $10,000 cash was the only consideration, and thus
does not contradict petitioner's testimony that he gave other consideration.

FN12 We note that petitioner testified that the cancelled promissory note had probably
been destroyed when his home burned down in 1958. Petitioner also testified that all of
the other individuals involved in his purchase of the Virginia property had passed away.

FN13 This represents a cost basis of $206.81 per acre, i.e. total basis of $24,900
divided by 120.4 acres, the acreage petitioner actually acquired after paying Dock
Dickerson a finder's fee of 44.1 acres.

FN14 Virginia Code section 5854.1 (1974) was not in force during 1953,the year
petitioner purchased the original Virginia property, because it was not added to the
Virginia Code until 1968. See 1968 Va. Acts c. 778. Virginia Code sections 5854 and
5854.1 were both repealed and essentially recodified at Va. Code sections 58.1801 and
58.1802 (1984) by 1984 Va. Acts c. 675, effective January 1, 1985.

FN15 Even if we were to follow the parol evidence rule of the Commonwealth of
Virginia, petitioner's testimony would be admissible. Virginia courts have, for quite some
time, acknowledged the admissibility of parol evidence to show the true consideration for
a deed. Swain v. Virginia Bank & Trust Co. 151 Va. 655, 144 S.E. 645 (1928). Later
cases have added the caveat, that to be admissible, parol evidence of the consideration
paid may not contradict the deed in that it alters the conveyance or the legal effect of the
deed. E.g., Gough v. Conley, 206 Va. 88, 141 S.E. 2d 690 (1965); Davis v. Marr, 200 Va.
479, 106 S.E. 2d 722 (1959); Adams v. Seymour, 191 Va.372, 61 S.E. 2d 23 (1950);
Collins v. Lyon, Inc., 181 Va. 230, 24 S.E. 2d 572 (1943); Otey v. Oakey, 157 Va. 314,
160 S.E. 8 (1931). Petitioner's testimony does not in any way affect the conveyance or
the legal effect of the deed. Thus, even under the Virginia parol evidence rule petitioner's
testimony is admissible.
FN16 See n. 5, supra.

FN17 As noted above, respondent also argues that petitioner's failure to introduce
documentary evidence of the conveyance is evidence that noconveyance took place. We
again reject respondent's argument primarily because of our acceptance of petitioner's
testimony. His testimony is also consistent with the legal description of the Virginia
property in the sales contract with the Turmans. The description indicates that the
Virginia property was bordered on the west by land owned by Dickerson.

FN18 See n. 13, supra. This situation, in a sense, represents the converse of the
severance damages cases. Where a portion of an owner's land is taken by eminent domain
and the land owner is paid an amount for the land actually condemned plus an amount for
severance damages to the remaining property he retains, the amount he receives as
severance damages simply reduces his basis in the retained land. See Vaira v.
Commissioner,444 F. 2d 770, 774, n. 6 (3d Cir. 1971), revg. and remanding in part
52T.C. 986 (1969); Pioneer Real Estate Co. v. Commissioner, 47 B.T.A. 886,892 (1942),
modified on another point by a Supplemental Memorandum Opinion of this Court. Here
petitioner transferred 44.1 acres to Dickerson as a finder's fee so he actually paid the
$24,900 to obtain the remaining 120.4 acres.

FN19 Petitioner testified that this additional amount was between $1,500 and $2,000.
Because petitioner's in exactitude is of his own making, we found as a fact that such
amount was $1,500. See Cohan v. Commissioner, 39F. 2d 540 (2d Cir. 1930).

FN20 Respondent again urges us not to rely on petitioner's testimony. However,


petitioner's testimony was entirely uncontradicted as well as reasonably specific with
respect to the types of capital improvements made and the costs thereof. Moreover, the
legal description of the Virginia property in the 1978 sales contract with the Turmans
indicates that it borders Floyd County High School and that it contains some of the
improvements that petitioner testified were those he had made in 1963.

FN21 Section 1.10021, Income Tax Regs., was promulgated under section 1002, which
has been repealed; at the same time section 1002 was repealed, substantially identical
language was added to section 1001(c). See secs.1901(b)(28)(B)(i) and 1901(a)(121) of
the Tax Reform Act of 1976, Pub. L.94455, 90 Stat. 1520, 1799, 1784, 19763 (Vol. 1)
C.B. 1, 275, 260, effective for taxable years beginning after December 31, 1976. In
T.D.7665, 19801 C.B. 319, respondent removed various regulations including section
1.1002, Income Tax Regs. The Treasury Decision was effective January 25, 1980, and
intended no substantive changes in the regulations. Although respondent has not placed
the substantive provisions of section 1.10021, Income Tax Regs., in a regulation under
section 1001(c), he has taken the position that it is applicable to section 1001(c). See Rev.
Rul. 8163, 19811 C.B. 455, 456. Section 1.10021, Income Tax Regs., is therefore
applicable to the 1978 taxable year before the Court. See Magneson v. Commissioner, 81
T.C. 767, 769770, n. 2 (1983), affd. 753 F. 2d 1490 (9th Cir. 1985).
FN22 See D'Onofrio v. Commissioner, T.C. Memo. 1983632 and Meadows v.
Commissioner, T.C. Memo. 1981417.

FN23 We note that the deficiency herein is based solely on the transactions described,
and that respondent has not sought to increase the amount thereof based on petitioner's
failure to report other income.

CODE §1031 SALE: NOT EXCHANGE:


DISBY

In this 1995 Tax Court decision, the Court addressed the familiar question in the
exchange area as to whether a transaction was in fact an exchange, properly structured,
under Code §1031, or whether it was a sale.

The Court concluded that the transaction was simply a sale and a reinvestment, thus
denying the use of Code §1031.

Julius and Hanan DIBSY, Petitioners,


v.
COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 1646693.
United States Tax Court.

T.C. Memo. 1995477 1995 WL 580927 (U.S.Tax Ct.), 70 T.C.M. (CCH) 918, T.C.M.
(PH) 95,477 Oct. 4, 1995.

MEMORANDUM FINDINGS OF FACT AND OPINION

GERBER, Judge:

Respondent determined a deficiency in petitioners' 1989 Federal income tax of


$34,079 and additions to tax under sections 6654 [FN1] and 6662(a) in the amounts of
$191 and $6,816, respectively. The issues for our consideration are: (1) Whether
petitioners are entitled to defer, as a likekind exchange, the income realized on the sale of
their liquor store;

FINDINGS OF FACT

Petitioners, at all pertinent times, were married, and they resided in Westminster,
California, at the time their petition in this case was filed. Julius and Hanan Dibsy
(petitioners) have been in the business of owning and operating liquor stores. On January
17, 1986, petitioners purchased a liquor store in Huntington Beach, California, from
William D. Hanshaw (Hanshaw). Petitioners changed the name of the store from "Hoovs
Hut Liquor # 4" to "Sunshine Liquor". Petitioners paid $210,000 for the noninventory
assets of Sunshine Liquor.
During 1988, petitioners entered into discussions with Hanshaw about obtaining a store
with a larger volume of sales. Petitioners learned that Hanshaw might sell "Bayshore
Liquor", a liquor store located in Seal Beach, California. Consequently, petitioners
immediately listed Sunshine Liquor for sale. On or about March 23, 1988, they entered
into an agreement to sell the noninventory assets of Sunshine Liquor to Sathit and Supin
Sathavoran. On March 31, 1988, petitioners agreed to purchase Bayshore Liquor from
Hanshaw, and they gave him $10,000 in "earnest money". On or about August 16, 1988,
the Sathavorans notified petitioners that they would not purchase Sunshine Liquor.

Petitioners requested that Hanshaw release them from the purchase of Bayshore Liquor.
Hanshaw refused to return the $10,000 "earnest money" and also refused to purchase
Sunshine Liquor from petitioners. However, Hanshaw allowed petitioners to defer
payment of a portion of the purchase price for Bayshore Liquor by petitioners' issuing a
note to Hanshaw in the amount of $150,000 plus interest, which was secured by the
assets of Sunshine Liquor.

On October 5, 1988, petitioners purchased Bayshore Liquor from Hanshaw for


$434,593.82. Petitioners financed the purchase as follows:

On March 31, 1989, petitioners sold Sunshine Liquor to Mr. and Mrs. Nam Kyun and
Sun Cha Shin for $286,423.63. This price was allocated as follows:

Petitioners then disbursed the funds from the sale as follows:

In connection with Sunshine Liquor, petitioners claimed a total of $100,547 as


depreciation and amortization expenses during 1986, 1987, and 1988. Their basis in the
noninventory of Sunshine Liquor was $109,453 on March 31, 1989. The selling price of
these assets was $242,500.

From October 5, 1988, until March 31, 1989, petitioners operated both Sunshine
Liquor and Bayshore Liquor, and they were entitled to any profits earned by either store.
The parties agree that if section 1031 does not apply to the disposition of Sunshine
Liquor, then petitioners must recognize a longterm capital gain of $133,047 on the
transaction.

OPINION

Respondent concluded that the purchase of one liquor store and subsequent sale of
another by petitioners were two separate taxable events. Accordingly, respondent
determined that petitioners should have reported a longterm capital gain from the sale of
Sunshine Liquor. Petitioners agree that, in form, a separate sale and purchase occurred.
They contend, however, that, in substance and when considered together, the transactions
resulted in a section 1031 like kind exchange. Petitioners' failure to include the capital
gain as income is justified if section 1031 is applicable.
Section 1001(c) generally requires that the entire amount of gain or loss on the sale or
exchange of property shall be recognized. Section 1031(a)(1), however, provides for the
nonrecognition of such gain or loss when "property held for productive use in a trade or
business or for investment * * * 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."

The parties disagree on whether petitioner "exchanged" Sunshine Liquor for Bayshore
Liquor. [FN2] Petitioners bear the burden of establishing that respondent's determination
is erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).

Essentially, section 1031 assumes that new property received in an exchange is "
'substantially a continuation of the old investment' ". Commissioner v. P.G. Lake, Inc.,
356 U.S. 260, 268 (1958) (quoting section 39.112(a)(1), Income Tax Regs. (promulgated
under the Internal Revenue Code of 1939), and analyzing a taxfree exchange under
section 112(b)(1) of the 1939 Code, a predecessor of section 1031). In an exchange of
likekind property, "the taxpayer's economic situation after the exchange is fundamentally
the same as it was before the transaction occurred." Koch v. Commissioner, 71 T.C. 54,
63 (1978). The U.S. Court of Appeals for the Fourth Circuit in Coastal Terminals, Inc. v.
United States, 320 F.2d 333, 337 (4th Cir.1963), stated:

The purpose of Section 1031(a), as shown by its legislative history is to defer


recognition of gain or loss when a direct exchange of property between the taxpayer and
another party takes place; a sale for cash does not qualify as a nontaxable exchange even
though the cash is immediately reinvested in like property.

See also Magneson v. Commissioner, 753 F.2d 1490, 1494 (9th Cir.1985), affg. 81 T.C.
767 (1983); [FN3] Starker v. United States, 602 F.2d 1341, 1352 (9th Cir.1979). In
Barker v. Commissioner, 74 T.C. 555, 561 (1980), this Court noted:

The "exchange" requirement poses an analytical problem because it runs headlong into
the familiar tax law maxim that the substance of a transaction controls over form. In a
sense, the substance of a transaction in which the taxpayer sells property and
immediately reinvests the proceeds in likekind property is not much different from the
substance of a transaction in which two parcels are exchanged without cash. Bell Lines,
Inc. v. United States, 480 F.2d 710, 711 (4th Cir.1973). Yet, if the exchange requirement
is to have any significance at all, the perhaps formalistic difference between the two types
of transactions must, at least on occasion, engender different results. Accord, Starker v.
United States, 602 F.2d, 1341, 1352 (9th Cir.1979).

Courts have afforded some latitude in structuring exchange transactions. See, e.g.,
Magneson v. Commissioner, supra (change in mechanism of ownership which does not
significantly affect amount of control or nature of underlying investment does not
preclude a taxfree exchange); Starker v. United States, supra at 13541355 (the transfers
need not occur simultaneously); [FN4] Alderson v. Commissioner, 317 F.2d 790, 793
(9th Cir.1963), revg. 38 T.C. 215 (1962) (parties can amend previously executed sales
agreement to provide for an exchange); Barker v. Commissioner, supra at 562 (a party
can hold transitory ownership solely for the purpose of effectuating an exchange); Biggs
v. Commissioner, 69 T.C. 905, 913914 (1978); affd. 632 F.2d 1171 (5th Cir.1980)
(multiple parties can be involved in an exchange with parties not owning any property at
the time of entering into an agreement to exchange); 124 Front Street, Inc. v.
Commissioner, 65 T.C. 6, 1718 (1975) (taxpayer can advance money toward purchase
price of property to be exchanged); Coupe v. Commissioner, 52 T.C. 394, 405, 409
(1969) (the taxpayer can locate and negotiate for the property to be acquired); J.H. Baird
Publishing Co. v. Commissioner, 39 T.C. 608, 615 (1962)(the taxpayer can oversee
improvements on the land to be acquired); Mercantile Trust Co. v. Commissioner, 32
B.T.A. 82, 87 (1935) (alternative sales possibilities are ignored where conditions for an
exchange are manifest and an exchange actually occurs). Provided the final result is an
exchange of property for other property of a like kind, the transaction may qualify under
section 1031. [FN5]

However, courts have discerned boundaries in the interpretation and application of


section 1031. In Barker v. Commissioner, 74 T.C. at 563564, we recognized that at some
point the confluence of some sufficient number of deviations will bring about a taxable
result. Whether the cause be economic and business reality or poor tax planning, prior
cases make clear that taxpayers who stray too far run the risk of having their transactions
characterized as a sale and reinvestment.

Other courts have acknowledged that transactions that take the form of a cash sale and
reinvestment cannot, in substance, constitute an exchange for purposes of section 1031,
even though the end result is the same as a reciprocal exchange of properties. Bell Lines,
Inc. v. United States, 480 F.2d 710, 714 (4th Cir.1973); Carlton v. United States, 385
F.2d 238, 241 (5th Cir.1967). Thus, our inquiry here focuses on whether petitioner's
disposition of Sunshine Liquor was a sale, as argued by respondent, or an exchange, as
argued by petitioner.

In Bezdjian v. Commissioner, 845 F.2d 217 (9th Cir.1988), affg. T.C.Memo 1987140,
the taxpayers received an oil company's offer to sell a gas station that the taxpayers
operated under a lease. The oil company refused to accept a rental property owned by the
taxpayers in exchange and, instead, insisted on a cash transaction. The taxpayers
consented and bought the gas station with the proceeds of a loan that was secured by a
deed of trust on their residence and the rental property. About 3 weeks after the gas
station was conveyed to the taxpayers, they sold the rental property to a third party who
assumed a mortgage and paid the remainder of the price in cash. The taxpayers treated
these transactions as a likekind exchange governed by section 1031 on their 1978 tax
return.

The U.S. Court of Appeals for the Ninth Circuit explained that there was no "exchange"
under the meaning of section 1031. The court found that the taxpayers failed to
understand that the parties involved must make an exchange of property or an interest in
property for other property of a like kind in order for the transaction to qualify for
nonrecognition. The court also found no proof that either party evidenced an intention to
make an exchange. "The fact that the * * * [taxpayers] intended the * * * [new] parcel to
replace the * * * [old] property in their holdings does not render their transactions an
exchange." Id. at 218.

Petitioners' factual circumstances are indistinguishable from Bezdjian v. Commissioner,


supra. In both cases, there was a desire to purchase property and a need to dispose of
likekind property to finance the acquisition. In both cases, there was an inability to find a
buyer for the original property and a purchase of the new property before the original
property could be sold. In both instances, there was a borrowing against the original
property to finance the purchase of the new property, and neither set of taxpayers
received cash in hand from the sale of the original property.

The facts here support respondent's position that petitioners possessed indicia of
ownership of both Bayshore Liquor and Sunshine Liquor. If petitioners had been unable
to sell Sunshine Liquor, they would still have been liable to Hanshaw on the note they
gave him to finance their purchase of Bayshore. Likewise, petitioners were legally
entitled to keep Sunshine Liquor in any event. Petitioners were liable to Hanshaw for the
outstanding debt, but they were not otherwise bound to sell Sunshine Liquor.
Furthermore, petitioners simultaneously operated Sunshine Liquor and Bayshore Liquor
from October 5, 1988, until March 31, 1989, when they finally sold Sunshine Liquor.
They kept the profits and losses from both businesses. These circumstances do not reflect
or otherwise show the existence of a taxfree exchange under section 1031.

The purchase of Bayshore Liquor and the subsequent sale of Sunshine Liquor were not
structured as a section 1031 exchange. The escrow documents do not refer to a section
1031 exchange. There is no indication that this transaction was intended to be a section
1031 exchange. Additionally, it does not appear that the ultimate purchasers of Sunshine
Liquor were aware that a section 1031 exchange was intended. There is no evidence that
petitioners relied on section 1031 until they filed their 1989 Federal income tax return.

Petitioners apparently argue that Hanshaw was the de facto owner of Sunshine Liquor
at the time of the sale because part of the proceeds from petitioners' sale of Sunshine
Liquor were utilized to pay off the debt incurred and owed to Hanshaw. In other words,
petitioners appear to contend that they had previously accomplished a section 1031
exchange with Hanshaw and were merely his "agents" in the sale of Sunshine Liquor.
This gloss on Hanshaw's role is not confirmed by the record. Hanshaw refused to
purchase Sunshine Liquor from petitioners when the Sathavorans reneged on the
agreement to purchase the store. Hanshaw did not have any rights other than those
granted to him by petitioners' note. Hanshaw was only a creditor of petitioners.
Petitioners retained title and equity in Sunshine Liquor until they sold it.

Petitioners' argument implies that an intent on their part to undertake an exchange


should be sufficient to bring the transactions within the ambit of section 1031. We cannot
agree. Although intent can be relevant in determining what events transpired, it is not
sufficient to cause these transactions to fall within section 1031. Garcia v. Commissioner,
80 T.C. 491, 498 (1983); Biggs v. Commissioner, 69 T.C. 905, 915 (1978). Rather these
transactions constitute a purchase and subsequent sale.
We hold that the transactions here are properly characterized as a purchase followed by
a sale. Accordingly, there was no exchange within the meaning of section 1031.

CHAPTER 6
QUALIFYING AS A TAX-DEFERRED EXCHANGE
THE DEFINITION OF AN EXCHANGE: BAIRD

In the Baird case, the issue was whether the Petitioner-Taxpayer had exchanged
business property for property of a like-kind plus cash, within the meaning of Section
1031. The Court said that the main issue was whether the Taxpayer had a qualified
exchange of its Berryhill Street property for the Sidco property. there is no question that
the properties were like-kind, said the Court.

The Court made it clear that there was no doubt, based on the evidence, that the
Taxpayer did not desire to make a sale of its property and incur the tax liability upon a
large capital gain. It had consistently refused to sell. Its representatives stated to an
interested party that the only acceptable deal would be one involving an exchange of
properties. It is, said the Court, "[A]xiomatic that the parties' expectation or hopes as to
the tax treatment of their conduct in themselves are not determinative . . . and that the
matter of taxation must be determined in the light of what was actually done rather than
the declared purpose of the participants. . . ."

The Court turned to a consideration of what took place in the rather complicated
transaction. The Court disposed of the argument that merely because there is a valuation
placed on property that it constitutes a sale. The Court concluded: "It is our conclusion
that the gain realized . . . by the taxpayer upon the transaction is to be recognized, under
Section 1031, but only to the extent of the money received ...."

The Court concluded that the Taxpayer met Section 1031, and the mere fact that a
valuation for the properties was established did not adversely affect that result. Although
this conclusion might be apparent to taxpayers now, it was certainly not so in the Baird
case.

J. H. BAIRD PUBLISHING COMPANY, PETITIONER,


v.
COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
39 T.C. 608 Docket Nos. 88428, 89711.
Filed December 28, 1962.

William Waller, Esq., for the petitioner.

Michael P. MacLeod, Esq., for the respondent.

1. The petitioner deeded real property used in its business to a real estate agent in 1956,
but retained the use of the property rent free until the real estate agent should acquire a lot
and construct a new building thereon and transfer it to the petitioner. The real estate agent
then deeded the property to a purchaser subject to the petitioner's use and with a part of
the proceeds acquired a lot and constructed a new building. The real estate agent
completed the new building and transferred it to the petitioner together with cash in 1957,
whereupon petitioner relinquished the use of the old property. Held, that petitioner, in
1957, exchanged its property for property of like kind plus money and that the gain upon
the transaction is recognizable but in an amount is not in excess of the money received.
Sec. 1031, I.R.C. 1954.

2. Held, further, that the petitioner has not shown that its basis for certain realty and
stock acquired in 1946 from its two stockholders was greater than the amount realized by
it in 1952 upon the sale of such properties and that hence it has not shown that it had, in
1952, a net capital loss for purposes of carryover to the taxable year 1957.

ATKINS, Judge:

The respondent determined deficiencies in income tax of the petitioner in the years and
amounts as follows:

Docket No. Year Amount:


88428 1956 $13,687.66
89711 1957 $13,816.19

The issues for decision are:

1. Whether petitioner exchanged business property for property of


a like kind plus cash, within the meaning of section 1031 of the
Internal Revenue Code of 1954, with the result that the gain is
recognizable only to the extent of the cash received, or whether,
as determined by the respondent, petitioner sold its property,
with the result that the full amount of gain is taxable to the
petitioner;
2. if there was a sale, whether it was consummated in 1956 or
1957; and
3. whether petitioner sustained losses upon the disposition of
certain real estate and stock in 1952 resulting in a capital loss
carryover to either 1956 or 1957.
FINDINGS OF FACT.

Some of the facts have been stipulated and the stipulations are incorporated herein by
this reference.

The petitioner, a Tennessee corporation, filed its income tax returns for the taxable
years 1952, 1956, and 1957 with the district director of internal revenue, Nashville, Tenn.
During all of such years it was in the business of publishing a trade paper, the Southern
Lumberman, in Nashville.

Since 1917 petitioner's stock has been owned equally by J. H. Whaley, who was its
president and treasurer, and by Stanley F. Horn, Sr., who was its vice president and
secretary. Whaley, who handled the business affairs of petitioner, and Horn, who was the
editor of the paper, were aged 77 and 72, respectively, at the time of trial.

For several years petitioner had conducted its business in a building which it owned on
Berryhill Street in Nashville, Tenn. In October of 1956 the land had a basis in the hands
of petitioner of $2,000. The buildings thereon had been fully depreciated except for
recent improvements of $899.34.

For some time prior to 1956 the Baptist Sunday?school board in Nashville had been
acquiring property in the area in which petitioner's building was situated and by 1956
owned property in the same block. In their prior acquisitions of property, such board had
been represented by Murphree Realty Co. (sometimes referred to hereinafter as the
Realty Co.), whose president was John W. Murphree. The Sunday?school board was
desirous of rounding out its holdings in such block and on several occasions prior to 1956
it had approached the petitioner about purchasing petitioner's property. In each instance
the petitioner refused to sell, despite attractive offers, because it was satisfied with its
location and because it did not wish to incur the tax on the capital gains which would
result from such a sale.

In 1956 the Sunday?school board, now acting through the Murphree Realty Co., again
offered to purchase petitioner's Berryhill Street property, but the petitioner again refused
to sell for the same reasons.

Thereupon Murphree conceived a plan of having the Sunday?school board construct a


building and exchange it for the petitioner's building. Whaley in refusing, on behalf of the
petitioner, to sell the property had indicated that the only type of deal petitioner would be
interested in would be an exchange of its building for a suitable building. The
Sunday?school board considered Murphree's proposal that they construct a building for
purposes of exchange, but rejected it. Thereafter Murphree suggested to Whaley that he,
Murphree, should construct a building and trade it for the petitioner's building. Whaley
advised Murphree he was willing to proceed on that basis because on the basis of a trade
there would be a saving in taxes.

In anticipation of constructing such a building, Murphree Realty Co. on June 12, 1956,
paid $50 to Suburban Industrial Development Co., referred to as Sidco, for an option to
purchase its lot No. 74.

Murphree's attorneys prepared a contract, which was executed on June 18, 1956, by
petitioner, by its president Whaley, and by Murphree Realty Co., by its president
Murphree. Therein, after reciting that the petitioner owned the Berryhill Street property
and that it desired to trade such property for a suitable building, it was provided:
NOW, THEREFORE, it is agreed that MURPHREE will have the right to execute an
option giving to a prospective purchaser the absolute right to buy from MURPHREE the
above property, provided, however, that BAIRD (the petitioner) will have the right to
occupy the property rent free until MURPHREE has provided BAIRD with another
building as hereinafter set out.

For and in consideration of the agreement of BAIRD, MURPHREE agrees within a


reasonable time to build a building and if the building is built, then BAIRD is to approve
the plans and specifications and said building and lot is to be accepted by BAIRD on a
basis of a value of $35,000.00 and MURPHREE, in addition to the building to be
provided, agrees to pay to BAIRD the sum of $22,700.00. If the cost of the building and
lot to be built by MURPHREE exceeds the fixed value hereinabove set out, then the cash
payment to be made by MURPHREE shall be reduced to (by) the amount of said excess
and if the cost of the building and lot is less than the amount set out above, then the cash
payment payable by MURPHREE shall be increased by the difference between the actual
cost and the sum set out herein.

BAIRD agrees to deed his property on Berryhill Street to MURPHREE on


MURPHREE'S order and it is understood that MURPHREE may execute options
wherein MURPHREE agrees to sell the Berryhill property subject to the conditions
hereinabove set out as to continued occupancy by BAIRD.

It is also understood that MURPHREE will within a reasonable time submit plans to
BAIRD for the building of a new building and it is contemplated that MURPHREE will
erect said building on Lot No. 74 of the Suburban Industrial Development Company Plan
* * *. It is further agreed that this contract, if entered into by BAIRD, will be approved
by two thirds' vote of the stockholders of BAIRD and the stockholders and directors will
authorize J. H. Whaley, the president, to execute this contract and anyand all deeds
necessary to convey the Berryhill property. * * *

On October 15, 1956, the Realty Co. purchased lot No. 76, which was an unimproved
lot in the Sidco subdivision (which was substituted for lot No. 74) for $6,900.

On October 31, 1956, the petitioner executed a deed of the Berryhill property to the
Realty Co.

On the same date the Realty Co. executed a deed of the Berryhill property to the
Sunday?school board for a consideration of $60,000, payment of which was made by
check of the Sunday?school board to the Realty Co.

Of the $60,000 the Murphree Realty Co. deposited $50,096.89 in the Third National
Bank in Nashville, Tenn., under the name of 'Murphree Realty Co., Escrow Agent for J.
H. Baird Publishing Co.' The amount deposited was the sale price, less the cost of the
Sidco lot of $6,900, taxes and fees aggregating. $745.61, an amount of $2,350, which
was retained by the Realty Co., and plus an amount of $92.50 representing the tax and fee
for recording the deed of the Berryhill property which was reimbursed to the Realty Co.
by the Sunday?school board.

The money in the escrow account was used, to the extent required, for construction of
the building on the Sidco property to the specifications of the petitioner. Construction
was promptly begun.

Withdrawals from the escrow account were by checks signed by Murphree Realty Co.,
by John W. Murphree, president, in payment for invoices approved by the petitioner.

At some time in 1957, after completion of the new building, the petitioner and
Murphree Realty Co. executed another contract which was intended to supersede the
prior contract executed on June 18, 1956. The new contract shows an execution date of
June 18, 1957, but such date was inserted in error, the parties having intended to show the
same execution date as the first contract. Such second contract contains the following
provisions:

BAIRD (the petitioner) is to occupy 917 Berryhill free of rent until April 1, 1957, after
which time BAIRD will be responsible to any new owner of the property. BAIRD is to
approve any contractor, plans and specifications and any change or agreements after the
original selection will be between BAIRD and the Contractor to erect the building.

MURPHREE agrees to give BAIRD $19,542.13 and Lot 76 and the building erected
thereon for the property located at 917 Berryhill.

BAIRD agrees to deed his property on Berryhill Street to MURPHREE on


MURPHREE'S order and it is understood that MURPHREE may execute options
wherein MURPHREE agrees to sell the Berryhill property subject to the conditions
hereinabove set out as to continued occupancy by BAIRD.

It is further agreed that this Contract, if entered into by BAIRD, will be approved by a
two?thirds' vote of the stockholders of BAIRD and the stockholders and directors will
authorize J. H. Whaley, the President, to execute this Contract and any and all deeds
necessary to convey the Berryhill property. * * * *

On July 19, 1957, the Sidco property, as improved by the building erected thereon, was
deeded to the petitioner by Murphree Realty Co.

None of the $60,000 purchase price of the Berryhill Street property was paid directly to
the petitioner until after the cost of the new building on the Sidco lot, $33,726.04, was
established. The amount of cash which the petitioner received, in addition to the new
property, was $17,055.65.

In its income tax return for the taxable year 1957 the petitioner reported as long?term
capital gain to be recognized upon the above transaction the amount of $17,055.65 with
the notation 'Exchange of land and building at 913 Berryhill Street for land and building
at 2916 Sidco Drive?? boot.'

About 1928 Horn and Whaley participate in a syndicate which purchased several
hundred acres of land on Lookout Mountain, near Chattanooga, Tenn., as a speculative
venture, hoping to sell the land to a developer for a quick profit. Horn and Whaley
obtained a one?eleventh interest at a cost of $15,000. The syndicate was unable to sell the
land, due to the depression, and in July 1931 the members of the syndicate formed a
corporation known as Mt. View Corporation with a capitalization of $1,320 represented
by 132 shares of $10?par?value stock, and the Lookout Mountain property was
transferred to the corporation in a nontaxable transaction. Horn and Whaley received 12
shares of the stock of such corporation. Mt. View Corporation never made any attempt to
develop the property, its sole activity being to hold title and pay the taxes thereon.

On or about October 16, 1946, Horn and Whaley transferred their stock in Mt. View
Corporation to the petitioner in consideration of the cancellation of their indebtedness to
petitioner in the total amount of $15,000. Thereafter, on August 12, 1952, petitioner sold
the stock of Mt. View Corporation for $423,24 and reported in its return for that year a
capital loss from such sale in the amount of $14,576.76. Mt. View Corporation was
liquidated in about 1952, and none of its financial records are available. Several years
prior to 1946, Horn and Whaley had acquired, at an undisclosed price, certain property
known as the Gardner Tract, in the Belle Meade section of Davidson County, Tenn.,
which was a desirable residential section.

By 1946 this property had been subdivided and all lots had been sold with the exception
of an area which was not accessible from a public road. In 1946, Horn and Whaley
transferred the above?referred?to remaining area of land to petitioner in consideration of
the cancellation of their indebtedness to petitioner in the total amount of $5,000. On July
22, 1952, petitioner sold such property to one of the owners of the surrounding properties
for a net consideration of $1,847.80.Petitioner reported a loss from the sale of this lot in
its 1952 income tax return in the amount of $3,152.20.

Petitioner, having reported no capital gains on any return between 1952 and 1956,
inclusive, reported the loss on the sale of the Mt. View stock ($14,576.76) and the loss on
the sale of the Gardner Tract property ($3,152.20) totaling $17,728.96) as an unused
capital loss carryover from the year 1952 in its income tax return for 1957. This had the
effect of completely offsetting the amount of $17,055.65 reported by it in 1957 as the
recognizable long?term capital gain on the transaction involving the disposition of its
Berryhill Street property.

In a deficiency notice dated June 27, 1960, covering the years 1956 and 1957, the
respondent determined that the petitioner sold its Berryhill Street property in 1956 and
that it realized a long?term capital gain in the amount of $54,750.66 therefrom which is
includable in taxable income in accordance with sections 61 and 1231 of the Internal
Revenue Code of 1954. * * * *
It is the position of the Internal Revenue Service that you realized taxable income in
the year 1956 from sale of a building. However, since you contend that the building was
not sold in the year 1956 but was exchanged for property of a like kind in the year 1957,
it is determined, in order to protect the interests of the Government, that you realized
long?term capital gain in the amount of $54,750.66, the excess of proceeds $57,650.00,
over adjusted basis, $2,899.34, which is includible in your taxable income in accordance
with section 61 of the Internal Revenue Code of 1954, from sale of the property in the
year 1957.

The respondent again determined that the petitioner was not entitled to a capital loss
carryover from the year 1952 because 'you sustained no such loss.'

The Realty Co. was not acting as agent for the petitioner in selling its Berryhill Street
property. On July 19, 1957, the petitioner transferred such property to the Realty Co. in
exchange for the Sidco property and money in the amount of $17,055.65.

OPINION

The principal issue is whether the petitioner exchanged its Berryhill Street property for
the Sidco property improved with the new building, within the meaning of section 1031
of the Internal Revenue Code of 1954.[FN1] There is no question that such properties
were of like kind within the meaning of the statute.

It is the respondent's contention that Murphree Realty Co., acting as petitioner's agent,
sold the petitioner's property and build petitioner a new building, and that petitioner is
taxable upon a long?term capital gain measured by the difference between a selling price
of $60,000 (less a selling commission of $2,350) and the adjusted basis of $2,899.34. He
points to the fact that the $60,000 selling price of the property was placed in a bank
account under the name of the Realty Co. as escrow agent for the petitioner, after the
Realty Co. had reimbursed itself for the cost of the lots and withheld an amount of
$2,350, and that the Realty Co. drew checks against this account to pay bills, after
approval of invoices by the petitioner, to construct a building to the specifications of the
petitioner. He states that an exchange differs from a sale in that no fixed money price or
value is placed upon either of the properties in an exchange, whereas in a sale there is
either a money consideration or the equivalent in property * * * *

The respondent states that here a definite money value was placed upon the Berryhill
Street property before it was transferred to the Realty Co. to sell and that a definite
money value was placed upon the new property which the Realty Co. was commissioned
to acquire or construct for the petitioner.

The respondent further contends that there could not have been an exchange between
the petitioner and the Realty Co. in 1956 when the petitioner deeded its property to the
Realty Co. since at that time the Realty Co. did not own any property of like kind which
it could exchange that at most what the Realty Co. owned was an unimproved lot (but
that in reality even that was held for the benefit of the petitioner). He states that there
could have been no exchange in 1957 when the Realty Co. transferred title to the new
property to the petitioner since at that time the petitioner itself did not have any property
to exchange, having transferred its property away in the prior year.

The petitioner, on the other hand, contends that the Realty Co. was not acting as its
agent, that the parties intended, and the contract provided for, an exchange of the
petitioner's property for property to be acquired and constructed by the Realty Co., that
all the steps taken were parts of a single transaction constituting an exchange, and that
consequently it is taxable on only that part of the gain derived which is not in excess of
the cash received, $17,055.65. It relies principally upon W. D. Haden Co. v.
Commissioner, (C.A. 5) 165 F.2d 588, affirming a Memorandum Opinion of this Court,
and Allegheny County Auto Mart, Inc. v. Commissioner, (C.A. 3) 208 F.2d 693,
affirming a Memorandum Opinion of this Court.

There can be no doubt, upon the evidence here, that the petitioner did not desire to
make a sale of its property and incur a tax liability upon the large capital gain which
would be realized. It consistently refused to sell and its representative stated to Murphree
that the only acceptable deal would be one involving an exchange of properties. It is, of
course, axiomatic that the parties' expectations or hopes as to the tax treatment of their
conduct in themselves are not determinative (Commissioner v. Duberstein, 363 U.S.
278), and that matters of taxation must be determined in the light of what was actually
done rather than the declared purpose of the participants (Weiss v. Stearn, 265 U.S. 242).
We turn then to a consideration of what was actually done?? the substance of the
transactions. Other cases, although they may be helpful, are not determinative since each
case must be decided upon the basis of its own facts.

It seems to us that the primary consideration is the relationship created between the
petitioner and the Realty Co.?? that is, was an agency created whereby the Realty Co., as
agent, sold the Berryhill Street property for the petitioner and with a part of the proceeds
acquired or constructed, as agent for the petitioner, the Sidco property.

Agency is founded upon a contract, either expressed or implied, by which one of the
parties confides to the other the management of some business, to be transacted in his
name or on his account, and by which the other assumes to do the business and to render
an account of it.

Insofar as provided by the contract, it was not necessary that the Realty Co. sell the
property in the name of the petitioner. Nor, insofar as the contract provided, was the
Realty Co. required to account for the selling price of the property. The only requirement
was that it construct a building to be transferred to the petitioner and pay over cash in an
amount sufficient, when added to the cost of the new property, to make up $57,700.

It is true, of course, that the contract would not be conclusive as to whether an agency
existed if other facts and the surrounding circumstances should indicate that an agency
did exist. However, we cannot conclude that the surrounding facts do indicate that the
Realty Co. was acting as agent for the petitioner. It is true that the Realty Co. did place a
portion of the $60,000 selling price which it had received from the Sunday school board
in a bank account in its name as escrow agent for the petitioner. However, the amount
placed in such account was not the full selling price, but amounted to $57,700, less the
amounts already expended toward complying with its undertaking to acquire a lot and
construct the building. Murphree testified that he customarily, in his business, set up
escrow accounts when funds were dedicated to a particular project. We accordingly think
this circumstance is not indicative of an agency arrangement. The amount which the
Realty Co. originally retained out of the $60,000 selling price was $2,350, which is
approximately the difference between $60,000 and $57,000 (which it was required to pay
to petitioner in the form of property and cash). In the final analysis, it appears that its
profit was only $1,61520, since it apparently bore some of the taxes and fees with respect
to the Sidco property. This circumstance would seem to indicate that the Realty Co. was
acting as a principal and not merely receiving an agent's commission. Nor do we think
that, under the present circumstances, it is indicative of an agency arrangement that the
petitioner approved the invoices for construction which the Realty Co. paid from this
account in view of the fact that the agreement was that the Realty Co. would provide a
building suitable to the petitioner.

The evidence shows that the representatives of the petitioner made it abundantly clear
to the Realty Co. that the petitioner was not interested in effecting a sale of its Berryhill
Street property and that the only transaction which it would consider was an exchange of
properties, together with 'boot.' To this end, the agreement was that the petitioner was to
retain the use, rent free, of the property until such time as the Realty Co. should provide
and transfer to the petitioner another suitable property. Murphree, president of the Realty
Co., fully understood the agreement and purported to be acting as a principal in obtaining
a lot and constructing a building which he could trade to the petitioner, and he testified
that he was not acting as an agent.

We think that the contract and other facts presented are sufficient to establish that the
Realty Co. was not acting as agent. There is no basis for assuming that there was some
other agreement between the petitioner and the Realty Co. which would establish an
agency relationship. We have accordingly concluded and found as a fact that the Realty
Co. was not acting as agent for the petitioner in selling its Berryhill Street property and
acquiring and constructing the Sidco property.

As stated, the respondent contends that the transaction cannot be considered as an


exchange since the Realty Co. did not own property of like kind to the Berryhill Street
property at the time (October 31, 1956) that the petitioner deeded the Berryhill Street
property to the Realty Co. It is true, of course, that the Realty Co. did not possess
property of a like kind at that time, but as we view the transaction, the transfer on
October 31, 1956, was but one of the steps in an integrated transaction which
contemplated an exchange of properties of like kind. Since, under the contract, any deed
executed by the Realty Co. with respect of the Berryhill Street property was subject to the
condition that the petitioner was to retain the use of such property rent free until the
Realty Co. should provide a suitable new building, the deed executed by the petitioner on
October 31, 1956, and the deed executed by the Realty Co. to the Sunday?school board
on the same date had the effect of transferring only legal title to the property. The
petitioner in effect retained the beneficial ownership of the property until the new Sidco
property was available for its use. Thus the petitioner's transfer of ownership of the
Berryhill Street property and the transfer of ownership of the Sidco property to the
petitioner were reciprocal and mutually dependent. When, on July 19, 1957, the Sidco
property was deeded to the petitioner by the Realty Co., beneficial ownership of the
Berryhill Street property passed through the Realty Co. to the Sunday?school board. At
that time there was effected, within the meaning of section 1031 of the Code, an
exchange by the petitioner of its Berryhill Street property for the Sidco property and
money in the amount of $17,055.65.

The transaction was not based solely on money values so as to render it a sale. The
statute itself presupposes the fixing of values for the properties in an exchange, since it
contemplates that any exchange may involve 'boot.' The case principally relied upon by
the respondent, Bloomington Coca?Cola Bottling Co. v. Commissioner, supra, is
distinguishable. There a contractor agreed to build a new plant for the taxpayer on land
owned by the taxpayer and to accept taxpayer's old plant in part payment of the contract
price.

It was clear that the contractor did not own the other property which, it was claimed,
was transferred to the taxpayer in an exchange. It is our conclusion that the gain realized
in 1957 by the petitioner upon the transaction is to be recognized, under section 1031, but
only to the extent of the money received in the amount of $17,055.65. It follows that the
respondent erred in his determination that the petitioner received recognizable gain of
$54,750.66 in 1956, or alternatively, in 1957.

* * * * Decisions will be entered under Rule 50.

BOOT

Section 1031(b) provides that if an exchange would be within the provisions of


subsection (a), were it not for the fact that the property received in an exchange consisted
not only of property permitted by Section 1031(a), in other words, "like-kind property,"
but also involved other property or money which is not like-kind, the gain, if any, to the
recipient, is recognized.

EXCHANGES NOT SOLELY IN KIND

Treas. Reg. Section 1.1031(b)1 provides for a number of examples which interpret this
particular subsection. The Regulation states that if in an exchange the taxpayer receives
other property, in addition to property permitted to be received without recognition of
gain, or receives money, the gain, if any, to the taxpayer will be recognized under Section
1031(b). However, it goes on to state that the amount that will be recognized will be an
amount not in excess of the sums of money and the fair market value of the non-like-kind
property received.
Illustrating Section 1031(b), the Regulation gives the following example: A, who is not
a dealer in real estate, in 1954 exchanges real estate held for investment, which he
purchased in 1940 for $5,000 for other real estate (to be held for productive use in trade
or business) which has a fair market value of $6,000 plus $2,000 in cash. The gain from
the transaction is $3,000, that is an adjusted basis of $5,000, with the fair market value of
property received being $8,000 or a net of $3,000. This is the realized gain under Code
Section 1001. However, the amount of gain that is recognized is only to the extent of the
cash received, namely $2,000. This is true since the rule is that the gain will be
recognized to the extent of the lesser of the boot, in this case $2,000 in cash, or the
realized gain, $3,000. Obviously since the $2,000 is a lesser amount, gain will be
recognized on this amount. (For adjustments to be made to basis as a result of the gain
realized and recognized, see Chapter 10; for a discussion of boot by means of "debt
relief," see Chapter 9.)

The Regulations under Section 1.1031(a)-1(c) state that no gain or loss will be
recognized if the taxpayer exchanges property held for productive use in trade or
business, together with cash, for other property of like-kind for the same use, such as a
passenger automobile for a new passenger automobile. The Regulations are emphasizing,
with this language, that it does not damage A, as to his exchange, when he transfers like-
kind property and also gives boot. The important point is that he did not receive boot.

BOOT AND MULTIPLE PIECES OF PROPERTY

It is possible that where there is an exchange there could also be multiple pieces of
property, where one must allocate the basis. In O. O. Sayre, 58-2 U.S.T.C. Para. 9625
(1958), the Court held that where a taxpayer exchanged his home and his farm for
another farm and cash, there is a required allocation between the properties. In this
particular case, the taxpayer could also use the benefits of Section 1034 and also
postpone the gain on the principal residence. However, there has to be an allocation of
the amount of cash received to determine whether it was paid for the residence or the
farm. The Court made this determination, based on the facts of the case; other parties
would be well advised to try to make a reasonable allocation within their own contract or
other agreement. (See also Code Section 1060.)

A. Debt on the property transferred, reduced by:


1. The debt on the property that is received.
2. The cash that is paid.
B. Determine the total amount of boot or non-like-kind
property, that is received, subtracting out items 1 and 2.
C. Determine the fair market value of any other property
received.
D. Determine the cash received.
E. Determine the total of items A, B, C and D.

BLATT V. COMMISSIONER
T. C. Memo 1994-48

A taxpayer will not qualify for a tax-deferred exchange where the taxpayer has boot
and debt relief. For the reaffirmation of these same principles, see Phil Blatt v. Comm., T.
C. Memo 1994.48.

Phil BLATT and Elaine Forge BLATT, Petitioners


v.
COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 2135191 United States Tax Court


T.C. Memo. 1994-48 (1994)

MEMORANDUM FINDINGS OF FACT AND OPINION


JACOBS

Respondent determined a deficiency in petitioners' 1989 Federal income tax in the


amount of $25,358 and an addition to tax under section 6662(a) in the amount of $4,072.
[FN1] On

October 13, 1989, petitioners exchanged residential rental property (the Spinel Avenue
property) for mountain vacation rental property (the Cedar Lane property). The exchange
constituted a like kind exchange within the purview of section 1031. [FN2]

After concessions by respondent, the issues for decision are: (1) Whether petitioners
must recognize a capital gain of $76,159 as a result of the exchange; (2) whether
petitioners are entitled to deduct depreciation of $641 on the Cedar Lane property; and
(3) whether petitioners are entitled to claim miscellaneous deductions of $684.

Some of the facts have been stipulated and are found accordingly. The stipulation of
facts and attached exhibits are incorporated herein by this reference.

At the time the petition in this case was filed, petitioners resided in Alta Loma,
California. Petitioners filed a joint Federal income tax return for 1989.

For convenience, our findings of fact and opinion for each issue are combined, and
each issue is discussed under a separate heading.

Issue 1. Exchange of Property

At the time of the exchange, the Spinel Avenue property's fair market value (FMV)
was $155,000, and it was subject to mortgages of $112,944. Petitioners' adjusted basis in
the Spinel Avenue property was $66,434.
As part of the exchange, the transferee assumed all the Spinel Avenue property's
mortgages. Petitioners received boot, in the .form of non exchange expenses which were
paid through escrow, of $1,822.

At the time of the exchange, the Cedar Lane property's FMV was $62,500. As part of
the exchange, petitioners assumed a $30,000 mortgage on the Cedar Lane property. In
addition, petitioners paid $1,000 in cash and incurred expenses of $3,673.

Petitioners' 1989 return disclosed the exchange on a separate statement. The disclosure
statement showed that no gain was realized on the exchange.

Respondent contends that due to the receipt of boot and debt relief, petitioners
recognized gain in the amount of $76,159 from the exchange. Respondent raised the issue
of the taxability of the section 1031 like kind exchange after the issuance of the statutory
notice of deficiency; therefore respondent bears the burden of proof with respect to this
issue. Rule 142(a); McSpadden v. Commissioner, 50 T.C. 478, 492?493 (1968). Section
1031(a)(1) provides that "No gain or loss shall be recognized on the exchange of property
held * * * for investment if such property is exchanged solely for property of a like kind
which is to be held * * * for investment. " However, gain is recognized to the extent of
cash or other boot which is received in the transaction.

Sec. 1031(b); sec. 1.1031(b)l, Income Tax Regs. Relief of the transferor taxpayer's
mortgage debt is considered boot received. Sec. 1.1031(b)?l(c), Income Tax Regs.
Further, the amount of boot received is decreased by the taxpayer's exchange expenses.
See Rev. Rul. 72?456, 1972?2 C.B. 468; see also sec. 1.1031(d)2, Example (2), Income
Tax Regs. Section 1031 is a deferral provision, not a forgiveness statute. See sec.
1.1031(d)l, Income Tax Regs.

Here, both properties involved were rental properties. Because petitioners received
boot and debt relief in the exchange, respondent claims petitioners must recognize a
capital gain in the amount of $76,159. We agree with respondent.

The Cedar Lane property had a FMV of $62, 500. Petitioners received boot valued at
$1,822 and were relieved of mortgages on the Spinel Avenue property totaling $112,944.
Thus, the total consideration which petitioners are deemed to have received in obtaining
the Cedar Lane property is $177,266.

The Spinel Avenue property (the exchanged property) had an adjusted basis of $66,434.
Petitioners paid $1,000 as part of the exchange and incurred $3,673 of valid exchange
expenses. (Although petitioners claimed to have incurred exchange expenses in excess of
$3,673, apparently some of the exchange expenses were deducted elsewhere on their
1989 return). Petitioners also assumed a mortgage of $30, 000 on the Cedar Lane
property. Thus, $101,107 should be subtracted from the $177,266 consideration, leaving
a gain realized of $76,159. Spinel Ave Property Cedar Ln Property Fair market value: * *
**
Gain realized $ 76,159 * * * *

INTENT, BOOT, MONEY PAID: MAYS

In Mays v. Campbell, the Court was faced with determining whether a transaction
qualified under Section 1031.

The Court listed the details and concluded that the Mays, the taxpayers, did not intend a
sale to the potential purchaser, Agridustrial; they intended only an exchange. The Court
said: "Such an exchange cannot be transformed into a sale for the sole purpose of
producing tax." The evidence, said the Court, was that there was solely an exchange of
properties between the Mays and a group called the Kilgore Foundation. There was not a
sale by Mays to Agridustrial with a reinvestment of those monies by purchasing a
property known as the Foundation property.

The Court found the transaction was properly executed and was therefore within the
provisions of Section 1031(e) -- even though the Mays transferred their like-kind
property and money.

Since the Mays were transferring money, not receiving money, there was no problem.
The transaction qualified for a tax-deferred exchange.

W. A. MAYS and Agnes Mays, Plaintiffs,


v.
Ellis CAMPBELL, Jr.,
District Director of Internal Revenue, Defendant.
66-1 U.S.T.C. Para. 9147,
246 F.Supp. 375 (D. Tex. 1966)

HUGHES, District Judge.

This action was submitted to the Court (without the intervention of a jury) upon a
written Stipulation of Facts and the uncontradicted Answers of Plaintiff, W. A. Mays, to
Interrogatories, both of which have been duly filed herein, and upon the briefs of the
parties, all of which have been duty considered by the Court.

FINDINGS OF FACT

The Court finds the facts to be as stipulated by the parties and as testified to by the
Plaintiff, W. A. Mays, in his answers to the interrogatories propounded to him by the
Defendant. Due to the length of said Stipulation of Facts and the exhibits thereto and of
the answers of Plaintiff, W. A. Mays, to said interrogatories, the facts so found will not
be repeated at length, but what the Court considers to be the controlling facts will be
summarized and next stated as a summary thereof.
1. This action was instituted by Plaintiffs, W. A. Mays and Agnes Mays, husband and
wife and residents of Amarillo, Potter County, Texas, against Defendant, Ellis Campbell,
Jr., District Director of Internal Revenue, for the recovery of income taxes and interest
thereon paid by the Plaintiffs to Defendant in respect to Plaintiffs' income tax liabilities
for the calendar years 1961 and 1962. Plaintiffs have duly complied with all procedural
requirements which are conditions precedent to their right to institute and maintain this
suit. In receiving the sums so paid by Plaintiffs to Defendant, Defendant acted in his
official capacity and with probable cause and is entitled to a Certificate of Probable
Cause for such actions.

2. The bases for the Plaintiffs' claims for the years 1961 and 1962 are entirely separate.
On brief, Defendant conceded that the Plaintiffs were entitled to recover with respect to
their claim for 1962. The amount of this recovery is $1,447.87, with interest as provided
by law from the date of payment, April 21, 1964. In view of this concession, no further
reference will be made in these findings to the matters involved with respect to the year
1962.

3. All of the property and income involved in this proceeding was the community
property of Plaintiffs, W. A. Mays and Agnes Mays, under the laws of Texas. Joint
income tax returns were filed by the Plaintiffs with Defendant for the years 1961 and
1962. W. A. Mays was the active manager of the community and for convenience only
his name will be used in this summary of the findings of fact although his actions
hereinafter described were on behalf of the community of W. A. Mays and Agnes Mays.

4. On August 30, 1961 W. A. Mays owned a parcel of real estate in Amarillo, Texas,
and a ranch in Kent County, Texas, both of which he had owned for more than six
months and had continuously held for investment, revenue, and for use in his business of
raising cattle. On that date, he entered into a written agreement (set out in full as an
exhibit to the Stipulation of Facts filed herein) with the Florence Lee and C. L. Kilgore
Foundation (sometimes hereinafter referred to as Kilgore Foundation) to convey the said
Amarillo property and the Kent County ranch to the Kilgore Foundation and to pay
Kilgore Foundation $212,979.05 in cash and to receive therefor a conveyance to a ranch
in Union County, New Mexico, then owned by Kilgore Foundation. The agreement (in
addition to the customary provisions as to title, etc.) contained the following:

'This agreement is contingent upon the First Party (Kilgore Foundation) being able to
procure a purchaser for the land at a price and upon terms agreeable to it which Second
Party (Mays) agrees to convey as part consideration, and First Party may terminate the
agreement if it cannot sell said land at a price and upon agreeable terms within 120 days
from the date hereof.'

5. On the same day (August 30, 1961), Kilgore Foundation entered into a written
contract (likewise set out in full as an exhibit to the Stipulation of Facts filed herein) with
Agridustrial Financing, a Texas corporation (sometimes hereinafter referred to as
Agridustrial), which recited that Kilgore Foundation was contemplating acquiring the
aforesaid Amarillo property and the Kent County ranch then owned by W. A. Mays, and
subject to such acquisition and the usual provisions as to title, etc., the contract provided
that Kilgore Foundation would sell the properties so to be acquired to Agridustrial for
$500,000 in cash, and Agridustrial agreed to purchase the property and pay for same.

6. In connection with the contracts referred to in Paragraphs 4 and 5, Mays made an


escrow deposit in the First National Bank of Amarillo, Texas, of $21,797.90, and
Agridustrial made an escrow deposit in the same bank of $50,000. Each amount was to
be forfeited if W. A. Mays, on the one hand, and Agridustrial, on the other, were to fail to
carry out the contract for any reason other than title, although Kilgore Foundation
reserved the right to enforce specific performance of each contract.

7. The aforesaid contracts between Mays and Kilgore Foundation and between Kilgore
Foundation and Agridustrial were consummated in the year 1961 in accordance with their
terms, the Mays?Kilgore Foundation transaction being first consummated, and this being
followed immediately by the consummation of the Kilgore?Agridustrial transaction.
After acquiring the New Mexico ranch, Mays held the same for use in his business of
cattle raising, and is still the owner of same.

8. W. A. Mays never at any time offered to purchase the Union County, New Mexico,
ranch. At the initiation of the negotiations which led to the execution of the aforesaid
agreement between W. A. Mays and Kilgore Foundation, W. A. Mays informed the
representative of Kilgore Foundation with whom he dealt that he wanted to work out an
exchange of properties, and subsequent negotiations proceeded upon that basis.

9. At all pertinent times, the capital stock of Agridustrial was owned of record by Mays
40%, Cleo G. Clayton 10%, Taylor Mays 25%, and Troy Mays 25%. The stock held in
the name of Clayton, who was attorney for W. A. Mays, was held for Mays' benefit.
Taylor Mays and Troy Mays are the sons of W. A. Mays, and at the time the contracts
were entered into, Taylor Mays was 39 years of age and Troy Mays was 37 years of age.
Both of these sons were mature, successful business men, and Troy Mays was the active
manager of Agridustrial. Agridustrial had been incorporated as a Texas corporation in
May, 1952. It was a successful business concern, engaged primarily in making loans,
investing in and leasing and renting real estate. On April 30, 1961, it had assets in excess
of $500,000 and liabilities of $50,719.07.

10. In the joint income tax return filed by the Plaintiffs for 1961, the aforesaid
transaction between W. A. Mays and Kilgore Foundation was treated as a non?taxable
exchange under Section 1031(a), Internal Revenue Code of 1954. Upon audit, the
Internal Revenue Service held that said transaction was taxable and resulted in Mays'
receiving long?term capital gain, arrived at by valuing the New Mexico ranch at
$500,000, which was the amount realized by Kilgore Foundation for the Kent County
ranch and the Amarillo property, which properties it had received from W. A. Mays and
then sold to Agridustrial. Because of this determination by the Internal Revenue Service,
a deficiency in income tax for the year 1961 in the amount of $117,170.96 was duly
assessed against the Plaintiffs and paid by them, with interest in the amount of
$14,176.05, on April 21, 1964. These payments represented overpayments which the
Plaintiffs are entitled to recover.

11. Upon brief, the Defendant contended that Mays made a sale for cash of his Kent
County ranch and Amarillo property to Agridustrial Financing, and that Mays then
purchased the New Mexico ranch from Kilgore Foundation for cash.

CONCLUSIONS OF LAW

1. The Court has jurisdiction of the parties and of the subject matter involved in this
proceeding.

2. Agridustrial Financing, even though wholly owned by the Mays family, being an
active, substantial corporation for almost ten years prior to 1961 with total assets in
excess of $500,000 and liabilities aggregating $50,719.07, its corporate entity will not be
disregarded.

3. Agridustrial Financing not having been organized for the purpose of effecting the
purchase of the Mays property, but having been an active and successful corporation for
almost ten years, it cannot be considered as a conduit for the exchange of the properties
involved herein even though Agridustrial was a family corporation in which Mays owned
40% Of the stock.

4. Mays not having intended or agreed to make a sale to Agridustrial, but only having
intended and agreed to exchange his properties for other properties of the Foundation,
such exchange cannot be transformed into a sale for the sole purpose of producing a tax.

5. There being no evidence in the record that Mays sold the properties owned by him to
Agridustrial for cash and then bought the ranch property owned by the Foundation for
cash, but rather the evidence being that there was solely an exchange of properties
between Mays and the Foundation, a taxable sale was not effected.

6. The transactions involved herein, being carried out in a legal manner and not being
simulated, must be given their normal effect, thus bringing the transactions within the
provisions of Section 1031(a) of the Internal Revenue Code of 1954.

7. There being a direct exchange by Mays of property held for productive use or for
investment with the Kilgore Foundation for property to be held for productive use or for
investment, even though Mays transferred money in addition to the property, no gain
should be recognized under the provisions of Section 1031(a) of the Internal Revenue
Code of 1954.

8. The transaction summarized in the Findings of Fact by which W. A. Mays conveyed


to Kilgore Foundation his Amarillo property and his Kent County ranch and paid Kilgore
Foundation $212,979.05 in cash was, from the standpoint of the Plaintiffs, a non?taxable
exchange under Section 1031(a), Internal Revenue Code of 1954, and Plaintiffs realized
no taxable gain therefrom, and the tax and interest assessed against the Plaintiffs and paid
by them to the Defendant upon the theory that said transaction resulted in the realization
of longterm capital gain by Plaintiffs were improperly and illegally assessed and
collected.

9. Every finding of fact which may be deemed to be a conclusion of law is hereby


concluded as a matter of law.

10. The Plaintiffs are entitled to judgment against the Defendant for $131,347.01, with
interest thereon as provided by law, on account of the illegal assessment for the year
1961. Plaintiffs are also entitled to recover from Defendant $1,447.87, with interest
thereon as provided by law, on account of the illegal assessment for the year 1962.
Plaintiffs are also entitled to recover their costs, as provided by law, and Defendant is
entitled to a Certificate of Probable Cause so that the amount of the judgment awarded
Plaintiffs may be paid from the Treasury of the United States. * * * *

ALLEN V. COMMISSIONER
T. C. Memo 1993-612

Although this case involved an exchange under Code §1031, it also involved numerous
other issues, including basis and distributions from an S Corporation.

As to the exchange issue, the Court held that when parties undertake certain steps
where an exchange is present, even a deferred exchange, it would be treated as such, even
though one party in the instant case attempted to argue that the exchange never took
place. However, the facts refuted the taxpayer's position and supported the posture that a
transfer of properties and possession of the various properties was conveyed to the parties
in interest and an exchange was determined to have occurred.

Michael L. ALLEN and Ann Marie Allen, Petitioners,


v.
COMMISSIONER OF INTERNAL REVENUE, Respondent.
No. 5567?91. United States Tax Court
T.C. Memo. 1993?612 (Dec. 22, 1993).
MEMORANDUM FINDINGS OF FACT AND OPINION

GERBER, Judge:

Respondent, by means of a statutory notice of deficiency, determined deficiencies in


petitioners' Federal income tax for taxable years 1980, 1981, and 1983 in the amounts of
$7,320.96, $157,601.08, and $6,535.80, respectively.

After concessions, the issues for our consideration are:

(1) Petitioner husband's adjusted basis in the stock and notes


of his solely owned S corporation for purposes of
computing his allowable loss for the 1980 tax year; and
(2) whether petitioner husband received a constructive
distribution of the S corporation's assets and, if so, the tax
consequences of the distribution.

FINDINGS OF FACT

Some of the facts have been stipulated and the stipulation of facts and attached exhibits
are incorporated by this reference. At the time of the filing of the petition herein,
petitioners were married and resided in Columbia Falls, Montana. Petitioners filed joint
Federal income tax returns for taxable years 1980, 1981, 1982, and 1983. Petitioners filed
amended joint tax returns for taxable years 1982 and 1983. References to petitioner in the
singular are to Michael L. Allen.

Beginning in August 1968, and through the years in issue, petitioner was a full?time
dentist practicing in Columbia Falls, Montana, and surrounding areas. In 1977, petitioner
learned, through friends in Columbia Falls and a banker in Libby, Montana, of property
in Libby that was for sale. The property, known as the Venture Inn, operated as a motel,
bar, and restaurant. Petitioners traveled approximately 118 miles to Libby to view the
property. Petitioner decided to purchase the Venture Inn mainly because he believed that,
when the Federal Government's planned dam re?regulation project was initiated in the
nearby area, there would be an increased demand for motel accommodations over the
next 5 to 7 years.

On April 9, 1977, an Agreement To Buy And Sell was executed between petitioner and
the sellers, Robert P. Chapman and Patricia J. Chapman (the Chapmans). On April 21,
1977, petitioner formed a corporation called The Venture Inn (TVI), which remained
inactive until January 1, 1978. On April 27, 1977, petitioner purchased the Venture Inn
from the Chapmans for $1,250,000. A downpayment of $250,000 was due immediately,
with the balance deferred in connection with a Contract for Deed. When he purchased the
Venture Inn, petitioner envisioned expanding the facility to meet the anticipated demand
for rooms. To facilitate his construction financing, petitioner, in negotiating the purchase,
required the Chapmans to subordinate their deferred purchase?money rights.

Petitioner paid the $250,000 downpayment in cash comprised of $60,000 of personal


funds, a $90,000 bank loan, and $100,000 borrowed from three of petitioner's friends. On
May 3, 1977, the Contract for Deed was recorded through a Notice of Purchaser's
Interest, which effectively made TVI the record owner of petitioner's rights under the
Contract for Deed.

TVI filed an election to be treated as an S corporation, effective as of January 1, 1978.


Also on that date, petitioner contributed the Venture Inn to TVI in a section 351 [FN1]
exchange and TVI began operating. Up until this time, petitioner had operated the
Venture Inn as a sole proprietorship and reported a loss on his Form 1040 Schedule C for
taxable year 1977. Petitioner was at all times the sole shareholder of TVI, which,
following petitioner's contribution, was in turn the owner of the Venture Inn. TVI
remained an S corporation throughout the years under consideration. TVI filed Small
Business Corporation Income Tax Returns, Forms 1120S, for taxable years 1980, 1981,
and 1982.

On October 17, 1978, petitioners acquired an unimproved lot (hereinafter sometimes


referred to as parcel B) from Hugh G. and Alice I. Cumming for $30,000. Parcel B
adjoins the Venture Inn and was acquired so that the motel could be expanded on its
existing site. Petitioners did not transfer ownership of parcel B to TVI. Petitioner
believed that retaining direct ownership afforded him a strong negotiating position in the
event that the investment proved unsuccessful and the Chapmans attempted to foreclose
on the corporate property.

To effectuate their expansion plans, on or about August 1, 1979, petitioners and TVI
obtained a $350,000 loan through a Mortgage Participation Agreement. The loan was
secured through the U.S. Small Business Administration (SBA) and the Bank of
Columbia Falls, Montana. In addition to the mortgage executed by TVI and petitioners,
petitioners were required to pledge as collateral two other parcels of their land.
Petitioners never paid on the SBA construction loan. In addition to the SBA construction
loan, TVI borrowed money from the First National Bank of Libby, Montana, which was
secured by a mortgage on TVI's inventory and equipment. TVI also borrowed funds from
petitioner.

After obtaining the financing, a twenty?one room addition was constructed. Sometime
after the commencement of the expansion, petitioner discovered that the Federal
Government had abandoned its plans for the dam re?regulation project in northwest
Montana. As a result of the discontinuation of the Government's project (which was to
have brought tourism to the area), the SBA, on August 7, 1980, made an economic
dislocation loan of $75,000 to assist TVI.

Paul Jackson (Jackson), one of petitioner's patients, managed motel properties and was
involved in putting together exchange transactions. Because of difficulties in managing
the motel and cash?flow problems which worsened (due in part to the increase in interest
rates on the SBA loan), petitioner contacted Jackson. Among other business ventures,
Jackson was involved in the operation of motel properties in the southeastern United
States. Jackson's business in Montana was conducted under the name of Imperial Motel
Associates, a sole proprietorship which he operated.

Petitioner's initial purpose in contacting Jackson was to see if he would take over the
management of the Venture Inn. However, during their first meeting Jackson proposed a
like?kind exchange, and petitioner agreed. On September 15, 1980, petitioner paid
Jackson $75,000 by check which was deposited into the account of Jackson Farms, an
account Jackson maintained in Great Falls, Montana.
On October 1, 1980, TVI and petitioner entered into a Real Estate Exchange
Agreement which contemplated a "Starker" like?kind exchange [FN2] between TVI,
petitioner and Jackson. Under the terms of the exchange agreement, TVI and petitioner
were to sell, transfer, or exchange the Venture Inn and parcel B (the motel properties) for
an agreed value of $1,900,000 together with $75,000 in cash, subject to encumbrances
totaling $1,413,000, in exchange for Jackson's acquiring and conveying to petitioners
certain farm property in Garfield County, Montana, for a value of $1,340,000 together
with storage bins constructed for $75,000. To qualify the transaction as a "Starker"
like?kind exchange, Jackson was to locate a purchaser for the motel properties within 2
years whereby the debt assumption by the Venture Inn and petitioners equaled the debt
relief. Under the terms of the agreement, petitioner had the right after 1 year to call in the
$75,000 advanced cash payment plus annual interest of 12 percent.

The agreement also provided that, commencing October 1, 1980, Jackson was to
assume the cash?flow benefits and burdens of operating the Venture Inn. Also on October
1, 1980, in furtherance and support of the Real Estate Exchange Agreement, several other
documents were executed by and between the parties, including: Notices of Exchange
Interest in Real Estate, Quitclaim Deeds, Bills of Sale, and Warranty Deeds. Attorney
John Lence (Lence) held all bills of sale and deeds related to the exchange agreement and
related transactions (discussed infra ) as an escrow agent.

Jackson, however, was unable to deliver title on the farm property originally
contemplated in the exchange agreement. On December 2, 1980, TVI, petitioner and
Jackson entered into a lease agreement made retroactive as of October 1, 1980, through
and including November 15, 1981, whereby Jackson d/b/a Imperial Motel Associates,
leased the Venture Inn from TVI and petitioner. The lease was prepared by Lence at the
request of petitioner and Jackson. The lease was a triple?net lease such that no cash rental
was called for, however, Jackson was responsible for all payments on all outstanding
loans on the property as well as all other costs and expenses of operation, including taxes,
fees, and other charges of any kind. In addition, Jackson was required to maintain
indemnity and casualty insurance on the property.

On November 15, 1981, the day the lease was to expire, petitioner, as president of TVI,
executed and delivered to Lence a Warranty Deed and Bill of Sale for the purpose of
conveying the Venture Inn and its related chattels to Jackson. On the same day, Berja
Investments (a general partnership consisting of Jackson and Joseph T. Berlin) executed
and delivered to petitioner a Warranty Deed to property in Bozeman, Montana,
(hereinafter referred to as the Norem Building) which it had acquired 3 months earlier on
August 14, 1981, from Gilbert T. Rodriguez. The transfer of the Norem Building to
petitioner was subject to a lease with Don Norem Chevrolet/Buick, Inc., and total
assumed encumbrances of $662,031.96. [FN3] Jackson also gave petitioner a signed
promissory note in the amount of $78,000 together with an Agreement Regarding
Collateral on that date. The Agreement Regarding Collateral describes the transaction as
an exchange of the Venture Inn and parcel B for the Norem Building. Under the terms of
the agreement, parcel B was to remain in petitioners' name until Jackson delivered to
petitioner a release on the underlying indebtedness of the Venture Inn and evidence that
the promissory note had been paid in full. Neither petitioners nor Jackson signed the
Agreement Regarding Collateral.

On December 10, 1981, a preliminary title insurance report was issued to Jackson, as a
prospective buyer of the Venture Inn, proposing to insure the motel and parcel B,
although no title insurance policy was ever issued. On the same day, Jackson entered into
a Real Estate Sales Agreement with Henry J. Ostle, Mildred B. Ostle, and Percy Ostle
(the Ostles). The agreement stated that Jackson, as owner of the Venture Inn, sold a 50
percent interest in the Venture Inn to the Ostles for a sales price computed as 50 percent
of $1,800,000 allocated between downpayment and assumption of liabilities in the
respective amounts of $400,000 and $1,400,000. In accordance with their 50? percent
interest, the Ostles made a downpayment of $200,000 and assumed 50 percent of the
approximately $1,400,000 of existing encumbrances.

Concurrent with these agreements, Grant Deeds were executed by Jackson giving
Henry J. and Mildred B. Ostle a 37.5 percent interest and Percy Ostle a 12.5 percent
interest in the Venture Inn and parcel B. In accordance with the sales agreement, a lease
agreement was simultaneously entered into by which Jackson leased back the Ostles'
50?percent interest for a period of 5 years for a yearly rental of $24,000, payable semi-
annually, payment of all existing and future debt service on the property, and payment of
all costs and operating expenses.

On January 20, 1982, Berja Investments and Bear Country Corp. [FN4] entered into an
exchange agreement with Harvey J. Parmelee (Parmelee). Under the agreement, in
consideration of a $50,000 payment by Parmelee, Berja's 28.32? percent interest in a
motel in Iowa and Bear Country's 50 percent interest in the Venture Inn were exchanged
for farm and ranchlands in Pondera County, Montana. There is indication that this
agreement was implemented. On January 25, 1982, Jackson executed a Grant Deed and
Bill of Sale in favor of Parmelee transferring to him a one?eighth interest in the Venture
Inn property, parcel B, and the personal property of the Venture Inn.

On February 26, 1982, Jackson filed a petition for protection under chapter 11 of the
Bankruptcy Code. Jackson listed all the debts due by the Venture Inn as his own on the
bankruptcy petition. He also listed a three?eighths ownership interest in the Venture Inn
as his asset.

On March 30, 1982, Lence, as escrow agent, released all bills of sale and deeds related
to the exchange agreement and related transactions and they were recorded. [FN5]

On May 26, 1982, the Chapmans and Jackson entered into a contract whereby the
Chapmans agreed to purchase all real and personal property of the Venture Inn. Under
the terms of the contract the Chapmans were to pay $100,000 at closing and to assume
the underlying debt as follows: * * * *

The contract states that the "Closing to be upon approval by Federal Bankruptcy Judge
in Seller's Chapter 11 Reorganization." In addition, among other things, Jackson, as
seller, was to secure a release from petitioner of his $78,000 equity claim and note, and a
full release of the Ostle and Parmelee interests. From August 16, 1982, through August
30, 1982, various documents were executed unraveling the various transactions regarding
the Venture Inn, resulting in the completed transfer of the Venture Inn back to the
Chapmans.

The transactions between Jackson and the Chapmans did not disturb petitioner's interest
in the Norem Building. Petitioner retained his interest in the Norem Building until 1986
at which time, following 2 years of negotiations, he sold it to Don and Katherine Norem
for $790,000.

As of December 31, 1979, petitioner's basis in his TVI stock was $22,424.25.

Petitioners requested an extension of time to file their 1980 individual return.


Petitioners explained the need for an extension as follows: "Taxpayer was engaged in a
motel business that was exchanged pursuant to Section 1031 of the Internal Revenue
Code. Additional time is needed to properly reflect deferred gain and carry over basis."
Respondent granted petitioners an extension to October 15, 1981. On Schedule E of their
1980 return, filed October 13, 1981, petitioners carried over TVI's 1980 reported loss of
$74,520.

When TVI filed its 1981 Small Business Corporation Income Tax Return on October
19, 1982, it reported a taxable loss of $304,751. TVI's 1981 return reflects November 1,
1981, as the date of disposition of all its assets.

For taxable year 1981, petitioners again requested and were granted an extension of
time to file their return. Petitioners' explanation for this request was as follows:
"Taxpayers were involved in a Section 1031 Tax?Free Exchange and additional time is
necessary [for] * * * computing basis on acquired property." On that return petitioners'
Schedule E reflects November 1, 1981, as the acquisition date of the Norem Building.
[FN6] Due to basis limitations, as computed by petitioners, their 1981 return reflected
$103,464 of TVI's reported loss. For taxable year 1981, TVI reported a complete
disposition of its assets. For 1982, TVI filed an inconsistent corporate return reflecting a
taxable loss of $124,877 in connection with the disposition of its assets. The difference in
the losses claimed on the corporate returns for 1982 and 1981 is attributable to additional
claimed depreciation on equipment and paving. The corporate return for taxable year
1982 states that the return for 1981 is to be amended; however, no amended return was
ever filed. Under the basis limitations as computed by petitioners, they brought forward a
$469 loss on their 1982 individual return.

OPINION

For convenience, we will summarize the relevant facts. Petitioner purchased the
Venture Inn in 1977 and transferred it to TVI, a wholly owned S corporation, in 1978.
Petitioner deducted losses relating to TVI for the years he claimed it owned the Venture
Inn. Petitioner experienced financial difficulties with respect to TVI and, in 1980,
contracted with Jackson to exchange the Venture Inn for other property in a section 1031
tax?free transaction. Jackson encountered difficulties in locating and acquiring property
suitable to execute the exchange. While Jackson was looking for property, he took over
management of the Venture Inn. On November 15, 1981, petitioner and Jackson executed
and delivered documents conveying the Venture Inn to Jackson and the Norem Building
to petitioner. After that date, petitioner exercised ownership over the Norem Building and
Jackson exercised ownership over the Venture Inn. Jackson even transferred a portion of
ownership in the Venture Inn to third parties. In 1982, under threat of repossession,
Jackson transferred the Venture Inn back to the owners from whom petitioner had
originally purchased it.

Petitioner's Basis and Loss Limitation for 1980

As a general rule, section 1374(a) provides that the net operating loss of an S
corporation passes through to its shareholders. However, section 1374(c)(2) [FN7] limits
each shareholder's portion of the S corporation's net operating loss to the sum of the
adjusted basis of the shareholder's stock and the adjusted basis of any indebtedness of the
corporation to the shareholder.

The parties are in agreement that as of December 31, 1979, petitioner's adjusted basis in
his TVI Stock was $22,424.25. It is from this date forward that the parties diverge.
Respondent determined that TVI's records reflected an increase in notes payable to
petitioner from the taxable year ending December 31, 1979, to the taxable year ending
December 31, 1980, in the amount of $8,784. Respondent determined that, as of
December 31, 1980, petitioner's adjusted basis in his TVI stock was $31,208 by adding
the increase in notes to petitioner's adjusted basis. Accordingly, of the $74,520 loss
claimed on their 1980 joint return, respondent disallowed $43,312 (total loss claimed of
$74,520 adjusted basis of $31,208 = $43,312). Petitioner bears the burden of proof that
respondent's determination is in error. Rule 142(a).

Disposition of TVI's Assets

Respondent argues that, on November 15, 1981, petitioner transferred TVI's assets and
parcel B for the Norem Building in a like?kind exchange. Respondent contends that, prior
to November 15, 1981, TVI constructively distributed its assets to petitioner, the sole
shareholder. Because TVI distributed its assets to petitioner, respondent determined that
he realized and recognized gain upon the receipt of the assets.

Petitioners contend that the exchange agreement was not consummated. Petitioner
further contends that on November 15, 1981, he purchased the Norem Building by
agreeing to the assumption of its existing debt, rather than accepting the property under
the exchange agreement. It is petitioners' position that TVI did not dispose of its Venture
Inn assets until August 30, 1982, when, under threat of repossession, the Venture Inn and
parcel B were sold to the Chapmans in exchange for relief from all obligations
encumbering the two properties. Petitioner argues, in the alternative, that TVI's assets
were disposed of on March 30, 1982, when Lence released the deeds in escrow to
Jackson. The parties have stipulated the amount of depreciation, asset classification and
basis for TVI's assets as of November 15, 1981, March 30, 1982, and August 30, 1982.
Accordingly, we need only determine the manner and date of disposition.

We do not agree with petitioners' characterization of the November 15, 1981,


transaction. Petitioner initially may have been reluctant to accept the Norem Building as
exchange property, but we are convinced that the exchange occurred. On and after
November 15, 1981, petitioner exercised control over and acceded to rights and
obligations of the Norem Building. In a similar fashion Jackson controlled the Venture
Inn properties. As a result of the November 15, 1981, transfers, petitioner received the
Norem property, Jackson received the Venture Inn, and TVI received nothing.

To reach this result, TVI is considered to have constructively distributed its assets to
petitioner. Despite petitioner's contrary arguments, the relevant documents and the record
reflect an exchange of property as of the 1981 date. Accordingly, petitioner and TVI must
recognize any realized gain on the distribution of the assets. We note that petitioner only
argued that there was no exchange of property as of November 15, 1981. Petitioner did
not contradict respondent's determination of the tax consequences that flowed from that
transaction. Having found that there was a constructive distribution on November 15,
1981, we accept respondent's computations.

Section 301 deals with distributions of property made by a corporation to a shareholder


with respect to its stock. The amount of the distribution is the amount of money received,
plus the fair market value of the other property received. Sec. 301(b)(1)(A). The
distribution amount is reduced, but not below zero, by the amount of any liability of the
corporation assumed by the shareholder in connection with the distribution. Sec.
301(b)(2)(A). The taxable amount of the distribution is set out in section 301(c), as
follows:

(c) Amount Taxable. In the case of a distribution to which subsection (a) applies??

(1) Amount Constituting Dividend.??That portion of the


distribution which is a dividend (as defined in section 316)
shall be included in gross income.
(2) Amount Applied Against Basis.??That portion of the
distribution which is not a dividend shall be applied against
and reduce the adjusted basis of the stock.
(3) Amount In Excess Of Basis.
(A) In General. Except as provided in subparagraph (B), that
portion of the distribution which is not a dividend, to the
extent that it exceeds the adjusted basis of the stock, shall be
treated as gain from the sale or exchange of property.

Section 316(a) defines a dividend as any distribution of property made by a corporation


to its shareholders out of accumulated earnings and profits or out of current year earnings
and profits.
Respondent argues that, as a result of TVI's constructive distribution of its assets to
petitioner, TVI distributed property subject to liabilities that exceeded its adjusted basis
and TVI must, therefore, recognize gain. Sec. 311(c). This gain flows through to
petitioner because it constitutes undistributed taxable income (UTI), in the amount of
$147,810, and petitioner takes into income his pro rata share (in this instance??100
percent) at the end of the year. Sec. 1373. Under section 1376(a), petitioner's basis is
increased by the amount required to be included in gross income under section 1373(b).

Respondent further determined that, in addition to the dividend income under section
1373(b) of $147,810, petitioner received a constructive distribution of property from UTI.
Petitioner argues that the fair market value of the TVI assets was less than the liabilities
and, therefore, no property was received. Sec. 301(b)(2)(A). We agree with respondent.

Respondent determined the fair market value of the Venture Inn's assets by reference to
the 1986 selling price of the Norem Building of $790,000. Respondent added $1,427,067,
the amount of the Venture Inn's liabilities petitioner was relieved of, and reduced that
amount by the liabilities encumbering the Norem Building which he assumed, to arrive at
her determination that the Venture Inn's assets had a fair market value of $1,555,035.
Respondent determined a property distribution of $127,968, the fair market value of the
property less its liabilities ($1,555,035??$1,427,067). Petitioners contend that the Norem
Building had no value greater than the debts encumbering it.

Petitioners contend that the Norem Building was a "bad bargain" because of the
unfavorable lease terms. At trial, Appeals Officer Anita Teichrow testified as to the
methodology used to arrive at respondent's determination. Ms. Teichrow explained that in
selecting the 1986 selling price of the Norem Building, respondent selected the most
conservative figure from the information available. Petitioner has not shown that
respondent's methodology is unreasonable or that the determination is in error.
Petitioners, therefore, have not carried their burden on this issue.

Having found that petitioner received a property distribution of $127,968 and a UTI
distribution of $147,810, we must determine the tax consequences of the distributions.
The notice of deficiency contains respondent's determinations with respect to the
corporate income, and the treatment of the income flowing through to petitioner, and the
constructive distribution of TVI's assets. Petitioner tried to recharacterize the transaction,
but has not shown that these calculations are inaccurate. Respondent determined that
petitioner has dividend income of $147,810 and that the remainder of the distribution is a
return of capital. [FN9] Petitioner has not shown that respondent's determination is in
error, and respondent's determination is sustained.

Decision will be entered under Rule 155.

FN1. All section references are to the Internal Revenue Code in effect for the years in
issue and all rule references are to the Tax Court Rules of Practice and Procedure, unless
otherwise indicated.
FN2. So?called Starker exchanges derive their name from Starker v. United States, 602
F.2d 1341 (9th Cir.1979), wherein it was held that the reciprocal transfer of property need
not be simultaneous to defer gain or loss under sec. 1031.

FN3. In the notice of deficiency respondent determined that petitioner assumed


liabilities of $622,032.96 in connection with the Norem Building. Based on this
mathematical error, respondent in the notice of deficiency adjusted petitioners' income to
reflect a $40,000 capital gain, which adjustment respondent now concedes.

FN4. There is little in the record in regard to Bear Country Corp.; however, it is
identified in the exchange agreement as a Montana corporation with the location of its
principal office being the same as that of Berja Investments. In addition, it, not Jackson,
is identified in the exchange agreement as the owner of an undivided 50?percent interest
in the Venture Inn.

FN5. The Real Estate Sales Agreement executed on Dec. 10, 1981, between Jackson
and Henry and Mildred Ostle and the exchange agreement executed on Jan. 20, 1982,
between Berja and Bear County and Parmelee were not recorded.

FN6. The return describes what has been referred to in this opinion as the Norem
Building as "Commercial Building Bozeman".

FN7. Sec. 1374(c)(2) provides as follows: (2) Limitation.??A shareholder's portion of


the net operating loss of an electing small business corporation for any taxable year shall
not exceed the sum of?? (A) the adjusted basis (determined without regard to any
adjustment under section 1376 for the taxable year) of the shareholder's stock in the
electing small business corporation, determined as of the close of the taxable year of the
corporation, (or, in respect of stock sold or otherwise disposed of during such taxable
year, as of the day before the day of such sale or other disposition), and (B) the adjusted
basis (determined without regard to any adjustment under section 1376 for the taxable
year) of any indebtedness of the corporation to the shareholder, determined as of the
close of the taxable year of the corporation (or, if the shareholder is not a shareholder as
of the close of such taxable year, as of the close of the last day in such taxable year on
which the shareholder was a shareholder in the corporation).

FN8. See also Putnam v. Commissioner, 352 U.S. 82 (1956); Underwood v.


Commissioner, 535 F.2d 309 (5th Cir.1976), affg. 63 T.C. 468 (1975); Perry v.
Commissioner, 47 T.C. 159 (1966), affd. 392 F.2d 458 (8th Cir.1968); Borg v.
Commissioner, 50 T.C. 257 (1968).

FN9. Respondent concedes that the remaining $19,842 in basis may be allowable as a
capital loss at some point. However, because of questions of timing and other factors,
respondent has not allowed the loss to petitioners in the years in issue. Petitioner argues
that any loss attributable to the stock would be a sec. 1244 loss. Petitioners have not
shown that the stock was issued under a written plan or that the other regulatory
requirements were met. Accordingly, petitioner's stock does not qualify as sec. 1244
stock.

GENERAL COUNSEL MEMORANDUM 34895


June 5, 1972

The GCM was asked to resolve the issue as to whether commissions that are paid to a
broker relative to an exchange that is deferred would be both an offset against the amount
realized as to gain, and also added to basis for the property received.

1. Be treated as an offset or reduction to the amount realized to


determine gain;
2. Be an offset to reduce boot received in determining gain
recognized; and
3. Be added to the basis of the property acquired.

The GCM concluded that under Treasury Reg. §1.1031(d)-2, cash paid as consideration
as to an exchange is offset against the boot received when determining realized gain as
well as recognized gain. In addition, it increases the basis. Therefore, this supports their
conclusion.

Cross reference this GCM to Revenue Ruling 72-456, which Ruling looks only to net
cash.

GENERAL COUNSEL MEMORANDUM (#34895)


In re: Exchanges of Property
June 5, 1972 * * * *

This is in response to your memorandum dated February 2, 1972 (T:I:I:P) in which you
referred to this Office, for formal consideration, a proposed revenue ruling concerning
section 1031.

ISSUE

Whether commissions paid to a real estate broker with respect to an exchange of


properties held for productive use in trade or business that results in the total or partial
deferral of the recognition of gain, should be both offset against the amount realized in
determining gain realized and added to basis in determining the basis of the property
received.

CONCLUSION

The proposed revenue ruling takes the position that brokerage commissions paid in
conjunction with a section 1031 exchange should be both offset against amount realized
in determining gain realized and added to the basis of the acquired property, but should
not be offset against boot received in determining gain recognized. It is our opinion that
the amount of brokerage commissions should be treated as consideration paid in the
exchange and offset against amount realized in determining gain realized, offset against
boot received in determining gain recognized, and added to the basis of the acquired
property.

FACTS

The proposed revenue ruling considers the effect of commissions attributable to the
exchange in the situations set forth below.

Situation 1. Taxpayer, not a dealer in property, exchanged his property with an


adjusted basis of $12,000 for property with a fair market value of $20,000 and $10,000 in
cash. He paid a commission of $2,000 to a real estate broker.

Situation 2. Taxpayer, not a dealer in property, exchanged his property with an


adjusted basis of $29,500 for property with a fair market value of $20,000 and $10,000 in
cash. He paid a commission of $2,000 to a real estate broker.

Situation 3. Taxpayer, not a dealer in property, exchanged his property with an


adjusted basis of $10,000 for property with a fair market value of $20,000. He paid a
commission of $2,000 to a real estate broker.

ANALYSIS

It is well established that in capital transactions involving a sale of property, expenses


attributable to the sale cannot be currently deducted as ordinary and necessary expenses,
but may be offset against the amount realized in computing the gain recognized on the
sale. See Spreckles v. Commissioner, 315 U.S. 626 (1942); Frank Cavanaugh, 19 B.T.A.
1251 (1930); H. M. N. Muhle, 19 B.T.A. 1247 (1930). Similarly, in a capital transaction
involving the acquisition of property, expenses attributable to such acquisition cannot be
currently deducted as an ordinary and necessary expense, but may be added to the basis
of the acquired property. See Helvering v. Winmill, 305 U.S. 79 (1938), I. N. Burman, 23
B.T.A. 639 (1931).

The proposed revenue ruling takes the position that brokerage commissions
attributable to an exchange of real estate, under section 1031, must be both offset against
the amount realized in determining gain realized on the exchange and added to basis of
the new property but should not be offset against boot received in determining gain
recognized. The proposed revenue ruling properly cites Spreckles v. Commissioner,
supra, and L. B. Maytag, 32 T.C. 270 (1959) for the proposition that disposition costs are
offset against amount realized. It also cites the case of Leslie Q. Coupe, 52 T.C. 394
(1969) (Acq. C.B. 1970?2, XIX) for the proposition that the disposition expenditures
related to transferred property and the acquisition expenditures related to acquired
property in a nontaxable or partially nontaxable exchange should also be added to the
basis of the acquired property for the purpose of determining the correct gain or loss upon
subsequent disposition of such acquired property. (Emphasis added.)
In that case, the taxpayers contracted to sell their farm, in a series of conveyances, to
the ?? Pacific Company (??) for $2,500 per acre. On advice of counsel, the contract was
reformed to enable the taxpayers to transfer parcels of their farm to third parties in
exchange for other property, and to then have such third parties transfer the individual
parcels to *** for $2,500 per acre. The third parties included the taxpayers' attorneys, ??
and ??

The court held that certain parcels of taxpayers' land were transferred for like kind
property, and, consequently, under section 1031, gain on those transfers would not be
recognized. A transfer of one parcel in exchange for a deed of trust in 1960, was,
however, held to be taxable. Similarly, a purported transfer of taxpayers' residence under
section 1034, in 1961, was held to be taxable. The court then stated that it did not decide
the amount of unrecognized gain on the nontaxable transactions, and that its discussion of
commissions paid to ?? and ?? 'pertains only to those items affecting the currently taxable
transactions.' Leslie Q. Coupe, supra at 413.

The Commissioner argued that the amounts paid to ?? and ?? were attributable mainly
to the acquisition of new properties since they were hired to represent taxpayers in such
acquisitions. See Brief 23506?Y?1 at 46. As such, it was argued that these expenditures
should be added to basis. The court, however, found that ?? spent a substantial amount of
time preparing documents for the disposition of the taxpayers' property. Thus, the court
treated a portion of the commissions paid in 1960 and in 1961 as SELLING expenses
attributable to the taxable sales. The court then stated:

The balance of the amounts ($4,000 in 1960 and $4,800 in 1961) was paid in
connection with the acquisition of the Sala, McEnerney, Bettencourt, and Schauer
properties, [i.e., the valid section 1031 exchanges] and as such are currently
nondeductible expenditures. Petitioners would have us separately allow a portion of the
$5,000 and $6,000 payments as currently deductible fees incurred in obtaining tax advice,
but both fees pertain to a capital transaction and can therefore only represent a part of the
basis of the property acquired, or a SELLING expense of the property sold. Leslie Q.
Coupe, supra at 414. It is our opinion, that since this statement is dictum [FN1] and
ambiguous, it does not support the position adopted in the proposed revenue ruling, i.e.,
that SELLING expenses must be both used to offset amount realized and added to the
basis of the acquired property.

It is our opinion, however, that reliance should be placed on Regs. 1.1031(d)? 2, which
provides that cash paid as consideration in connection with an exchange under section
1031 is offset against boot received for purposes of determining gain realized as well as
for purposes of determining gain recognized. In addition, this cash paid is added in
determining the basis of the acquired property.

In Example (2)(a) and (c) of Regs. 1.1031(d)?2, E transfers his apartment house
(adjusted basis $175,000, fair market value $250,000, subject to a mortgage of $150,000)
and $40,000 to D in exchange for D's apartment house (fair market value $220,000,
subject to a mortgage of $80,000). The $40,000 paid by E figured in the computations of
(1) gain realized, (2) gain recognized, and (3) basis of acquired property: * * * *

In our opinion, for purposes of the above computations, there is no significant


difference between the $40,000 that was paid by E to D and the $2,000 commission paid
by the taxpayer in the proposed revenue ruling. Both were paid to consummate the
exchange. In both situations, as a result of the exchange, the taxpayer paid out cash. The
difference in identity of the payees is not meaningful.

The following computations based on the examples set forth in the facts of the
proposed revenue ruling will demonstrate the effect of this approach. * * * *

In each situation recognized gain is reduced by the expenses of consummating the


transaction. Furthermore, in both types of transactions the gain recognized and the basis
of the 'acquired' property are the same.

Example 2(a) Property worth $20,000 and cash of $10,000 are received for property with
a basis of $29,500 in a section 1031 exchange. The taxpayer incurs a brokerage
commission of $2,000. * * * *

Example 2(b) The same facts exist except that the facts are modified to fit a section 1033
involuntary conversion. * * * *

FN* Section 1033 is inapplicable because the taxpayer did not recognize gain on the
transaction A different result occurs here because losses are not recognized for tax
purposes on section 1031 exchanges. Thus, the basis of the property in example 2(a) is
$1,500 higher than in example 2(b).

Example 3(a) Property with an adjusted basis of $10,000 is exchanged for property with a
value of $20,000. A brokerage commission of $2,000 is paid. * * * *

Example 3(b). The same facts exist but are modified to fit a section 1033(a)(3)
involuntary conversion. * * * *

Here gain the recognized gain and the basis are the same under section 1031 and
section 1033.

Consistent with the above discussion we have revised the proposed revenue ruling and
attached a copy of such revision to this memorandum. * * * *

Acting Chief Counsel Internal Revenue Service Control No. 71?3?05786 SECTION
1031.??EXCHANGE OF PROPERTY HELD FOR PRODUCTIVE USE OR
INVESTMENT 26 CFR 1.1031(b)?1: Receipt of other property or money in a tax free
exchange. 26 CFR 1.1031(d)?1: Property acquired upon a taxfree exchange. REV. RUL.
Advice has been requested concerning the proper treatment to be accorded brokerage
commissions paid relative to exchanges of properties that result in a nontaxable or
partially nontaxable exchange under section 1031 of the Internal Revenue Code of 1954
in the situations described below.

Situation 1. Taxpayer exchanged his property, held for productive use in trade or
business or for investment, with an adjusted basis of $12,000, for property of a like kind,
to be held for productive use in trade or business or for investment, with a fair market
value of $20,000 and $10,000 in cash. He paid a commission of $2,000 to a real estate
broker.

Situation 2. Taxpayer exchanged his property, held for productive use in trade or
business or for investment, with an adjusted basis of $29,500, for property of a like kind,
to be held for productive use in trade or business or for investment, with a fair market
value of $20,000 and $10,000 in cash. He paid a commission of $2,000 to a real estate
broker.

Situation 3. Taxpayer exchanged his property, held for productive use in trade or
business or for investment, with an adjusted basis of $10,000, for property of a like kind,
to be held for productive use in trade or business or for investment, with a fair market
value of $20,000. He paid a commission of $2,000 to a real estate broker.

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

Section 1031(b) of the Code provides, in part, that if an exchange would be within the
provisions of subsection (a) if it were not for the fact that the property received in
exchange consists not only of property permitted by such provisions to be received
without the recognition of gain, but also other property or money, then the gain, if any, to
the recipient shall be recognized, but in an amount not in excess of the sum of such
money and the fair market value of such other property.

Section 1031(c) of the Code provides, in part, that if an exchange would be within the
provisions of subsection (a) if it were not for the fact that the property received in
exchange consists not only of property permitted by such provisions to be received
without the recognition of gain or loss, but also of other property or money, then no loss
from the exchange shall be recognized.

Section 1.1031(d)1(c) of the Income Tax Regulations provides, in part, that if, upon an
exchange of properties of the type described in section 1031, the taxpayer received other
property (not permitted to be received without the recognition of gain) and gain from the
transaction was recognized as required under section 1031(b), the basis of the property
transferred by the taxpayer, decreased by the amount of any money received and
increased by the amount of gain recognized, is the basis of the properties (other than
money) received on the exchange.

Section 1.1031(d)2 of the regulations, example (2), indicates that money paid out in
connection with an exchange under section 1031 is offset against boot received in
computing gain realized and gain recognized and is also added in determining the basis of
the acquired property. * * * *

BOOT:
GOLDBERG

There were numerous tax issues involved in this very long and extensive case.
However, focusing on the exchange issue, the Court was faced with the issue as to
whether the requirements under Code §1031 were met. The Court concluded that the
taxpayer received a partially taxed transaction, not a totally-deferred transaction under
Code §1031, given that the taxpayer received cash, or boot, which resulted in taxable
gain.

Leo and Alla GOLDBERG, Petitioners


v.
COMMISSIONER OF INTERNAL REVENUE, Respondent.
No. 18842?94. United States Tax Court
T.C. Memo. 1997-74 1997 WL 53452 (U.S.Tax Ct.)
Feb. 11, 1997. * * * *
MEMORANDUM FINDINGS OF FACT AND OPINION

COHEN, Chief Judge:

Respondent determined deficiencies in, additions to, and penalties on petitioners'


income taxes as follows: * * * *

In the alternative to fraud, respondent determined that petitioners were liable for the
section 6653(a) addition to tax for negligence for 1988 and the section 6662(a)
accuracy?related penalty for 1990 and 1991. Unless otherwise indicated, all section
references are to the Internal Revenue Code in effect for the years in issue, and all Rule
references are to the Tax Court Rules of Practice and Procedure.

After concessions by the parties, the issues remaining for decision are: * * * *

FINDINGS OF FACT

Some of the facts have been stipulated, and the stipulated facts are incorporated in our
findings by this reference. Petitioners, Leo Goldberg (petitioner) and Alla Goldberg (Mrs.
Goldberg), were married and resided in Orange County, California, at the time they filed
their petition.
Petitioner immigrated to the United States from the Soviet Union in 1977. Petitioner
received a degree in engineering from Moscow University, and he earned an M.B.A.
from Pepperdine University in December 1987. Petitioner has been involved, at least to
some extent, with real estate since 1986. He became familiar with Internal Revenue Code
provisions dealing with real estate transactions. He prepared petitioners' tax returns for
each of the years in issue. Mrs. Goldberg signed the returns, but petitioner did not go over
the contents of the returns with her nor did she review the returns line by line.

Petitioners reported the receipt of the following amounts on their 1988 return: * * * *

Exchange Properties

On or about January 31, 1986, petitioners acquired for $205,000 an interest in certain
property in Orange County, California, known as the Detroit properties. In February
1986, petitioners conveyed an undivided one half interest in the Detroit properties to
Boris and Natliya Landau (the Landaus) for no cash consideration.

In August 1988, petitioners entered into an exchange agreement under which they
would exchange their interest in the Detroit properties for yet unspecified property that
was subject to a mortgage of at least $106,523. By grant deed dated August 31, 1988,
petitioners transferred their interest in the Detroit properties to IEC. IEC and the Landaus
then conveyed the Detroit properties to a purchaser for $365,000, or $182,500 for
petitioners' one half interest. On their 1988 return, petitioners reported that their adjusted
basis in the Detroit properties was $132,840 and that the Detroit properties were sold in a
transaction in which no gain or loss was recognized under section 1031. By the end of
1988, petitioners had taken depreciation on the Detroit properties equal to $14,073.

On or about July 10, 1986, petitioners acquired an interest in certain real property in
Huntington Beach, California, known as the 8th Street property. On or about August 19,
1986, petitioners acquired an additional interest in the 8th Street property.

In September 1988, petitioners entered into an exchange agreement with IEC to


exchange their interest in the 8th Street property for, as of then, unidentified property. By
grant deed dated September 12, 1988, petitioners transferred their interest in the 8th
Street property to IEC. IEC then conveyed the 8th Street property to a purchaser for
$344,000. Petitioners reported that their adjusted basis in the 8th Street property was
$219,234 and that allowable depreciation totaled $13,753. On their 1988 return,
petitioners reported that the 8th Street property was sold in a transaction in which no gain
or loss was recognized under section 1031.

Standard Pacific allowed each purchaser to purchase only one home on Hastings
through its lottery system. Lisa Shumin (Shumin), Mrs. Goldberg's mother, entered the
lottery with Standard Pacific and was selected to acquire 29 Hastings. The total purchase
price of 29 Hastings was $475,000. Standard Pacific received an initial deposit of $8,000
in Shumin's name on or about May 2, 1988.
During 1988 through 1990, Shumin worked as an accountant and earned
approximately $24,000 per year. Shumin qualified to purchase 29 Hastings only because
she misrepresented her income and job title on the Buyer's Financial Worksheet provided
to Standard Pacific's representative and on the loan application with Home Savings of
America under which the bank loaned $356,200 to her. Of the $122,500 that was needed
as a downpayment to acquire 29 Hastings, petitioners provided at least $93,500,
including the initial deposit and $80,000 that was transferred from petitioners' escrow on
the sale of 14 Siros.

On August 14, 1988, escrow opened for Shumin's purchase of 29 Hastings. Shumin
paid $10,119 for flooring installed in 29 Hastings. From December 2, 1988, until
February 1989, Shumin paid $46,500 for landscape improvements to 25 and 29 Hastings.
On October 5, 1988, petitioners, Shumin, and IEC executed a document entitled
"Acquisition of Exchange Property Instructions" that designated 29 Hastings as the
exchange property for the Detroit properties and the 8th Street property. IEC agreed to
purchase 29 Hastings for $540,000.

Escrow closed for Shumin's purchase of 29 Hastings on October 21, 1988. The
proceeds from Shumin's $356,200 Home Savings of America loan were remitted to
Standard Pacific.

On December 15, 1988, escrow closed on Shumin's sale of 29 Hastings to petitioners


(through IEC), and she received $180,094 from Merrill Lynch Escrow. Petitioners
assumed the Home Savings of America loan on 29 Hastings. The proceeds from the sales
of the Detroit properties and the 8th Street property resulted in a balance of
approximately $219,516.78 in petitioners' escrow account. Approximately $184,000 of
these funds was needed for the purchase of 29 Hastings. Instead of receiving the excess
proceeds from the escrow, petitioners, under the terms of the exchange agreement,
deposited the excess proceeds to be used to pay down the mortgage they assumed on 29
Hastings. On December 21, 1988, Home Savings of America received $36,335.11 from
Merrill Lynch Escrow on behalf of petitioners to be applied to reduce the mortgage on 29
Hastings. Home Savings of America confirmed, in a letter to petitioners dated February
1, 1989, that petitioners' December 20, 1988, payment was received on December 21,
1988, and was applied to the principal ($33,366.58) and to the interest ($2,818.53) on the
29 Hastings loan.

Petitioners realized gain from the above exchange transactions in an amount equal to
the following:

Unreported Income?? Like-Kind Exchange

Respondent initially argued that petitioners' transfer of $80,000 from the 14 Siros
escrow to Shumin for the downpayment on 29 Hastings and their provision of other
amounts necessary for Shumin's purchase of 29 Hastings somehow alter the exchange.
Respondent has not argued that petitioners were not repaid for the advances to Shumin.
That petitioners provided funds for Shumin's purchase of 29 Hastings does not change
the treatment of the exchange of properties. In 124 Front Street, Inc. v. Commissioner, 65
T.C. 6 (1975), the taxpayer owned an option to purchase property that Fireman's
Insurance Company (Fireman's) wanted to acquire. Fireman's advanced to the taxpayer
the funds to acquire the property so that the taxpayer could exchange the property for
property owned by Fireman's. We held that the transaction was a like?kind exchange and
that the advance, which was bona fide, was not boot to the taxpayer. Id. at 15?16; see also
Biggs v. Commissioner, 69 T.C. 905 (1978), affd. 632 F.2d 1171 (5th Cir.1980). In the
instant case, as in 124 Front Street, Inc., there is no evidence that the advances that were
made by petitioners were not bona fide. Petitioners acquired 29 Hastings in a transaction
that will be respected for tax purposes. See, e.g., Estate of Bowers v. Commissioner, 94
T.C. 582, 590 (1990); Biggs v. Commissioner, supra at 918 (courts have afforded great
latitude in structuring exchanges under section 1031).

Section 1031(a) provides the general rule that "No gain or loss shall be recognized on
the exchange of property held solely 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." Emphasis added.
Petitioners exchanged two pieces of real estate (the Detroit properties and the 8th Street
property) for one piece of real estate (29 Hastings) plus the excess cash proceeds. Cash is
not property of like kind to real estate, and, thus, petitioners' exchange was not solely in
kind. Gain must be recognized to the extent of such cash received (boot). See sec.
1031(b).

The excess proceeds must be taken into account as boot because the replacement
property, 29 Hastings, cost IEC less than the proceeds available from the disposition of
the relinquished property. By using the excess proceeds to increase their equity in 29
Hastings (by reducing the mortgage) instead of receiving the excess proceeds outright,
petitioners attempted to avoid treating the excess proceeds as property not of like kind.
That petitioners, not IEC, agreed to pay down the mortgage on 29 Hastings is indicative
of petitioners' control over the excess proceeds. " 'The power to dispose of income is the
equivalent of ownership of it. The exercise of that power to procure the payment of
income to another is the enjoyment, and hence the realization, of the income by him who
exercises it.' * * * [The taxpayer's] failure to receive cash was entirely due to his own
volition." Murphy v. United States, 992 F.2d 929, 931 (9th Cir.1993) (quoting Helvering
v. Horst, 311 U.S. 112, 118 (1940)). Petitioners realized gain of over $176,000 and, thus,
must recognize gain on the exchange equal to $36,335.11. Sec. 1031(b). * * * *

Decision will be entered under Rule 155.

PARTIALLY TAXABLE TRANSACTION: COLEMAN

Where a taxpayer attempts to come within tax-deferred Code Section 1031(a), and the
taxpayer also receives non-like-kind property in the form of debt relief, cash or other
property, taxation of that gain can be generated. This is illustrated in the Coleman case.
COLEMAN
v.
COMMISSIONER OF INTERNAL REVENUE.
180 F.2d 758 (8th Cir. 1950)

GARDNER, Chief Judge.

Petitioner seeks a review of the decision of the Tax Court which adjusted a deficiency
in his income taxes for the taxable year 1944, in the sum of $3,985. The facts are not in
dispute and so far as here material they are substantially as follows: Petitioner is engaged
in the business of cotton growing and farming and owns a number of farms in
southeastern Missouri. In about 1936 he acquired a farm of 754 acres in southeastern
Missouri known as the 'Babler Farm.' In 1944 he made an oral agreement with one
Clayton to exchange the 'Babler Farm' for a farm consisting of 886 acres known in the
record as the 'Carroll Farm' and to pay Clayton $21,000 in cash. It transpired, however,
that the 'Carroll Farm' was encumbered by a mortgage for $35,000 and the owner of the
indebtedness would not accept advance payment of the loan. As the oral agreement could
not be consummated petitioner then entered into a written contract with Clayton, by the
terms of which he agreed to deed the 'Babler Farm' to Clayton in exchange for the
'Carroll Farm,' to assume the $35,000 mortgage, and to receive from Clayton $14,000 in
cash. This written contract for the exchange of properties was consummated and
petitioner received the $14,000 in cash, which was deposited in his general bank account.
Petitioner made no agreement that the $14,000 received by him was to be used
specifically to apply on the payment of the loan secured by the mortgage. The 'Carroll
Farm' had a fair market value at the time of the transaction of $64,432 but was mortgaged
to the extent of $35,000. The 'Babler Farm' was carried on petitioner's books at an
adjusted cost of $20,384.12. It is conceded that by this transaction petitioner profited in
an amount exceeding $20,000. It was the contention of petitioner in the Tax Court, and he
renews the contention here, that the exchange of these farms was a non?taxable exchange
under Section 112(b)(1) of the Internal Revenue Code, 26 U.S.C.A. 112(b)(1). The
respondent, on the other hand, contended before the Tax Court and here contends, that
the exchange came under the provisions of Section 112(c)(1) of the Internal Revenue
Code and was taxable to the extent of the $14,000.00 cash received. This is the sole issue
presented.

In seeking reversal petitioner states his theory of the case as follows: (1) that in the
exchange of the farms he transferred his 'Babler Farm' free and clear of encumbrances for
the 'Carroll Farm' free and clear of encumbrances, and gave $21,000 to boot, as a result of
which the exchange was a non?taxable exchange under Section 112(b)(1) of the Internal
Revenue Code; (2) that the $14,000 received was not boot for his 'Babler Farm,' but was
a payment upon the $35,000 mortgage which could not be reduced and which he assumed
and agreed to pay; (3) that the petitioner has not received income as defined by the
Constitution and laws of the United States, but has merely increased his investment by
the exchange in the sum of $21,000.
Section 112(b)(1) of the Internal Revenue Code, so far as here material, reads as
follows: 'No gain or loss shall be recognized if property held for productive use in trade
or business or for investment * * * is exchanged solely for property of like kind to be
held either for productive use in trade or business or for investment.

' The 'Babler Farm' was held by petitioner for productive use and the 'Carroll Farm' was
of like character.

Section 112(c)(1) of the Internal Revenue Code, so far as here pertinent, reads as
follows: 'If an exchange would be within the provisions of subsection (b)(1), (2), (3), or
(5), or within * * * Subsection (1), of this section if it were not for the fact that the
property received in exchange consists not only of property permitted by such paragraph,
or by subsection (1), to be received without recognition of gain, but also of other property
or money, then the gain, if any, to the recipient shall be recognized, but in an amount not
in excess of the sum of such money and the fair market value of such other property.'

It is conceded that the exchange resulted in a gain for petitioner in an amount exceeding
the $14,000 cash which he received. The transaction as it was actually consummated was
evidenced by the written contract between the parties and not by the previous oral
agreement which was abandoned. We must determine the issue by considering what was
actually done rather than what the parties might have done or, indeed, what they may
have had in mind but were unable to consummate. Confessedly, there was here an
exchange of farms held for productive use or for investment but the exchange did not
consist solely of such property. Petitioner received not only the 'Carroll Farm,' but he
received other property; to wit, the sum of $14,000. That much of his gain in the
transaction was realized and the gain must be recognized to the extent of the cash
received.

Petitioner's argument is bottomed on the theory that originally the parties had agreed to
exchange the properties on a plan requiring petitioner to pay $21,000 in cash and it is
argued that this agreement expressed the actual purpose of the parties. But it was found
that it was not possible to consummate the transaction on the plan originally agreed upon
and hence it was abandoned and a new contract entered into in writing. This contract
must be accepted as reflecting the actual nature of the transaction. Had the original plan
been carried out petitioner would have paid $21,000, but under the transaction as actually
consummated he received $14,000 in cash, which he was at liberty to use as he pleased.
He was not required to apply this payment upon the mortgage indebtedness but he at once
realized a portion of his total gain resulting from the exchange of the properties.

Petitioner, to be entitled to the benefit of Section 112(b)(1), must bring himself squarely
within the explicit provisions of the exception there provided for. Gregory v. Helvering,
293 U.S. 465, 55 S.Ct. 266, 79 L.Ed. 596, 97 A.L.R. 1355; City Bank Farmers Trust Co.
v. Hoey, 2 Cir., 125 F.2d 577. Section 112(a) requires recognition of the total gain so that
petitioner is claiming under an exception to this general rule. The issue before us is
limited to the amount of petitioner's gain which is to be recognized. Section 112(c)(1)
provides for the recognition of gain to the recipient of other property or money to the
extent of the sum of such money or the value of the property received. Petitioner received
$14,000; hence, he had a partial cash realization of his total gain. To the extent that his
gain was thus realized, we think it was taxable. He was not a mere conduit whereby the
$14,000 was conveyed to the holder of the $35,000 mortgage in reduction thereof. He
was under no obligation to apply the $14,000 to the mortgage indebtedness, and in fact
could not presently so do because of the terms of the mortgage. The mortgage
indebtedness was not due but was a long term obligation that might never be paid.

Being of the view that the decision of the Tax Court is correct, the judgment is
affirmed.

REVENUE RULING 84-121

The following Ruling addresses the tax considerations when property that is
transferred in a proposed exchange under Code §1031 also involved an option to buy.

Depending on the facts of a given case, involving options, the exchange treatment
under Code §1031(a) could apply. To the extent there is any boot (non-like-kind
property), taxable gain could be generated (limited to actual gain, as opposed to the boot).

REVENUE RULING 84-121


1984-33 I.R.B. 4
1984-2 C.B. 168
ISSUE

What are the federal income tax consequences to the seller and the purchaser of real
property in the transaction described below?

FACTS

A, an individual, owned a parcel of unencumbered real property that is being used in


A's trade or business and that had an adjusted basis of 50x dollars. For 5x dollars, A
granted to B an option to purchase A's real property for a price of 100x dollars. The
option allowed B to pay the option price in cash or to transfer real property equal in value
to the option price. At the time the option was granted, A's real property had a fair market
value of 100x dollars. B exercised the option before the expiration of the option period,
but instead of paying A 100x dollars in cash, B purchased for 100x dollars another parcel
of real property with a fair market value of 100x dollars and immediately transferred that
property to A. At the time B exercised the option, A's real property had a fair market
value of 150x dollars. A used the property acquired from B in A's trade or business. B is
neither related to A nor employed by A.

LAW AND ANALYSIS


Under section 1001(a) of the Internal Revenue Code, the gain or loss on a sale or other
disposition of property is the difference between the amount realized from the transaction
over the adjusted basis provided in section 1011.

Under section 1031 of the Code, no gain or loss is recognized if property held for
productive use in a trade or business or for investment (not including stock in trade or
other property held primarily for sale, nor stocks, bonds, notes, choses in action,
certificates of trust or beneficial interest, or other securities or evidences of indebtedness
or interest) is exchanged solely for property of a like kind to be held either for productive
use in a trade or business or for investment.

Under section 1031(b) of the Code, if an exchange would be within the provisions of
subsection (a) if it were not for the fact that the property received in exchange consists
not only of property permitted by such provision to be received without recognition of
gain, but also other property or money, then the gain, if any, to the recipient shall be
recognized, but in an amount not in excess of the sum of such money and the fair market
value of such other property.

Under section 1031(d) of the Code, if property was acquired on an exchange described
in section 1031, then the basis shall be the same as that of the property exchanged,
decreased in the amount of any money received by the taxpayer and increased in the
amount of gain or decreased in the amount of loss to the taxpayer that was recognized on
such exchange.

In Rev. Rul. 75?291, 1975?2 C.B. 332, the Internal Revenue Service considered the
income tax consequences of an exchange of land and a factory used by a manufacturing
corporation for land and a factory owned by another corporation that acquired the land
and constructed the factory solely for the purpose of making the exchange. The ruling
holds that the exchange, as to the manufacturing corporation, qualified for nonrecognition
of gain or loss under section 1031 of the Code because it used the property it transferred
in its trade or business, but as to the other corporation, the exchange did not qualify under
section 1031 because the property it transferred had not been used in its trade or business.

Similarly, the exchange of real property here qualifies under section 1031 with respect
to A because both the real property A transferred to B and the real property A received
were used in A's trade or business. The exchange, however, does not qualify under
section 1031 with respect to B because the property B acquired before the exchange was
not used in B's trade or business or held for investment.

In Helvering v. San Joaquin Fruit and Investment Co. 297 U.S . 496 (1936), XV? 1
C.B. 196, the Supreme Court of the United States held that the exercise of an option to
purchase real property is not treated as an exchange of the option and the option premium
for the real property, but rather is treated as an acquisition of the property on the date the
option is exercised. The Court indicated that the basis of real property acquired by the
exercise of an option was the amount paid for the property under the option, not the
property's fair market value on the date of exercise.
In Rev. Rul. 78?182, 1978?1 C.B. 265, 266 (Ruling 4A), dealing with "call" (purchase)
options for stock, it was held that the basis of stock acquired on exercise of a "call"
option is the option price of the stock, which is consistent with the holding of San
Joaquin, plus the premium paid for the option. See also Rev .Rul. 67?96, 1967?1 C.B.
195.

Here, the basis of the property acquired by B upon exercise of the option is the cost of
the property, plus the premium paid for the option. The disposition of property by B in
payment of the option price is a taxable event.

HOLDING

Pursuant to section 1031(b) of the Code, A does not recognize gain or loss on the
transfer of A's real property in exchange for the real property received from B, except to
the extent of the 5x dollars premium paid by B to A for the option. Under section
1031(d), the adjusted basis to A in the property acquired from B is 50x dollars, that is, the
adjusted basis of A's old property of 50x dollars decreased by the 5x dollars received by
A and increased by the 5x dollars of gain recognized by A on the exchange.

When B transfers to A the property that B had acquired in order to exercise the option,
B has disposed of B's property in a taxable transaction because B has not met the
requirements of section 1031. On the present facts, B has no gain or loss because the
amount considered realized by B (the option price of 100x dollars) equals B's basis in the
property (100x dollars). The adjusted basis to B in the property acquired from A is 105x
dollars, the option price for the property that B paid to A, plus the premium for the option
paid by B to A.

INTENT TO HOLD FOR INVESTMENT:


PRIVATE LETTER RULING 8429039

The following Ruling involves an exchange of rental property held by a trust for a
personal residence. The trust was to hold it for rental, but it would be held for less than
two (2) years, according to the terms of the trust. The question was whether this qualified
for an exchange under Code §1031.

PRIVATE LETTER RULING 8429039

* * * This is in reply to a letter dated February 14, 1984, submitted on your behalf by
your authorized representative, requesting a ruling with respect to the applicability of
section 1031 of the Internal Revenue Code to an exchange of rental property held by the
Trust for a personal residence that the Trust intends to rent for a period not less than two
years after the exchange.

The pertinent facts are understood to be as set forth below:


The Trust owns a beach house that it has been renting since January 1982.T is an
individual who owns a personal residence. T wants to exchange the residence for the
beach house held by the Trust. T vacated the residence on November 1, 1981. Since early
1983 the residence has been rented to an unrelated third party. On December 1, 1982, this
office issued an adverse private letter ruling to the Trust under section 1031 of the Code
because the Trust intended to sell the residence soon after its acquisition. The Trust now
represents that it will hold the residence for productive use in a trade or business or for
investment for a period not less than two years from and after the exchange.

Section 1031(a) of the Code provides that no gain or loss shall be recognized if property
held for productive use in trade or business or for investment (excluding certain
enumerated property) is exchanged solely for property of like kind to be held either for
productive use in trade or business or for investment.

In order to qualify for section 1031 nonrecognition, three elements must be present: (1)
the property transferred by the taxpayer must have been held by him either for productive
use in a trade or business or for investment, (2) the property received by the taxpayer
must be held by him either for productive use in a trade or business or for investment, and
(3) the properties transferred and received must be of like kind.

In this case the Trust will exchange rental real property for other real property which it
will hold as rental property for a minimum of two years. This is a sufficient period to
ensure that the residence to be acquired will meet the holding period test prescribed by
section 1031 of the Code, which requires that the property received by a taxpayer be held
either for productive use in a trade or business or for investment.

Accordingly, based on the information submitted, we conclude that the exchange by the
Trust of the beach house for the residence will qualify as a nontaxable exchange under
section 1031 of the Code. * * * *

CHASE

This case illustrates the interplay of installment sales and exchanges, along with what
was held to be a sale, not an exchange.

DELWIN G. CHASE AND GAIL J. CHASE, Petitioners


v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
92 T.C. No. 53 (1989) * * * *

FAY, JUDGE:

Respondent determined a deficiency in petitioners' Federal income tax for the 1980
taxable year in the amount of $1,074,874. After concessions, the following issues are
presented for decision:
(1) Did petitioners satisfy section 1031 [FN1] on the disposition of the John Muir
Apartments? * * * *

We hold that, applying the substance over form doctrine, the John Muir Investors, a
partnership, rather than petitioners disposed of the John Muir Apartments. Further, we
hold that petitioners, as partners of John Muir Investors, are not entitled to the benefits of
section 1031 nonrecognition. * * * *

FINDINGS OF FACT

Some of the facts have been stipulated. The stipulated facts and attached exhibits are
incorporated herein by this reference.

Petitioners Delwin G. Chase ('Mr. Chase') and Gail J. Chase ('Mrs. Chase'), resided in
Alamo, California, at the time their petition herein was filed. Petitioners filed a joint
Federal income tax return for the year at issue.

DISPOSITION OF THE JOHN MUIR APARTMENTS

On January 26, 1978, Mr. Chase formed John Muir Investors ('JMI'), a California
limited partnership. JMI was formed for the purpose of purchasing, operating and holding
the John Muir Apartments, an apartment building located in San Francisco, California
(hereinafter referred to as the Apartments), which were purchased by JMI on March 31,
1978, for $19,041,024. Subsequently, Triton Financial Corporation ('Triton') was added
as a general partner of JMI. Triton was a corporation in which petitioner held a
substantial interest. Mr. Chase and Triton were general partners who had the exclusive
right to manage JMI.

Pursuant to JMI's limited partnership agreement, once limited partners made


contributions to JMI, they were prohibited from receiving distributions of property, other
than cash, in liquidation of their capital contributions to JMI. A section of the JMI limited
partnership agreement entitled 'status of limited partners' provided as follows:

No limited partner shall have the right to withdraw or reduce his invested capital except
as a result of the termination of the partnership or as otherwise provided by law. No
limited partner shall have the right to bring an action for partition against the partnership.
No limited partner shall have the right to demand or receive property other than cash in
return for his contribution, and no limited partner shall have priority over any other
limited partner either as to the return of his invested capital or as to profit, losses or
distribution.

After JMI held the Apartments for approximately one year, there developed a high level
of speculative interest in San Francisco in purchasing apartment buildings for conversion
to condominium units for sale to individuals. This speculative interest caused the value of
real estate capable of being converted to condominium units, such as the Apartments, to
appreciate. By mid 1979, JMI was attempting to find a buyer for the Apartments.
On January 20, 1980, JMI accepted an offer ('first offer') to purchase the Apartments
from an unrelated individual for $28,421,000. Subsequent to JMI's acceptance of the first
offer, but prior to the scheduled closing date, petitioners attempted to structure the sale of
the Apartments in such a way that they would not have to recognize any taxable gain. To
accomplish this, Mr. Chase caused JMI to distribute to himself and his wife a deed to an
undivided 46.3527 percent interest in the Apartments in liquidation of petitioners'
46.3527 percent limited partnership interest in JMI. Petitioners attempted to structure the
subsequent disposition of the Apartments pursuant to the first offer so that, as to them,
such disposition would be treated for Federal tax purposes as a nontaxable
nonsimultaneous exchange of real property for other real property.

THE IMPORTANCE OF FORMAT: BORCHARD

In the Borchard case, the Tax Court was faced with the question of whether the
transaction, which took the form of an exchange, failed to qualify under Section 1031
because the taxpayer-transferor was obligated to deliver his property for cash, if suitable
exchange property was not located by a set closing date. An examination of this
important case follows. It supports the proposition of flexibility in this area. This case is
also relevant to the question of nonsimultaneous exchanges (see Chapter 10).

ANTONE BORCHARD and ANNA A. BORCHARD, Petitioners,


v.
COMMISSIONER OF INTERNAL REVENUE, Respondent.
24 T.C.M. 1643, T.C. Memo. 1965?297
MEMORANDUM FINDINGS OF FACT AND OPINION.

HOYT, Judge:

Respondent determined a deficiency of $121,500.88 in the income tax of petitioners


Antone and Anna A. Borchard for the taxable year 1958. The sole issue for decision is
whether the transfer by petitioners of certain parcels of land constituted a taxable sale or a
nontaxable exchange.

FINDINGS OF FACT.

Some of the facts have been stipulated and the Stipulation of Facts and exhibits
attached thereto are incorporated herein by this reference. The petitioners are husband
and wife presently residing in Santa Ana, California. They filed a joint income tax return
for the year 1958 with the district director of internal revenue at Los Angeles, California.

In February 1957, and at all times thereafter until on or about January 7, 1953,
petitioners jointly were the owners of two parcels of real property located in Orange
County, California, which two parcels comprised approximately 160 acres in total. These
two parcels together will hereinafter be referred to as the Orange County property.
During 1957 and for many years prior thereto, petitioners used the Orange County
property for agricultural purposes. During the latter part of 1956 Reginald F. Keller, a
real estate broker, hereinafter referred to as Keller, was employed by Burroughs
Corporation to locate a parcel of real property within a radius of approximately 30 miles
of the City of Los Angeles which Burroughs might acquire for a manufacturing plant site.

At some time on or before February 28, 1957, Keller contacted petitioners and inquired
whether they would be interested in selling their Orange County property. Petitioners told
Keller that they might consider selling the property but they would prefer to exchange it
for other farm property. Keller told petitioners that he and his client, Burroughs
Corporation, would not enter into a transaction with petitioners if the consummation of
such transaction were dependent solely upon the parties' ability to make an exchange;
Keller and Burroughs wanted assurance that Burroughs could acquire the property even if
an exchange could not be worked out. Keller also advised petitioners that any transaction
must be contingent upon the proper zoning of the property for his client's use. Burroughs
only needed about 65 acres, but petitioners would not consider transferring anything less
than the entire 165 acres.

Petitioners said they would consider a sale at $6,000 an acre, but suggested that Keller
speak to their son-in-law who was an attorney. Keller informed Burroughs about the
possible availability of the Orange County property, advising that the acreage beyond the
corporation's needs for its plant could be resold at no loss. Burroughs was interested and
wanted to make soil tests and investigate other matters such as sewers, water, lights,
curbs, sidewalks and labor supply, but it would not proceed further without some form of
option on the property.

On February 28, 1957, petitioners gave to Keller a written option to acquire the Orange
County property, which option provided in pertinent part as follows: During this period
you may assign this option to a responsible major national manufacturing corporation, or
to any other responsible organization or individual satisfactory to us. On or before April
15, 1957, this option may be exercised by you, or by your assignee, by the opening of a
proper escrow at the Title Insurance & Trust Company, Santa Ana, California, which
escrow shall include the following provisions:

1. This escrow will close on October 1, 1957, and we shall be


entitled to the proceeds of all crops grown on said property
during the current season.
2. The consideration for said property, at our option, shall be
either other real property acceptable to us, or shall be the net
sum of $960,000.00 cash, or shall be a combination of such real
property and cash. In the event such real property shall not be
found prior to the close of this escrow, we shall nevertheless be
obligated to convey said property at the close of this escrow for
the sum of $960,000.00 cash.
3. The sum of $25,000.00 cash shall be deposited upon the
opening of this escrow, which sum shall be credited against the
purchase price of such other real property, or against the
purchase price of this property, as the case may be, at the close
of this escrow. In the event this escrow is cancelled by you or
your assignee, said sum shall be immediately paid to us.
4. This escrow shall be made contingent upon the ability of you or
your assignee to secure the annexation of said property to the
City of Santa Ana, and to secure a use variance, or change of
zone, as the case may be, covering the proposed use of said
property by you or your assignee. (Emphasis supplied.)

On or about March 5, 1957, petitioners delivered to Keller a written modification of the


option dated February 28, 1957. This modification was in all material respects a
repetition of the terms of the original document with the exceptions that a recital of
nominal consideration for the granting of the option was added and the following
sentence was added to the end of the paragraph numbered 2 in the above quoted excerpt:
In no event shall your obligation for the purchase price of said property (whether by
purchasing other property or by direct purchase) exceed the sum of $960,000.00.

On or about April 8, 1957, petitioners delivered to Keller a further modification of the


option. This modification extended the option termination date from April 15 to April 29,
1965, and it extended the date for close of escrow (i.e., the date by which petitioners
would be required to deed the property to the transferee if the option were exercised)
from October 1, to November 15, 1957.

On April 25, 1957, an escrow was opened at Title Insurance and Trust Company, Santa
Ana, California (hereinafter referred to as 'Title Co.'), between petitioners and Burroughs
Corporation. On that date petitioners and Burroughs executed a form document entitled
'EXCHANGE ESCROW INSTRUCTIONS,' which contained the following pertinent
provisions:

[FN1] EXCHANGE ESCROW INSTRUCTIONS


Escrow No. 241810
MGL cb Santa Ana, California
April 25, 1957
TITLE INSURANCE AND TRUST COMPANY:

On or before October 1, 1957, I will hand you or cause to be handed you a deed or
deeds covering real property acceptable to Borchards or the net sum of $960,000.00 cash
or a combination of real property and cash, and I hand you the sum of $25,000.00
herewith which sum shall be credited against the purchase price as herein provided, (The
description of property so selected by Borchard to be furnished you at a later date and
made a part of these instructions.) (herein referred to as FIRST property) * * * *
providing you obtain for me a deed to (A detailed description of the Orange County
property is here inserted.) (herein referred to as SECOND property) The closing of this
escrow is contingent upon the ability of R. F. Keller and/or Burroughs Corporation to
secure:

(a) The annexation of said property to the city of Santa. All on


terms acceptable to R. F. Keller and/or Burroughs Corporation.
(b) A Use Variance, or change of zone as the case may be,
covering the proposed use of said property by Burroughs
Corporation, all on terms acceptable to said corporation.
(c) Title in form satisfactory to Burroughs Corporation and/or R. F.
Keller.

As a memorandum in this escrow with which Title Insurance and Trust Company is in
no way to be concerned, it is mutually agreed that these instructions are entered into by
the parties hereto for the purpose of enabling Title Insurance and Trust Company to close
this escrow but it is in no way intended to in any way modify, supplement or supersede
that certain agreement executed by and between R. F. Keller and Antone Borchard and
Anna A. Borchard, dated March 5, 1957, as amended.

In the event said escrow is cancelled by Burroughs Corporation and/or R. F. Keller for
any reason other than the three contingencies above shown the $25,000.00 deposited
herewith shall be immediately paid to the Borchards as liquidated damages, it being
understood that it will be impossible or impracticable to determine actual damages in
such event. However, if said escrow is cancelled by the Burroughs Corporation and/or R.
F. Keller under any of the three contingencies above shown, said $25,000.00 is to be
refunded to said Burroughs Corporation and/or R. F. Keller. In the event said escrow is
cancelled for any reason whatsoever Burroughs Corporation and/or R. F. Keller agree to
deliver all engineering data, maps, surveys, soil test reports and any other data pertaining
to said Land to the Borchards. (Here there appear signatures of Keller and an official of
Burroughs Corporation.) Santa Ana, California TITLE INSURANCE AND TRUST
COMPANY: April 25, 1957 I have read and approve the foregoing instructions.

On or before October 1, 1957 19_ _ (sic) I will hand you a deed to said SECOND
property to the vestee shown, executed by the undersigned which you will deliver when
you obtain for me a deed to * * * property acceptable to the undersigned (sic) and when
you can issue your title insurance policy on the title to said land * * * and when you hold
for me the sum of $960,000.00 in cash or property.

In the event real property acceptable to the undersigned shall not be found prior to the
closing date of this escrow, we shall nevertheless be obligated to convey 'Second
Property' at the close of said escrow for the sum of $960,000.00 cash.

In no event shall R. F. Keller and/or Burroughs Corporation's obligation for the


purchase price of said property (whether by purchasing other property or by direct
purchase) exceed the sum of $960,000.00. (At the end of the document there appear
spaces for the signatures of both petitioners.)

[FN2] The escrow established by this document will hereinafter sometimes be referred
to as Escrow No. 241810. The $25,000 referred to in the above?quoted excerpts from
Escrow No. 241810 was deposited by Keller on behalf of Burroughs, as provided. By two
separate written amendments to the escrow instructions, dated July 31, 1957, and
December 26, 1957, the date for closing of the escrow was extended to January 7, 1958.

During the autumn of 1957 petitioners secured the annexation of the Orange County
property to the City of Santa Ana and arranged for the rezoning of the property from
residential to light industrial, both of which actions were conditions precedent to the
closing of escrow No. 241810.

During 1957 petitioners attempted to locate other suitable real property which they
might be willing to accept from Burroughs in exchange for their Orange County property.
Prior to 1957 they had owned property in Imperial County, California, and they had for
many years prior to 1957 looked at Imperial County properties with a view to some day
acquiring a parcel there in exchange for their Orange County property. After contacting
real estate brokers in 1957, petitioners located four separate parcels of real property in
Imperial County which they were willing to take in trade. These four parcels were owned
by separate individuals, hereinafter referred to, respectively, as Singh, Church, W.
Ferguson and C. Ferguson. The prices at which these individuals would sell their
properties were ascertained by petitioners through real estate brokers representing the
individuals, however, petitioners at no time ever committed themselves either orally or in
writing to buy any of these properties.

In a letter to Burroughs dated November 4, 1957, petitioners approved escrow


instructions proposed to be entered between Burroughs and the Churches and to accept
the Churches' Imperial County property 'in partial satisfaction (to the extent of
$600,000.00)' of Burroughs' obligations under Escrow No. 241810. On that same date
Burroughs and the Churches entered into an escrow (hereinafter referred to as the Church
escrow) for the purchase by Burroughs of the Church property for $600,000, and escrow
instructions were executed.

In three separate letters dated December 18, 1957, petitioners notified Burroughs that
they would accept the Singh, W. Ferguson and C. Ferguson properties in partial
satisfaction of Burroughs' obligations under Escrow No. 241810. These letters were all
identical in material respects to the November 4, 1957, letter referred to above.

The letters agreed to accept the Singh property in satisfaction of Burroughs' obligations
'to the extent of approximately $36,000.00,' the W. Ferguson property 'to the extent of
approximately $207,500.00,' and the C. Ferguson property 'to the extent of approximately
$112,460.00.' Also on December 18, 1957, Burroughs entered into three separate escrows
with the Singhs, W. Ferguson, and C. Ferguson, respectively, for the purchase by
Burroughs of their respective Imperial County properties at prices corresponding to the
amounts referred to above in the respective letters from petitioners to Burroughs. Escrow
instructions were executed. The escrows for the purchase by Burroughs of all four
Imperial County properties were entered with Title Co., the same escrow agent involved
in Escrow No. 241810. Each of the four contained a clause making closing contingent
upon the closing of Escrow No. 241310; each provided that Burroughs would pay no
charges. On January 6, 1958, Keller, acting for Burroughs, delivered to Title Co. a check
issued by Burroughs in the amount of $937,707.60.

On January 7, 1958, all of the five escrows to which Burroughs was a party were
closed. On the same day, four separate deeds were recorded in the County Recorder's
office of Imperial County conveying the Singh, Church, W. Ferguson and C. Ferguson
properties to Burroughs. Also on January 7, 1958, four separate deeds conveying these
properties from Burroughs Corporation to petitioners were recorded, and the Orange
County property was conveyed by petitioners to Burroughs. Prior to the transfer of the
Orange County property to Burroughs, petitioners held it for productive use for
agricultural purposes in their trade or business or for investment, and not primarily for
sale. In 1957 the Church, Singh, W. Ferguson and C. Ferguson properties were being
used for agricultural purposes, and petitioners continued to use them for agricultural
purposes in their trade or business or as an investment after they were acquired by
petitioners in January 1958. All of these properties were of a like kind.

OPINION.

It is the position of petitioners that the transactions detailed in our Findings of Fact
constituted a tax-free exchange of properties of like kind within the meaning of section
1031 of the 1954 Code.

[FN3] Respondent, on the other hand, determined that the transactions amounted to a
sale by the petitioners of the Orange County property followed by a purchase by them of
the Imperial County properties, and that there was a taxable long?term capital gain on the
sale of the Orange County property. The principal issue for our decision is simply stated
as follows: Does a transaction which takes the form of an exchange fail to qualify under
section 1031 because the taxpayer?transferor was obligated to deliver for cash but prior
to closing date exercised an option to accept like property instead of cash.

In Mercantile Trust the taxpayer entered into a contract with Title Guarantee and Trust
Co. to exchange properties for other properties not then owned by Title Guarantee. In the
event that Title Guarantee could not obtain ownership of the desired property, the
taxpayers agreed to sell and Title Guarantee to buy taxpayers' property for $300,000 cash.
Four days later Title Guarantee signed a contract with the owners of the specified
exchange property to purchase it, and at the same time agreed to sell the taxpayers'
property it would acquire in the exchange to a third party for $300,000 cash.

The following month the transactions were closed; taxpayers deeded their property to
Title Guarantee; Title Guarantee deeded the property it had purchased for the purpose of
making the exchange to taxpayers. Title Guarantee deeded the property it thus acquired
from taxpayers to the third party for $300,000. The Commissioner disregarded the form
of the transactions and determined that taxpayers had made a sale of their property rather
than an exchange. It was urged that Title Guarantee was an agent or dummy and that the
transaction was a sham and a fictitious device which should be disregarded. We rejected
respondent's arguments and held that there was an exchange of like properties not a sale
so that the nonrecognition of gains provisions of the Code applied.

In James Alderson, supra, a case similar to the instant case in its superficial factual
context, yet factually distinguishable in several legally significant respects, we held that
there was a sale, and not an exchange as the taxpayers contended. In that case, as in this
case, the petitioners owned farm property in Orange County, California. They entered
into an agreement to sell their land to a corporation (referred to as Alloy) for cash, and an
escrow was opened for that purpose. They did not advise the purchaser that they intended
or desired to make an exchange. Several months later the taxpayers located other property
in Monterey County which they wished to acquire. Taxpayers and Alloy then executed an
amendment to their escrow to provide that Alloy would acquire the Monterey County
property, and then exchange it for the taxpayers' property. On the same day as this
amendment was executed, taxpayers, not Alloy, entered into an escrow to purchase the
Monterey County property from its then owners, instructing that the deed thereto should
be delivered to Alloy.

Subsequently Alloy deposited into the Monterey County property escrow the exact
amount of cash which Alloy had originally agreed to pay for the Orange County farm.
The Monterey County property was deeded to Alloy and Alloy then deeded it to the
taxpayers, and received from them a deed to the Orange County farm. We held that the
series of steps taken in Alderson amounted to a sale and purchase and not an exchange.
We concluded that the taxpayers had been the true purchasers of the Monterey County
property and that Alloy took title thereto merely as a conduit through which title was
actually conveyed from the owners of the property to taxpayers. Such is not the situation
in the instant case.

[FN4] The critical distinction between this case and Alderson, as we view the facts, is
that in Alderson the taxpayers entered into a contract to sell their property to Alloy for
cash and made no contract at that time for an exchange. Thereafter, acting for themselves,
they took the steps which led to the conveyance by the owners of the Monterey County
property to Alloy. There the petitioners executed the escrow for the conveyance of that
property, and by the terms of that escrow they were unconditionally liable for the
purchase price. We stated at page 221: Nothing in the record indicates that Alloy was the
purchaser of the (Monterey County) property. Nor is there any indication that Alloy was
liable for any part of the purchase price of that property. Petitioners have introduced no
evidence which would substantiate the possibility that petitioners merely acted for Alloy
in acquisition of the (Monterey County) property. Thus, we are not faced with a situation
in which a party wishing to acquire title to a taxpayer's property acts independently, and
for itself, to acquire another piece of property desired by the taxpayers in order to
exchange it for the property which the purchaser wants.

Unlike Alderson, we are here faced with the situation described in the last quoted
sentence. With the exception of locating the parcels and ascertaining the selling prices,
petitioners here took no part in the acquisition of title to the four Imperial County
properties by Burroughs. Petitioners entered no negotiations to purchase those properties,
nor agreements, formal or informal, oral or written, with any of the Imperial County land
owners.

It was Burroughs that negotiated and contracted with these land owners; Burroughs that
entered the four escrows with them; Burroughs that put up the cash used to purchase the
four parcels; and Burroughs to which the owners deeded the property. On these facts
there can be little question that it was Burroughs, not petitioners, that purchased the
Imperial County farms for which petitioners then exchanged their Orange County land.

The key distinction [FN5] between the instant case and Alderson is the same as the
distinction we recognized in Alderson between that case and our earlier decision in
Mercantile Trust Company of Baltimore, supra, in which we held, on facts even more
favorable to respondent but substantially identical to those before us here, that there was
a tax?free exchange. Respondent argues that while in form the transaction may have been
an exchange, in substance it amounted to a sale and purchase. This was not the case in
Mercantile Trust Company of Baltimore, supra, and as we view the facts herein, it is not
the case here. Respondent at trial, and to a more limited extent on brief, contended that
petitioners' Orange County property was held primarily for sale and was therefore
specifically excluded from the non recognition provisions of section 1031, and also that
the Orange County and Imperial County properties were not of like kind. Our Findings
indicate our conclusions as to those matters.

To the extent these positions were not abandoned on brief we hold that they are without
merit. Petitioners have satisfactorily proved that their Orange County property and the
Imperial County properties were farm lands held by them for productive use in their trade
or business or for investment. See section 1.1031(a)??1(b), Income Tax Regs.

FN4 Although we find this case distinguishable on its facts from James Alderson, 38
T.C. 215 (1962), we note that on appeal even the facts in Alderson were regarded by the
Court of Appeals as resulting in a tax?free exchange. Alderson v. Commissioner, 317
F.2d 790 (C.A. 9, 1963). FN5 Another factual distinction between the two cases is that in
Alderson the original transaction between taxpayers and Alloy was a straight cash sale
which was later amended after taxpayers located property they wished to acquire and
then advised Alloy that they desired to make a trade rather than a sale; in the instant case
petitioners at all times desired and intended to make an exchange and so advised
Burroughs, and the transaction from the outset contemplated an exchange.

SERIES OF TRANSACTIONS

Taxpayer thus argues that there was no gain or loss to him after the series of
transactions which resulted in an exchange. With regard to the congressional intent
behind the nonrecognition section he notes this court's holding in Century Electric Co. v.
C.I.R., 192 F.2d 155, 159 (8th Cir. 1951), that the section is to be applied 'where in
theory the taxpayer may have realized gain or loss but where in fact his economic
situation is the same after as it was before the transaction.' In finding that a sale had
actually taken place and that taxpayer had realized a taxable gain, the Tax Court rejected
taxpayer's argument that his financial position was unchanged.

It reasoned that the 1968 purchase of the Custer County land was not a transaction to be
considered because it was not part of the over all design to make a §1031(a) exchange.
The Tax Court ruled that only those transactions which were executed in contemplation
of the exchange should be considered in determining whether a sale or exchange had
actually taken place. The court thus eliminated from consideration the taxpayer's position
that theoretically the $40,000.00 he received was the same $40,000.00 he himself had
paid for the land, but considered as relevant the taxpayer's transfer of 516 acres to his
brother for $40,000.00. We are mindful of authority holding that a transaction may not be
separated into its component parts for tax purposes. Century Electric Co. v. C.I.R., supra,
192 F.2d at 159. See also C.I.R. v. Court Holding Co., 324 U.S. 331, 334, 65 S.Ct. 707,
89 L.Ed. 981 (1945); Redwing Carriers, Inc. v. Tomlinson, 399 F.2d 652 (5th Cir. 1968);
Alderson v. C.I.R., 317 F.2d 790, 793 (9th Cir. 1963).

But we have reviewed the record and hold that substantial evidence supports the finding
of the Tax Court that the 1968 purchase was not, while the conveyance of the 516 acres
to the brother was, in contemplation of a subsequent nontaxable exchange. Neither
taxpayer's testimony nor that of his brother indicated that the 1968 purchase by taxpayer
of the Custer County land was part of the scheme to sever the interests of taxpayer and
his brother through a §1031(a) exchange. However, both taxpayer and his brother
indicated that the 1969 transfer by taxpayer to the brother of 516 acres for $40,000.00
was executed on the advice of counsel and pursuant to an oral agreement that the parties
would later exchange properties. Thus we hold that it was proper for the Tax Court not to
consider the 1968 purchase.

In C.I.R. v. Court Holding Co., supra, 324 U.S. at 334, 65 S.Ct. at 708, the Supreme
Court stated that 'the transaction must be viewed as a whole, and each step, from the
commencement of negotiations to the consummation of the sale, is relevant.' (Emphasis
added.) By considering every transaction which was in contemplation of the overall
scheme to effect a nontaxable exchange, the Tax Court considered the transaction as a
whole and not in component parts. We are in full agreement with taxpayer that the Tax
Court should look to the substance of the transaction in reaching its decision. Yet its
consideration is not limited to the fact that taxpayer and his brother exchanged warranty
deeds.

In C.I.R. v. Court Holding Co., supra, 324 U.S. at 334, 65 S.Ct. at 708, the Supreme
Court held as follows: The tax consequences which arise from gains from a sale of
property are not finally to be determined solely by the means employed to transfer legal
title. . . . To permit the true nature of a transaction to be disguised by mere formalisms,
which exist solely to alter tax liabilities, would seriously impair the effective
administration of the tax policies of Congress. * * * *

To determine whether a transaction is a sale or exchange a court any look to the intent
of the parties as well as to what was actually done. See Alderson v. C.I.R., supra; Coastal
Terminals, Inc. v. United States, 320 F.2d 333 (4th Cir. 1963).[FN2] FN2. Even though
intent is a consideration, it is not controlling. See Carlton v. United States, 385 F.2d 238
(5th Cir. 1967), where the court found no exchange but where the government had
stipulated that an exchange was intended but alleged that no exchange was actually
effected. Taxpayer points out that where the record shows that what actually took place
was an exchange, the taxpayer is entitled to nonrecognition treatment of gain or loss,
even if property involved was acquired for the sole purpose of exchange.

[FN3] Alderson v. C.I.R., supra; Coastal Terminals, Inc. v. United States, supra. And,
taxpayer argues that the question is 'whether what was done, apart from the tax motive,
was the thing which the statute intended.' Gregory v. Helvering, supra, 293 U.S. at 469,
55 S.Ct. at 267. FN3. There is no issue concerning whether the properties are of 'like
kind' for purposes of nonrecognition treatment. We do not dispute the legal right of a
taxpayer to avoid or decrease his tax obligations as allowed by law. See, e.g., Gregory v.
Helvering, supra, 293 U.S. at 469, 55 S.Ct. 266. Redwing Carriers, Inc. v. Tomlinson,
supra, 399 F.2d at 659. But this situation does not call for application of the rule that tax
motive is not to be considered, for 'the transaction upon its face lies outside the plain
intent of the statute.

To hold otherwise would be to exalt artifice above reality and to deprive the statutory
provision in question of all serious purpose.' Gregory v. helvering, supra, 293 U.S. at 470,
55 S.Ct. 266. Looking beyond the formal exchange of property by taxpayer and his
brother, it is clear that the parties intended to consummate a sale of taxpayer's undivided
one-half interest in the Dawson County property to his brother for $40,000.00, and after
all relevant transactions had been completed taxpayer owned the same Custer County
property he had owned before.

[FN4] * * * * The decision of the Tax Court is affirmed. LEE The issue in this 1986
Tax Court decision was to determine whether certain Hawaiian real estate was within
Code Section 1031 as to its disposition. The Taxpayers purchased and sold real estate.
They argued that the transactions were part of a single event; therefore, the gain on the
sale should be postponed as a result of the reinvestment. It is clear from the facts that the
Taxpayers sold property, received cash and reinvested that cash. The question in the case
is whether the transactions were interdependent, and, therefore, should be treated as one
transaction within Code Section 1031. The Taxpayers were required to show that the
property in question was like-kind and property used in the trade or business or held for
investment. The Taxpayers were not successful in sustaining their burden of proof.

SALE OR EXCHANGE: CENTURY ELECTRIC CO.

In Century Electric Co., the court, addressing a question that seems to arise often in the
Section 1031 area, was faced with the issue of whether a transaction for tax purposes was
a sale property or whether it was an exchange. The taxpayer, Century Electric Co., was a
corporation engaged in the manufacture and sale of electric motors. It was not a dealer in
real estate. As of December 1, 1943, the taxpayer transferred the foundry building owned
and used by it for manufacturing and the land on which it was located to William Jewell
College for $150,000 with a leaseback clause. It claimed a deductible loss on the
transaction. The Commissioner of Internal Revenue denied the loss. The deed to the
college and the leaseback were executed and delivered as provided by a resolution of the
corporation. Neither the deed nor the lease referred to each other. The tax basis for the
foundry building for the taxpayer was $531,000, with the sales price of $150,000. Thus,
the taxpayer took the position that he had a deductible loss.

On the other hand, the Tax Court held that this was an exchange of property for
productive use in trade or business, and therefore the loss deduction was denied. In other
words, it was an exchange of a fee interest for a leasehold interest. The Court of Appeals,
when reviewing the Tax Court position, held that the transaction fell within Code §112
(predecessor to §1031). As such, the court said that the transaction could not be separated
into its component parts for tax purposes. Tax consequences, said the court, must depend
on what actually took place and not on separate steps to reach a desired end. The net
effect was that the foundry property was used before for the transaction of the trade or
business of the taxpayer and was used after the transaction as property in the trade or
business.

The Court of Appeals further referred to the Treasury Regulations which interpret this
type of position. The Court stated: Under the Treasury interpretation, a lease with 30
years or more to run and real estate are properties of "like-kind." With the controlling
purpose of the applicable section of the revenue code in mind, we cannot say that the
words "like kind" are so definite and certain that interpretation is neither required nor
permitted.

The regulation, enforced for many years, has survived successive re-enactments of the
Internal Revenue Acts and has thus acquired the force of law. Thus, we can see not only
the importance of looking to the substance of the transaction, as well as to the form, but
also the need to consult the Regulations when looking to an interpretation of Section
1031 (and other sections).

As far as structuring the transaction to allow it to qualify, one might conjecture a


number of alternatives. Literally speaking, if one would draw a lease that is under 30
years, then technically it would not fit within the equivalency doctrine mentioned. It
would also have helped if the lease arrangement was connected with the sale
arrangement. It would have helped if other parties were involved relative to the lease. It
would have helped if the documents were not executed on the same day. And so on.

CENTURY ELECTRIC CO. v. COMMISSIONER OF INTERNAL REVENUE.


51-2 U.S.T.C. Para. 9482 192 F.2d 155 (8th Cir. 1951)

RIDDICK, Circuit Judge.

The petitioner, Century Electric Company, is a corporation engaged principally in the


manufacture and sale of electric motors and generators in St. Louis, Missouri. It is not a
dealer in real estate. As of December 1, 1943, petitioner transferred a foundry building
owned and used by it in its manufacturing business and Jewell College and claimed a
deductible loss on the transaction in its tax return for the calendar year 1943. The
Commissioner of Internal Revenue denied the loss. The Commissioner was affirmed by
the Tax Court and this petition for review followed.

The opinion of the Tax Court and its findings of fact, stated in great detail, are reported
in 15 T.C. 581. Petitioner accepts the Tax Court's findings of fact as correct. Since its
organization in 1901 petitioner has been continuously successful in business. In its
income tax return for the year 1943 it reported gross sales of $17,004,839.73 and gross
profits from sales of $5,944,386.93.

On December 31, 1942, petitioner owned land, buildings, and improvements of the
total depreciated cost of $1,902,552.16. On December 31, 1943, its actual cash on hand
amounted to $203,123.70 During the year 1943 it distributed cash dividends of
$226,705.69 and made a contribution to Washington University of $42,500. It also held
tax anticipation notes and Series G bonds totaling $2,000,000, readily convertible into
cash and sufficient to liquidate its outstanding 1943 tax liability and its two outstanding
90 day bank notes due January 20, 1944.

Petitioner has always operated its business in large part on borrowed capital. In 1943 it
had open lines of credit with the Chase National Bank of New York of $300,000, with the
Boatmen's National Bank of St. Louis of the same amount, and with the Mercantile
Commerce Bank and Trust Company of $400,000. At the end of 1943 its outstanding
loans from the Mercantile bank amounted to $600,000 approved by the authorized
officers of the bank. Petitioner has always been able to liquidate its outstanding 90 day
bank loans as they become due either by payment or renewal.

The assessed value of petitioner's foundry building and land upon which it is located for
1943 was $205,780. There was evidence that in St. Louis real property is assessed at its
actual value. There was also evidence introduced by petitioner before the Tax Court that
the market value for unconditional sale of the foundry building, land, and appurtenances
was not in excess of $250,000.

As of December 1, 1943, the adjusted cost basis for the foundry building, land, and
appurtenances transferred to William Jewell College was $531,710.97. The building was
a specially designed foundry situated in a highly desirable industrial location. It is
undisputed in the evidence that the foundry property is necessary to the operation of
petitioner's profitable business and that petitioner never at any time considered a sale of
the foundry property on terms which would deprive petitioner of its use in its business.

Petitioner's explanation of the transaction with the William Jewell College is that in the
spring of 1943 a vice president of the Mercantile bank where petitioner deposited its
money and transacted the most of its banking business suggested to petitioner the
advisability of selling some of its real estate holdings for the purpose of improving the
ratio of its current assets to current liabilities by the receipt of cash on the sale and the
possible realization of a loss deductible for tax purposes. Petitioner's operating business
was to be protected by an immediate long term lease of the real property sold. Petitioner's
board of directors rejected this proposition as unsound.

But in July 1943, when a vice president of the Mercantile bank suggested to petitioner's
treasurer that it would be a good idea for petitioner to pay off all its bank loans merely to
show that it was able to do so, petitioner interpreted this advice as a call of its bank loans.
Acting on this interpretation, petitioner borrowed from the First National Bank in St.
Louis on the security of tax anticipation notes held by it, funds with which it discharged
all its bank loans. Immediately thereafter it re-established its lines of bank credit and
began consideration of a sale of the foundry property and contemporaneous lease from
the purchaser. On September 2, 1943, petitioner's board of directors adopted a resolution
that the executive committee of the board study the situation 'and present, if possible, a
plan covering the sale and rental back by Century Electric Company of the foundry
property.'

The decision to enter into the transaction described was communicated to the
Mercantile bank, but petitioner never publicly offered or advertised its foundry property
for sale. The Tax Court found that petitioner 'was concerned with getting a friendly
landlord to lease the property back to it, as there was never any intention on the part of
petitioner to discontinue its foundry operations.' Several offers to purchase the foundry
property at prices ranging from $110,000 to $150,000 were received and rejected by
petitioner.

At a special meeting of the board of directors of petitioner on December 9, 1943, the


president of petitioner reported that the officers of petitioner had entered into negotiations
for the sale of the foundry property to William Jewell College for the price of $150,000
with the agreement of said college; 'that in addition thereto said Trustees of William
Jewell College further have agreed to execute a lease of the property so purchased to
Century Electric Company for the same time and on substantially the same terms and
conditions which were authorized to be accepted by the special meeting of shareholders
of this corporation, held on the 24th day of November, 1943.' The stockholders at the
November meeting had authorized the sale of the foundry property at not less than
$150,000 cash, conditioned upon the purchaser executing its lease of the property sold for
a term of not less than 25 and not more than 95 years.

The Board by resolution approved the proposed transaction with the William Jewell
College, but on condition that 'this corporation will acquire from Trustees of William
Jewell College, a Missouri Corporation, an Indenture of Lease * * * for a term of not less
than twenty-five years and for not more than ninety-five years.' The resolution set out in
detail the terms of the lease from the college to petitioner, approved the form of the deed
from the petitioner to the college, authorized the president and secretary of petitioner to
execute the lease after its execution by the trustees of the college, and directed 'that the
president and secretary of this corporation be authorized to deliver said Warranty Deed to
said purchaser upon receiving from said purchaser $150,000 in cash, and upon receiving
from said purchaser duplicate executed Indenture of Lease on the forms exhibited to this
Board.'
The resolution provided that the deed and lease should be dated December 1, 1943, and
effective as of that date. The deed and the lease were executed and delivered as provided
by the resolution of petitioner's board of directors. Neither instrument referred to the
other. The deed was in form a general warranty deed, reciting only the consideration of
$150,000 in cash. The lease recited among others the respective covenants of the parties
as to its term, its termination by either the lessor or lessee, and as to the rents reserved.

As of December 31, 1942, the ratio of petitioner's current assets to its current liabilities
was 1.74. The $150,000 in cash received by petitioner on the transaction increased the
ratio of current assets to current liabilities from 1.74 to 1.80. The loss deduction which
petitioner claims on the transaction and its consequent tax savings would if allowed have
increased the ratio approximately twice as much as the receipt of the $150,000. The
questions presented are:

1. Whether the transaction stated was for tax purposes a sale of the foundry property
within the meaning of section 112 of the Internal Revenue Code, 26 U.S.C.A. 112, on
which petitioner realized in 1943 a deductible loss of $381,710.97 determined under
section 111 of the code (the adjusted basis of the foundry property of $531,710.97 less
$150,000) as petitioner contends; or, as the Tax Court held, an exchange of property held
for productive use in a trade or business for property of a like kind to be held for
productive use in trade or business in which no gain or loss is recognized under sections
112(b)(1) [FN1] and 112(e)[FN2], and Regulation 111, section 29.112(b)(1)?1. [FN3]

2. Whether if the claimed loss deduction is denied, its amount is deductible as


depreciation over the 95 year term of the lease as the Tax Court held, or over the
remaining life of the improvements on the foundry as the petitioner contends. On the first
question the Tax Court reached the right result. The answer to the question is not to be
found by a resort to the dictionary for the meaning of the words 'sales' and 'exchanges' in
other contexts, but in the purpose and policy of the revenue act as expressed in section
112.* * * *

In this section Congress was not defining the words 'sales' and 'exchanges'. It was
concerned with the administrative problem involved in the computation of gain or loss in
transactions of the character with which the section deals. Subsections 112(b)(1) and
112(e) indicate the controlling policy and purpose of the section, that is, the
non?recognition of gain or loss in transactions where neither is readily measured in terms
of money, where in theory the taxpayer may have realized gain or loss but where in fact
his economic situation is the same after as it was before the transaction.

For tax purposes the question is whether the transaction falls within the category just
defined. If it does, it is for tax purposes an exchange and not a sale. So much is indicated
by subsection 112(b)(1) with regard to the exchange of securities of readily ascertainable
market value measured in terms of money. Gain or loss on exchanges of the excepted
securities is recognized.
Under subsection 112(e) no loss is recognized on an exchange of property held for
productive use in trade or business for like property to be held for the same use, although
other property or money is also received by the taxpayer. Compare this subsection with
subsection 112(c)(1) where in the same circumstances gain is recognized but only to the
extent of the other property or money received in the transaction. The comparison clearly
indicates that in the computation of gain or loss on a transfer of property held for
productive use in trade or business for property of a like kind to be held for the same use,
the market value of the properties of like kind involved in the transfer does not enter into
the question.

The transaction here involved may not be separated into its component parts for tax
purposes. Tax consequences must depend on what actually was intended and
accomplished rather than on the separate steps taken to reach the desired end. The end of
the transaction between the petitioner and the college was that intended by the petitioner
at its beginning, namely, the transfer of the fee in the foundry property for the 95 year
lease on the same property and $150,000. It is undisputed that the foundry property
before the transaction was held by petitioner for productive use in petitioner's business.

After the transaction the same property was held by the petitioner for the same use in
the same business. Both before and after the transaction the property was necessary to the
continued operation of petitioner's business. The only change wrought by the transaction
was in the estate or interest of petitioner in the foundry property.

In Regulations 111, section 29.112(b)(1) 1, the Treasury has interpreted the words 'like
kind' as used in subsection 112(b)(1). Under the Treasury interpretation a lease with 30
years or more to run and real estate are properties of 'like kind.' With the controlling
purpose of the applicable section of the revenue code in mind, we can not say that the
words 'like kind' are so definite and certain that interpretation is neither required nor
permitted. The regulation, in force for many years, has survived successive reenactments
of the internal revenue acts and has thus acquired the force of law. * * * * The decision of
the Tax Court is affirmed.

FN1. 'Sec. 112. Recognition of Gain or Loss.' Exchanges solely in kind.


(1) Property held for productive use or investment. No gain or loss shall be recognized if
property held for productive use in trade or business or for investment (not including
stock in trade or other property held primarily for sale, nor stocks, bonds,notes, choses in
action, certificates of trust or beneficial interest, or other securities or evidences of
indebtededness or interest) is exchanged solely for property of a like kind to be held
either for productive use in trade or business or for investment.'

FN2. '(e) Loss from exchanges not solely in kind. If an exchange would be within the
provisions of subsection (b)(1) to (5), inclusive, or (10), or within the provisions of
subsection (l), of this section if it were not for the fact that the property received in
exchange consists not only of property permitted by such paragraph to be received
without the recognition of gain or loss, but also of other property or money, then no loss
from the exchange shall be recognized.'
FN3. 'Sec. 29.112(b)(1) 1. Property Held for Productive Use in Trade or Business or for
Investment. As used in section 112(b)(1), the words 'like kind' have reference to the
nature or character of the property and not to its grade or quality. One kind of class or
property may not, under such section, be exchanged for property of a different kind or
class. The fact that any real estate involved is improved or unimproved is not material,
for such fact relates only to the grade or quality of the property and not to its kind or
class. * * *'No gain or loss is recognized if * * * (2) a taxpayer who is not a dealer in real
estate exchanges city real estate for a ranch or farm, or a leasehold of a fee with 30 years
or more to run for real estate, or improved real estate for unimproved real estate * * *.'

IS THE LOSS TO BE RECOGNIZED?:


BLOOMINGTON COCA-COLA BOTTLING CO.

In the Bloomington case, Judge Kerner was faced with the question of whether the Tax
Court had correctly upheld the Internal Revenue Service's position, through the
Commissioner, that in 1939 the taxpayer had sustained a loss upon the sale of real estate
which was not within the scope of Code Section 112(b),the predecessor to Section 1031.

The government argued that the loss was recognizable under this Section and affected
the corporation's computation of its income. The taxpayer had purchased the bottling
plant in 1930 in Bloomington, Illinois. In 1938 he concluded the plant was inadequate
and, therefore, built a new plant. The contractor agreed to build the new plant for a given
sum of money, and to accept the other plant as part of the payment. Because of the way
the transaction was structured, the Tax Court held that the transaction was not a tax-
deferred exchange under Code Section 112, but in fact was a sale.

The Circuit Court reviewed the facts and concluded that the Tax Court was not in error.
The taxpayer had not carried its burden of showing that the transaction did not constitute
a sale. The Court said that in this case the contractor bought the plant in one transaction
and built the building in another, even though the two were interrelated. The taxpayer had
also argued that there was an abandonment of the old plant, and he should be entitled to
take the deduction as a result of the abandonment. The Court disagreed. The Court
followed the structure of the transaction to its conclusion. (This case involved a
consideration by the taxpayer of an excess profits tax, which is a historical consideration.
Under the circumstances, because of the calculation, it was not in the taxpayer's interest
to have the transaction treated as an exchange within Section 112.)

BLOOMINGTON COCA COLA BOTTLING CO.


v.
COMMISSIONER OF INTERNAL REVENUE.
51-1 U.S.T.C. 9320, 189 F.2d 14 (7th Cir. 1951)

KERNER, Circuit Judge.

The question presented by this petition for review is whether the Tax Court correctly
upheld the Commissioner's determination that in 1939 the taxpayer sustained a loss upon
the sale of real estate which did not come within the scope of Sec. 112(b)(1) of the
Internal Revenue Code, 26 U.S.C.A. 112(b), but was recognizable under Sec. 112(a)
thereof for the purpose of computing its excess profits tax credit based on an average
base period net income.

The Tax Court held that the transaction was not an exchange protected from tax impact
by Sec. 112(b)(1) but was a sale which resulted in a recognizable loss. In this court
taxpayer claims 'no error with respect to the findings of facts of the Tax Court, but alleges
that the Tax Court erred in applying the law to those facts.' It makes the point that the
payment of $64,500 cash in addition to the transfer of an old bottling plant as
consideration for the construction of a new plant did not remove the transaction from the
purview of Sec. 112(b) (1) of the Revenue Act of 1938. The material facts are that in
1930 taxpayer, at a cost of $36,000, acquired a bottling plant in Bloomington, Illinois
allocating $30,500 to buildings and $5,500 to land. In 1938, concluding that the plant was
inadequate for its needs, taxpayer decided to build a new plant. It decided it had no use
for the old plant and wished to dispose of it. With those purposes in mind, it entered into
a contract with a contractor to construct a new plant. The new plant was completed in
1939.

By the contract the contractor furnished the necessary material and labor, and
completed the building in accordance with the plans and specifications prepared by its
architect for a total of $72,500. Of this sum the contractor was paid $64,500 in cash and
accepted taxpayer's old buildings and the land upon which the old plant was located at a
valuation of $8,000, and the old building and land were transferred to the contractor.

Taxpayer, in its 1939 tax return, reported the transaction thusly: Lot, Cost July 1930
$5,500.00 Sold April 30, l939 1,424.55 Loss 4,075.45 Limitation (2,000.00) Building,
Cost July 1930 30,500.00 Depreciation on building to April 30, 1939 5,113.21 Net Book
Value April 30, 1939 25,386.79 Sold April 30, 1939 6,575.45 $18,811.34 Schedule B of
taxpayer's 1943 and 1944 excess profits tax return shows the 1939 base period excess
profits net income as follows:

l. Normal tax (or special class) net income $ 2,278.25


2. Net capital loss used in computing line 1 2,000.00
4. Net loss from sale or exchange of property
other than capital assets deducted in
computing line 1 (for taxable years beginning
after December 31, 1937) 18,811.34
Excess profits net income $23,089.59

The Commissioner in determining the excess profits taxes for the years 1943 and 1944
adjusted the average base period net income for the year 1939 as computed by the
taxpayer by deducting the amount of $22,886.79 as a loss not coming within the scope of
Sec. 112(b)(1) of the Internal Revenue Code. This resulted in a deficiency of $8,049.19 in
1943 and $8,492.13 in 1944. The taxpayer contested this determination. The Tax Court,
finding the facts in detail, sustained the Commissioner.
The Commissioner's determination and its approval by the Tax Court that taxpayer's
disposition of the old plant constituted a sale and not an exchange of property for like
property must be considered as prima facie correct, and the burden of proving it wrong is
upon the taxpayer. We may not reverse the decision unless we can say the decision is
clearly erroneous. It is elementary that the language of a revenue act is to be read in the
light of the practical matters with which it deals and is to be given its ordinary
significance in arriving at the meaning of the statute.

The applicable statute, 26 U.S.C.A. 112, provides: 'Sec. 112. Recognition of gain or
loss * * * * '(b) Exchanges solely in kind? (1) Property held for productive use or
investment. No gain or loss shall be recognized if property held for productive use in
trade or business or for investment (not including stock in trade or other property held
primarily for sale, nor stocks, bonds, notes, choses in action, certificates of trust or
beneficial interest, or other securities or evidences of indebtedness or interest) is
exchanged solely for property of a like kind to be held either for productive use in trade
or business or for investment.' And Treasury Regulations 111, Sec. 29.112(a) 1 states that
to constitute an exchange within the meaning of Sec. 112(b)(1) the transaction must be a
reciprocal transfer of property as distinguished from a transfer of property for a money
consideration only.

A 'sale' is a transfer of property for a price in money or its equivalent. 'Exchange' means
the giving of one thing for another. That is to say, in a sale, the property is transferred in
consideration of a definite price expressed in terms of money, while in an exchange, the
property is transferred in return for other property without the intervention of money.
True, 'Border-line cases arise where the money forms a substantial part of the adjustment
of values in connection with the disposition of property and the acquisition of similar
properties. The presence in a transaction of a small amount of cash, to adjust certain
differences in value of the properties exchanged will not necessarily prevent the
transaction from being considered an exchange. Where cash is paid by the taxpayer, it
may be considered as representing the purchase price of excess value of 'like property'
received.' But this is not a case where the contractor exchanged a completed plant owned
by the contractor for property and money, hence the contractor at no time had like
property within the meaning of Sec. 112(b)(1) of the Revenue Act.

Under these circumstances we would not be warranted in saying that the finding and
conclusion of the Tax Court are clearly erroneous. On the contrary, we think the facts
adequately support the Tax Court's conclusion that the taxpayer's disposition of its old
plant constituted a sale.

Another contention urged is that the loss which was incurred by taxpayer in 1939 on its
disposal of its old bottling plant must be disallowed under the provisions of Sec.
711(b)(1)(E), 26 U.S.C.A. 711(b)(1)(E) on the ground that the property was abandoned.
This section provides that deductions for abandonment of property shall not be allowed in
the computation of excess profits net income for the base years. And Sec. 29.23(e) 3 of
Regulations 111 provides that when, through some change in business conditions, the
usefulness in the business of some or all of the capital assets is suddenly terminated so
that a taxpayer discards such assets permanently from use in such business, it may claim
a loss as prescribed.

In considering the contention that the property had been abandoned it will be enough to
say that we agree with the Tax Court: 'The old plant was sold for a consideration of
$8,000; it was not abandoned. There are no facts established justifying a finding of
abandonment, or that the loss was due to obsolescence. The old plant was an operating
plant at the time petitioner (taxpayer) moved to its new building, and its use as a bottling
plant could have been continued. The testimony was not that the plant was abandoned,
but that its sale was determined upon. A claim of loss consequent upon the abandonment
of property must be supported by clear and convincing proof of intention to abandon and
discard the property (citing case). The record contains nothing to sustain the argument of
abandonment, and the facts established are to the contrary. * * * * Affirmed. * * * *

EDWARD C. LEE AND MARY C. LEE, Petitioners


v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
T.C. Memo. 1986-294 (1986)
MEMORANDUM FINDINGS OF FACT AND OPINION

WILBUR, JUDGE:

Respondent determined the following deficiencies in, and additions to, petitioners'
Federal income taxes:

Additions to Tax Year Deficiency Sec. 6651(a)(1)


[FN1] Sec. 6653(a)1976 $ 4,733 $ 797 $664 1977 4,190 1,048 678 1978 4,541 1,135
686 * * *

Some of the facts have been stipulated and are found accordingly. Petitioner Edward C.
Lee (hereinafter referred to as 'petitioner') resided in Port Angeles, Washington, when the
petition was filed in this case. Petitioner Mary C. Lee resided in Ocala, Florida, at that
time. Petitioners were husband and wife during the years in issue.

ISSUE 4. GAIN ON DISPOSITION OF HAWAII REAL ESTATE


FINDINGS OF FACT

In 1961, petitioners purchased five parcels of land in Hawaii. The land was classified as
agricultural by the State Tax Commissioner. In November 1977, petitioners purchased a
farm in Washington from Ronald and Heidi Craig. In June 1978, petitioners sold each of
the five parcels in Hawaii by statutory warranty deed. Each parcel was sold to a different
purchaser but the deeds were executed on the same day. The proceeds from the sale of
the land in Hawaii were transferred directly to Ronald and Heidi Craig as part of the
purchase price of the Washington farm. The proceeds did not pass through petitioners'
hands. None of the purchasers of the land in Hawaii were related to the sellers of the land
in Washington. Petitioners realized a gain on the sale of the property in Hawaii. They did
not, however, report this gain. Respondent determined that the gain should have been
reported in 1978.

OPINION

The issue is whether the gain realized by the petitioners on the sale of their land in
Hawaii is within the nonrecognition provisions of section 1031. Section 1031 provides
that, '(n)o gain or loss shall be recognized if property held for productive use in a trade or
business or for investment is exchanged solely for property of a like kind to be held either
for productive use in a trade or business or for investment.' Petitioners contend that the
properties they purchased and sold were like kind and were held for investment or for
productive use in a trade or business. They further contend that the purchase and sale
were handled by a real estate broker as a single transaction and that, therefore, the gain
realized on the sale of the Hawaii property was within the nonrecognition provisions of
section 1031. Petitioners do not dispute the amount of the gain determined by respondent.

Respondent contends that these transactions were a sale of one property for cash
followed by a separate investment of the proceeds and that such a transaction is not an
EXCHANGE as required by section 1031. Respondent further contends that petitioners
have failed to establish that the purchased farm was held for investment or for use in a
tradeor business. Respondent concludes that petitioners must recognize the gain on the
sale of the Hawaii land in 1978. We agree with respondent. Section 1031 has three
requirements:

(1) there must be an EXCHANGE;


(2) the properties exchanged must be of like kind; and,
(3) the property transferred and the property received must be
held by the taxpayer either for use in a trade or business or
for investment.

Respondent has not argued in this case that the properties transferred were not of like
kind. Respondent's regulations provide that if a person 'EXCHANGES city real estate for
a ranch or farm, or EXCHANGES a leasehold of a fee with 30 years or more to run for
real estate, or EXCHANGES improved real estate for unimproved real estate,' the
properties exchanged are of like kind. Section 1.1031(a)?1(c), Income Tax Regs. The
property transferred and the property received in this case were both real estate and were
clearly of like kind within the meaning of section 1031. Respondent contends that there
was no EXCHANGE in this case. An essential prerequisite for nonrecognition treatment
under ection 1031 is that there be an 'EXCHANGE' of properties. A sale of one property
for cash followed by a separate investment of the proceeds in like kind property does not
qualify as an EXCHANGE. Barker v. Commissioner, 74 T.C. 555, 560-561 (1980). But
in determining whether an EXCHANGE has occurred we look to the substance of a
transaction rather than to the form in which it is cast. Biggs v. Commissioner, 69 T.C.
905, 914 (1978), affd. 632 F.2d 1171 (5th Cir. 1980).
Where, as here, the transaction is a so called 'three-corner' transaction, contractual
interdependence is not required. Biggs v. Commissioner, supra at 914. Such a transaction
is within the ambit of section 1031 if the taxpayer's transfer and receipt of property 'were
interdependent parts of an overall plan, the result of which was an EXCHANGE of like
kind properties.' Biggs v. Commissioner, supra at 914. Petitioners must demonstrate that
the transfers of property in this case were interdependent parts of an overall plan in order
for such transfers to constitute an 'EXCHANGE' within the meaning of section 1031. The
record in this case is nearly devoid of information about the interrelationship of the sales
of the Hawaii property and the purchase of the Washington farm. The statutory warranty
deeds executed upon the sale of the Hawaii property, entered by petitioners as exhibits,
make no reference to the transfer or transferors of the Washington farm.

Similarly, the escrow agreement and sales contract executed upon the purchase of the
Washington farm, also entered by petitioners as exhibits, make no reference to the
transfer or transferees of the Hawaii property. The purchase of the Washington farm
occurred more than 7 months before the sale of the Hawaii property and petitioners have
failed to show that the sale of the Hawaii property was even contemplated at the time of
the purchase of the Washington farm. The only evidence showing a relationship between
these transactions, other than petitioners' participation in them, is petitioner's testimony
that the proceeds from the sale of the Hawaii land went directly to the sellers of the
Washington farm. This evidence establishes nothing more than that the proceeds of the
sale were used to pay a preexisting obligation of petitioners. The burden of proof is on
petitioners to show that an EXCHANGE occurred within the meaning of section 1031.

Rule 142(a). Petitioners have failed to satisfy this burden. Petitioners also have failed to
prove that the property acquired, the Washington farm, was to be held for productive use
in a trade or business or for investment. The record contains no evidence as to the actual
use of the farm. Petitioner testified that the land was classified as agricultural by either
the State or county but this does not establish that the farm was, or was intended to be,
used for agricultural purposes. Nor does the label 'farm ' tend to prove that the land was
used for other than personal uses. Petitioners have not demonstrated that the sale of the
Hawaii property satisfied the requirements of section 1031. Accordingly, we hold that
petitioners must recognize their gain on the sale of the Hawaii property in 1978.

Decision will be entered under Rule 155.

SALE AND REINVESTMENT IS NOT AN EXCHANGE:


LINCOLN V. COMMISSIONER,
T. C. Memo 1998-421

The essence of the Lincoln case can be found in many other cases dealing in the
exchange area, viz., was there an exchange or a sale? The Court concluded that there was
no reciprocal transfer. Rather, there was a sale and reinvestment; therefore, it did not
qualify within Code §1031 to defer the gain.
Chad A. and Katherine J. LINCOLN, Petitioners
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent.
United States Tax Court. T.C. Memo.1998-421
1998 WL 811784 (U.S.Tax Ct.), 76 T.C.M. (CCH) 926,
T.C.M. (RIA) 98,421, 1998 RIA TC Memo 98,421 Nov. 24, 1998
MEMORANDUM FINDINGS OF FACT AND OPINION

THORNTON, Judge:

Respondent determined a deficiency of $55,814 in petitioners' 1993 Federal income tax


and a $11,163 accuracy related penalty under section 6662(a). The issues for decision
are:

(1) Whether petitioners are required to include in income capital


gain from the sale of investment property;
(2) whether certain interest payments and taxes that petitioners
reported as Schedule E deductions from rental real estate
income should be redesignated as Schedule A itemized
deductions; and
(3) whether petitioners are liable for an accuracy? related
penalty pursuant to section 6662(a).
FINDINGS OF FACT

The parties have stipulated some of the facts, which are so found. The stipulation of
facts is incorporated herein by this reference. At the time the petition was filed,
petitioners were husband and wife whose primary residence was in Carmel, California.
On July 12, 1976, petitioners purchased a house in Pacific Grove, California, for $48,351.
They resided in this house for approximately 4 years before converting it into rental
property. On April 7, 1992, petitioners purchased a 5?acre lot in Big Sur, California, for
$160,316. Their purchase offer contained no contingencies. Borrowing against a personal
line of credit,petitioners paid the seller of the property, Marcia D'Esopo, $35,316 as a
cash downpayment and assumed a note for the balance of the purchase price. In July
1992, petitioners began work to construct a house on the Big Sur property. The house
was completed in August 1994, and petitioners commenced using it as a rental property.

In the meantime, on March 16, 1993, petitioners sold the Pacific Grove property to
Allen and Maria Elvin (the Elvins) for $228,668. The Elvins entered into an agreement
with petitioners whereby, upon the closing of a Chicago Title Company escrow account,
the money consideration for the Pacific Grove property would be deposited into an
account that petitioners opened at Provident Central Credit Union for this purpose. After
the sales proceeds were deposited, petitioners directed Provident Central Credit Union to
make payments by cashier's check to contractors hired to make improvements on the Big
Sur property. In addition, petitioners directed Provident Central Credit Union to
reimburse petitioner husband for the downpayment on the Big Sur property and for
expenses incurred to improve it. Statements from the Provident Central Credit Union
account were sent directly to petitioners' home address. Petitioners had sole authority to
withdraw funds and make payments from the account. Petitioners did not report any gain
on the sale of the Pacific Grove property on their joint 1993 Federal income tax return,
nor did their return include a Form 8824, Like-Kind Exchanges.

In the notice of deficiency, respondent determined that petitioners failed to meet the
requirements for a section 1031 exchange and included in petitioners' income capital gain
from the sale of the Pacific Grove property. Respondent also reallocated certain interest
and tax expenses attributable to the Big Sur property from Schedule E (expenses of rental
real estate) to Schedule A (itemized deductions).

OPINION

Section 1031 Exchange Generally, a taxpayer must recognize the entire amount of gain
or loss on the sale or exchange of property. Sec. 1001(c). Section 1031(a)(1) contains an
exception to this general rule:

(1) In general. 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. The purpose of section 1031 is to defer recognition of gain or
loss when an exchange of like-kind property takes place between a taxpayer and another
party. Coastal Terminals, Inc. v. United States, 320 F.2d 333, 337 (4th Cir.1963).

The basic reason for this tax treatment is that the exchange does not materially alter the
taxpayer's economic situation, the property received in the exchange being viewed as a
continuation of the old investment still unliquidated. Koch v. Commissioner, 71 T.C. 54,
63 (1978).

Eligibility for this treatment is circumscribed by a number of specific statutory


requirements. For purposes of this case, we need be concerned only with the threshold
requirement that there be an "exchange" of property. We hold that petitioners'
transactions did not constitute an exchange. An exchange ordinarily requires a "reciprocal
transfer of property, as distinguished from a transfer of property for a money
consideration only". Sec. 1.1002?1(d), Income Tax Regs. A sale for cash does not
constitute an exchange even though the cash is immediately reinvested in like property.
Coastal Terminals, Inc. v. United States, supra at 337; see also Bell Lines, Inc. v. United
States, 480 F.2d 710, 714 (4th Cir.1973); Carlton v. United States, 385 F.2d 238, 242 (5th
Cir.1967); Rogers v. Commissioner, 44 T.C. 126, 136 (1965), affd. per curiam 377 F.2d
534 (9th Cir.1967).

Petitioners purchased the Big Sur property from Marcia D'Esopo with a cash
downpayment and assumed a note for the balance of the purchase price. Almost a year
later, they sold the Pacific Grove property to the Elvins and received cash. Although
petitioners may have intended to effect a section 1031 exchange, there is no evidence that
either Marcia D'Esopo or the Elvins agreed to participate in an exchange of property.
Indeed, petitioner husband testified at trial that it was only after receiving an offer on the
Pacific Grove property almost a year after buying the Big Sur property that he began
investigating the possibility of effecting a section 1031 exchange. In these circumstances,
we believe it is abundantly clear that petitioners' purchase of the Big Sur property and
their subsequent sale of the Pacific Grove property constituted two separate transfers of
property for money consideration, rather than an exchange. In a case with facts that are
not favorably distinguishable for petitioners, the court to which an appeal of this case
would lie reached a similar conclusion.

In Bezdjian v. Commissioner, 845 F.2d 217 (9th Cir.1988), affg. T.C. Memo.1987?140,
the taxpayers wished to exchange a rental property they owned for a gas station. The gas
station owner, however, declined to participate in an exchange. The taxpayers purchased
the gas station using proceeds of a loan secured in part by a deed of trust on their rental
property. About 3 weeks later, the taxpayers sold the rental property to a third party. The
court held that there was no exchange within the meaning of section 1031, because the
taxpayers simply acquired one parcel of real property from one party and sold another
parcel to a different party; although the taxpayers may have intended to make an
exchange, there was no evidence that either of the other parties agreed to participate in an
exchange. See also Dibsy v. Commissioner, T.C. Memo.1995-477 (holding that the
taxpayers' purchase of one liquor store and their subsequent sale of another constituted
two independent events, rather than a section 1031 exchange) Petitioners contend that
they never would have sold the Pacific Grove property except for their need to generate
funds to improve the Big Sur property, and that hence the two transactions were
interdependent. We question the premises and disagree with the conclusion.

While petitioners may have viewed the sale of the Pacific Grove property as a source of
revenue to finance construction on the Big Sur property, a year prior to the sale of the
Pacific Grove property they were able to borrow against their personal line of credit to
make a cash downpayment on the Big Sur property. Moreover, they began construction
on the Big Sur property 9 months prior to the Pacific Grove sale.

In any event, neither the petitioners' financial motivation for selling the Pacific Grove
property nor their application of the sales proceeds operates to transform the independent
purchase and sale transactions into an exchange. See Anderson v. Commissioner, T.C.
Memo.1985-205. Likewise, it is of no material significance that the Elvins agreed that the
money consideration for their purchase of the Pacific Grove property shouldbe deposited
into petitioners' Provident Central Credit Union account.Indeed, it is difficult to imagine
what difference it could have made to the Elvins. Petitioners had unfettered and
unrestrained control over the money in the Provident Central Credit Union account,
which was in their names. Although the funds were used to finance improvements at the
Big Sur property and to reimburse petitioner husband for the cash downpayment on the
Big Sur property, petitioner husband conceded at trial that payment could have been
made out of the account for any purpose.

These circumstances strongly support the conclusion that the Pacific Grove sale was an
independent transfer of property for money consideration rather than part of an exchange.
See Carlton v. United States, 385 F.2d 238, 243 (5th Cir.1967); Hillyer v. Commissioner,
T.C. Memo.1996?214; Nixon v. Commissioner, T.C. Memo.1987?318.

At most, the circumstances relating to petitioners' establishment and use of the


Provident Central Credit Union account evidence their belated intent to avail themselves
of section 1031 treatment and the Elvins' awarenessof their intent. The circumstances do
not, however, suggest any mutuality of intent between petitioners and the Elvins, much
less between petitioners and Marcia D'Esopo, to effect an exchange. It is well settled that
a taxpayer's unilateral intent to undertake an exchange does not govern the tax
consequences where no reciprocal transfer of property actually occurs. See Bezdjian v.
Commissioner, supra at 218; Garcia v. Commissioner, 80 T.C. 491, 498 (1983); Rogers
v. Commissioner, supra at 136. At trial and on brief, petitioners cite Starker v. United
States, 602 F.2d 1341 (9th Cir.1979), as their underlying authority for section 1031
exchange treatment. Their reliance is misplaced. In Starker, the taxpayer transferred
timberland to a corporation which, within a previously agreed period, transferred to the
taxpayer various parcels of land and certain contract rights. In Starker, unlike the instant
case, no cash was ever transferred. Starker held, in relevant part, that the
nonsimultaneous transfers of property did not preclude section 1031 treatment.

[FN1] Starker does not, however, dispense with the requirement that there in fact be an
exchange of property. As previously discussed, petitioners have failed to cross that initial
threshold. Accordingly, we sustain respondent's determination that petitioners have failed
to meet the requirements for a section 1031 exchange.

Interest Expenses and Taxes

Petitioners bear the burden of proving that respondent's determinations are erroneous.
Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). At trial, petitioner husband
indicated that in the event section 1031 treatment were disallowed, he "understood"
respondent's determination as to reallocation of these expenses. On brief, petitioners did
not address the issue. Accordingly, we sustain respondent's determination in this regard.
Accuracy-Related Penalty Section 6662(a) imposes a 20-percent penalty on the portion of
an underpayment of tax attributable to, among other things, a substantial understatement
of income tax, which is defined as an understatement that exceeds the greater of 10
percent of the tax required to be shown or $5,000. Sec. 6662(d)(1)(A). Petitioners' failure
to report the gain from the sale of the Pacific Grove property and their disallowed claim
to Schedule E expenses resulted in a $55,814 understatement of income tax. This amount
is in excess of $5,000 and exceeds 10 percent of the amount of tax required to be shown
on the return.

Petitioners' position is not supported by any well reasoned construction of the relevant
statutory provisions. There is no substantial authority for their position that the purchase
of the Big Sur property and the subsequent sale of their Pacific Grove property
constituted an exchange. The cases petitioners have cited on brief are readily
distinguishable and to the extent they are pertinent, undermine their position.
Similarly, there is no substantial authority for petitioners' treatment of the reallocated
items. Accordingly, we sustain respondent's imposition of the accuracy-related penalty.
To reflect the foregoing, Decision will be entered for respondent.

MARS Charles Mars executed a contract with Hudson, giving Hudson the right to
purchase 250 acres of land. Slightly over one year later, Mars agreed to sell the property
in question to Hudson. After the sale took place, there was a note involved from the
Purchaser to the Seller. Later, the Purchaser informed the Seller that he could not pay all
of the amount on the Note. The Seller alleged that at this juncture the sale was canceled,
although no reconveyance was shown of record. Some months after that, a new exchange
contract was entered between the prior Buyer and Seller. Along with additional facts, as
explained in the case, the Court ruled that the initial transaction, coupled with the alleged
undoing of that transaction and the subsequent exchange, did not constitute a valid Code
Section 1031 transaction.

CHARLES W. MARS AND RUBY G. MARS, Petitioners


v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
T.C. Memo. 1987-481 (1987)
MEMORANDUM FINDINGS OF FACT AND OPINION

DRENNEN, JUDGE:

Respondent determined deficiencies in petitioners' Federal income tax and additions to


tax as follows: Income Tax Additions to Tax Year Deficiencies Sec. 6651(a)(1)
Sec.6653(a) 1977 $79,071.03 $11,885.11 ?- 1978 19,403.51 ?- $970.18 After
concessions, [FN1] the issues for decision are

(1) whether the conveyance by petitioners of certain property


referred to herein as the 'golf course property' constitutes an
exchange of like kind property subject to the tax deferral
rules of section 1031, or a taxable sale of real property;
(2) whether petitioners are liable for interest income in the
amount of $22,201.01 in taxable year 1977 and $5,091.70
for taxable year 1978, in connection with the disposition of
the golf course property;
(3) whether petitioners are entitled to a bad debt deduction in
the amount of $26,000 for funds transferred to their son in
1978;
(4) whether petitioners are entitled to the depreciation claimed
with respect to certain equipment in 1977 and 1978;
(5) whether petitioners are liable for the delinquency addition
pursuant to section 6651(a)(1) for 1977; and
(6) whether petitioners are liable for the negligence addition
pursuant to section 6653(a) for 1978.
FINDINGS OF FACT

Petitioners Charles W. Mars (Charles) and Ruby G. Mars (Ruby), are married and their
legal address was in Oakridge, Tennessee at the time they filed their petition in this case.
Petitioners filed joint Federal income tax returns for taxable years 1977 and 1978 with the
Internal Revenue Service Center in Memphis, Tennessee. On November 14, 1974
petitioners signed a document captioned 'Short Form Option Agreement' giving Henry
Hudson (Hudson), an irrevocable right to purchase a 250 acre 'golf course tract' (golf
course property), for a purchase price undisclosed in the document but later agreed upon
by the parties. Hudson gave petitioners at least $40,000 in cash for the option.

[FN2] On March 24, 1976 petitioners signed a document captioned 'Contract to


Purchase Real Estate in Anderson County, Tennessee' (hereinafter referred o as Purchase
Contract I), wherein petitioners agreed to sell the golf course property to Hudson in
consideration for a purchase price of $800,000. Purchase contract I utilized language
characterizing petitioners as the 'seller' and Hudson as the 'purchaser' of the golf course.
The $800,000 purchase price was satisfied as follows: Cash downpayment $ 50,000
Hudson's assumption of petitioners' first mortgage note to Seeber 300,000 Hudson's
promissory note to petitioners 450,000 Total to petitioners: $800,000 Purchase Contract I
provided that the $50,000 cash downpayment had been previously paid to petitioners.

[FN3] Hudson's promissory note for $450,000 (Hudson note) was payable to petitioners
with simple interest at 10 percent per year computed from April 24, 1976 as follows:

(1) principal payments of $50,000 each due on December 31,


1976, 1977, 1978, 1979, 1980 and 1981;
(2) principal payment of $150,000 due on December 31, 1982;
and
(3) 10 percent interest on the unpaid balance due every six
months beginning June 30, 1976.

On May 12, 1976 petitioners signed a closing statement showing that they were entitled
to receive the Hudson note for the sale of the golf course property. Hudson was given
credit for making the $50,000 cash downpayment and for assuming a $300,000 mortgage
on the property owed to Seeber. Petitioners incurred closing costs of $1,765 on this
transaction.

On May 14, 1976 petitioners conveyed the golf course property by warranty deed to
Hudson in consideration for the $800,000 purchase price. The May 14, 1976 warranty
deed recited that Hudson had assumed a deed of trust on the golf course owed to Seeber
in the amount of $300,000. Hudson assumed this debt. On May 14, 1976, Hudson signed
and delivered to petitioners the Hudson note in the amount of $450,000. The Hudson note
was secured by a deed of trust on the golf course property.
In addition, on May 14, 1976 petitioners entered into a security agreement with Hudson
to secure payment of the Hudson note. The security agreement was collateralized by
certain 'goods'[FN4] owned by Hudson. On May 14, 1976 petitioners signed a separate
agreement transferring possession of the golf course property to Hudson on or before
May 24, 1976.Some time after the May 14, 1976 closing, Hudson informed petitioners
that he was financially unable to pay in cash the indebtedness evidenced by the Hudson
note.

Upon being informed that Hudson could not perform on the note, petitioners allegedly
informed Hudson that the transaction was cancelled. The cancellation of Purchase
Contract I was allegedly documented by a 'cancellation letter' drafted by petitioners' now
deceased attorney, Dwight Cortland, and delivered to Hudson by petitioners and Mr.
Cortland.

[FN5] At no time did petitioners receive a warranty deed of reconveyance from Hudson
nor did petitioners otherwise reinvest themselves with title to the golf course property
pursuant to the default provisions of the Hudson note, the security agreement or the deed
of trust. On December 31, 1976 petitioners and Hudson entered into a Contract to
Purchase Real Estate (hereinafter referred to as Purchase Contract II) wherein petitioners
agreed to purchase from Hudson three parcels of real property known individually as the
'Wilson Sporting Goods Building', the 'Sky Harbor Apartments', and the 'Burger Chef
Restaurant'; and known collectively as the 'Sky Harbor Complex.'

Purchase Contract II provided that the purchase price for the Wilson Sporting Goods
Building was $174,331.42 which was to be paid $50,000 upon the execution of the
contract and the remaining $124,331.42 by petitioners assuming an existing indebtedness
encumbering the Wilson Sporting Goods Building.

The combined purchase price for the Burger Chef Restaurant and Sky Harbor
Apartments was stated as $623,502.31, to be paid as follows:

(1) $250,000 in cash to be paid by petitioners when Hudson


delivered to them deeds conveying the remaining
property;
(2) a promissory note in the amount of $100,000 payable to
Hudson from petitioners due and payable January 10,
1978, and bearing interest at the rate of 10 percent per
annum; and
(3) the balance of $273,502.31 by petitioners taking title to
this property subject to existing deeds of trust.

Pursuant to Purchase Contract II, petitioners received four separate warranty deeds
from Hudson reflecting the transfer in ownership of the Sky Harbor Complex. A warranty
deed conveying title to the Wilson Sporting Goods Building to petitioners was dated
December 31, 1976. That deed was notarized on January 29, 1977 and recorded on
February 17, 1977. A warranty deed conveying title to the Sky Harbor Apartments and
adjoining tract of land to petitioners was signed and notarized on April 12, 1977 and
recorded on May 16, 1977. A warranty deed conveying title to Burger Chef Restaurant,
and a warranty deed conveying title to a strip of land around the Sky Harbor Complex to
petitioners were both signed on February 2, 1978, notarized on February 4, 1978, and
recorded on April 10, 1978. On April 18, 1977 Hudson and petitioners executed an
instrument captioned 'Substitution of Collateral' which released from the deed of trust
securing the Hudson note all of the property described in said deed of trust and
substituting therefor as collateral Hudson's Burger Chef Restaurant property.

As provided in the substitution of collateral agreement, a deed of trust dated April 12,
1977 evidencing the encumbrance on the Burger Chef was recorded in Nashville,
Davidson County, Tennessee. Also on April 18, 1977 petitioners and Hudson exchanged
receipts, each in the amount of $250,000. Hudson acknowledged receipt of $250,000
from Charles for 'equity on apartment & office complex.' Petitioner acknowledged receipt
of $250,000 from Hudson for 'payment on note' with 'balance due $100,000.' On
February 2, 1978 petitioners and Hudson again exchanged receipts. Hudson
acknowledged receipt of $100,000 from petitioners for 'purchase of Burger Chief (sic)
property known as part of Sky Harbor Complex, in the Second Civil District, of Davidson
County, in Nashville, Tennessee.' Petitioners acknowledged receipt of $100,000 from
Hudson for 'release of Burger Chef property known as part of Sky Harbor Complex, in
the Second Civil District, of Davidson County, in Nashville, Tennessee.' Petitioners did
not cancel the Hudson note in 1976; nor did petitioners release the deed of trust or any
other security interest in the golf course property in that year.

On April 28, 1978 petitioners signed a 'Full Release of Trust Deed' for the golf course
property stating that petitioners acknowledged 'the payment in full of said indebtedness
and the satisfaction and discharge of said Deed of Trust.' Hudson had legal title to the
golf course property at all times after it was conveyed to him in May of 1976. At no time
did petitioners attempt to have title reconveyed to them after the alleged rescission of
Purchase Contract I. Petitioners retained a lien on the property until its release.

In connection with their acquisition of the Sky Harbor Complex, petitioners entered
into a Management Agreement with Hudson, dated December 31, 1976, which provided
that petitioners 'have acquired title to the Sky Harbor Complex' and further provided that
Hudson would continue to operate and manage the complex. The agreement provided
that Hudson would pay all the operating expenses, would pay petitioners $3,333.00 per
month, and would be entitled to retain any excess from theincome from operation of the
property. On June 21, 1978, petitioners and Hudson terminated the management
agreement, effective May 31, 1978, and petitioners took over the management and
operation of the Sky Harbor Complex. None of the aforementioned documents, including
Purchase Contract I, Purchase Contract II or any of the deeds, notes, security agreements
or receipts reflected any of the above property transfers as an exchange.

The only documentary evidence in the record directly or indirectly referring to the
property transfers as an exchange is a letter dated December 30, 1976 from a vice
president of Commence Union Bank to Hudson which reads as follows: 'Per our
discussions today regarding the release of the Wilson Sporting Goods property and the
Sky Harbor property which we presently have a lien on, Commerce Union Bank will
release the Wilson Sporting Goods property immediately to facilitate your property swap
in Clinton, Tennessee. However, the remaining Sky Harbor property will not be released
until final endorsement is received from GNMA on the Millwood II project. This
includes release of the letters of credit, as well as repayment of the loans advanced
against retainage on this project.'

On their Federal income tax returns for 1976, 1977 and 1978 petitioners reported the
golf course property transfer to Hudson as an installment sale rather than a like kind
exchange. In his statutory notice of deficiency, respondent determined that petitioners'
long?term capital gain from the sale of the golf course was $384,082.02 and $62,524.98
in 1977 and 1978, respectively, rather than $63,495 and $58,964.94 as reported on
petitioners' returns. Petitioners did not claim the property transactions constituted a like
kind exchange until respondent issued the statutory notice of deficiency.

OPINION DISPOSITION OF GOLF COURSE PROPERTY

The first issue for decision is whether the gain realized on the disposition of petitioners'
golf course property qualifies for nonrecognition under section 1031 or is taxable as a
sale of real property.

Section 1031(a), as in effect during the year in issue, provided that: No gain or loss
shall be recognized if property held for productive use in trade or business or for
investment is exchanged solely for property of a like kind to be held either for productive
use in trade or business or for investment. See also section 1.1031(a)-1, Income Tax
Regs.

The requirements of section 1031 are thus threefold:

(1) there must be an exchange;


(2) the properties exchanged must be of a like kind; and
(3) the property transferred and the property received
must be held by the taxpayer either for use in a trade
or business, or for investment. The parties do not
dispute that the last two requirements had been
complied with [FN9]; rather, the dispute centers on
the first requirement, whether there was an exchange.

At the heart of section 1031 is a requirement that there must be an EXCHANGE of


like-kind business or investment properties, as distinguished from a sale of the property.
This requirement has been repeatedly addressed when the taxpayer sells property for cash
and then reinvests the proceeds in other like kind property. See, e.g., Barker v.
Commissioner, 74 T.C. 555, 560?561 (1980); Swaim v. United States, 651 F.2d 1066,
1069-1070 (5th Cir. 1981); Starker v. United States, 602 F.2d 1341, 1352 (9th Cir. 1979);
Smith v. Commissioner, 537 F.2d 972, 975?976 (8th Cir. 1976), affg. a Memorandum
Opinion of this Court; Carlton v. United States, 385 F.2d 238, 241 (5th Cir. 1967);
Rogers v. Commissioner, 44 T.C. 126, 133 (1965), affd. per curiam 377 F.2d 534 (9th
Cir. 1967).

The inherent difficulty in drawing such distinctions is the weight that must be given the
form of a transaction rather than its substance. As we stated in Barker v. Commissioner,
supra at 561: The 'exchange' requirement poses an analytical problem because it runs
headlong into the familiar tax law maxim that the substance of a transaction controls over
form. In a sense, the substance of a transaction in which the taxpayer sells property and
immediately reinvests the proceeds in like?kind property is not much different from the
substance of a transaction in which two parcels are exchanged without cash. Bell Lines,
Inc. v. United States, 480 F.2d 710, 711 (4th Cir. 1973).

Yet, if the exchange requirement is to have any significance at all, the perhaps
formalistic difference between the two types of transactions must, at least on occasion,
engender different results. Accord, Starker v. United States, 602 F.2d 1341, 1352 (9th
Cir.1979). We must first analyze the form in which the subject property transfers were
cast and determine whether that form more closely resembles an exchange or a sale.

Next we must decide whether the transactions' form conflicts with its economic
substance or the intent of the parties. While intent alone in like kind transfers is not
sufficient (Carlton v. United States, supra), it is relevant to a determination of what
transpired. Biggs v. Commissioner, 69 T.C. 905 (1978), affd. 632 F.2d 1171 (5th Cir.
1980). The burden of proving that disposition of petitioners' golf course property
qualifies as a like kind exchange under section 1031 is on petitioners. Welch v.
Helvering, 290 U.S. 111 (1933); Rule 142(a). Furthermore, where the taxpayer seeks to
avoid the form of his own agreement, a higher level of proof, known as the 'strong proof
standard' is required. See Coleman v. Commissioner, 87 T.C. 178, 201?203 (1986), on
appeal (3d Cir., Mar. 10, 1987); Major v. Commissioner, 76 T.C. 239, 247 (1981). See
also Schulz v. Commissioner, 294 F.2d 52, 55 (9th Cir. 1961), affg. 34 T.C. 235 (1960).

On May 14, 1976, petitioners and Hudson entered into Purchase Contract I wherein
petitioners sold the golf course property to Hudson for $800,000. Thereafter, on or about
December 31, 1976, petitioners and Hudson entered into a separate contract, Purchase
Contract II, wherein Hudson sold different but similar real estate to petitioners.
Petitioners concede that Purchase Contract I was structured as a cash sale of petitioners'
property and that the parties had no intention at that time of exchanging properties.

Petitioners claim however that upon learning of Hudson's inability to perform on the
Hudson Note that the parties subsequently agreed to rescind Purchase Contract I and
complete an exchange of like-kind property. Charles testified that the rescision was
evidenced by a letter drafted by Mr. Cortland, petitioners' attorney who is now deceased,
signed by Charles and subsequently delivered to Hudson. Petitioners were unable to
produce this letter.
[FN10] The only documentary evidence in the record referencing an exchange of real
property is the December 30, 1976, letter from Commerce Union Bank to Hudson
wherein the bank agreed to release its lien on the Wilson Sporting Goods Building to
'facilitate your property swap in Clinton, Tennessee.' The form chosen by the parties to
document the real property transfers was a sale, not an exchange. We find no reason to
conclude that the parties intended a different result than that represented by the
documents they signed. We find it curious that if petitioners and Hudson had intended to
rescind Purchase Contract I and restructure the transaction as an exchange of like kind
property that Purchase Contract II would make no reference to either the previous
contract, its rescission or the intent of the parties to link the transfer of property from
Hudson to petitioners to the transfer of real property from petitioners to Hudson.

Petitioners' only explanation for the failure of the documents to refer to the transfers as
an exchange was Charles' desire to eliminate the legal fees which would have been
incurred in redrafting the documents. Such an explanation is not credible given that
Purchase Contract II was signed, and presumably drafted, after the alleged rescission of
Purchase Contract I and after the parties had allegedly agreed to restructure the
transaction as an exchange. The documentation of Purchase Contract II was very detailed
and precise. It seems only reasonable that the parties would insist that the second
purchase contract accurately reflect the substance of an exchange, if they had so intended,
particularly if they purposefully intended it to be an exchange rather than a sale.

[FN11] In this context, a failure of Purchase Contract II to mention the transfer of


property as an exchange lends support to respondent's argument that on December 31,
1976, the parties did not in fact intend to restructure the transaction as an exchange, but
rather petitioners agreed to accept the Sky Harbor Complex as payment on the Hudson
note. Additional factors indicate that the two real estate transactions were in neither
substance nor form a like kind exchange.

Although not determinative, it is also interesting to note that on their 1977 and 1978
Federal income returns petitioners treated the disposition of their golf course property as
an installment sale. It was not until respondent issued his statutory notice of deficiency
that petitioners characterized the disposition as a like kind exchange. We are aware that
the transfers of property in this case show some attributes normally associated with a like
kind exchange. Contrary to respondent's repeated assertions, there is no evidence that any
cash was exchanged between petitioners and Hudson other than the $50,000 option price
which was later categorized by the parties as an earnest money deposit.

[FN12] We conclude that petitioners have failed in their burden to establish that the
transactions in question qualified, either in form or substance, as a like kind exchange.
Purchase Contract II, signed after the alleged rescission of Purchase Contract I, is
curiously devoid of any reference to Purchase Contract I, the desire of the parties to
exchange property in lieu of the cash sale, or of a reciprocal transfer of property. Apart
from the Commerce Union Bank letter, which merely reflects the understanding of a third
party not directly involved in the transaction, there is a total absence of documentary
evidence to support the contention that the parties intended and in fact accomplished an
exchange of property.

[FN13] The absence of any statement or testimony of Hudson is particularly damaging


to petitioners' case. If petitioner and Hudson intended to rescind a carefully drawn written
agreement and substitute an entirely different agreement therefor it should surely have
been evidenced in writing. Charles' only explanation was that he didn't want to pay
additional legal fees for such a document. But legal fees must have been paid for the deed
conveying the Wilson Sporting Goods property to petitioner.

But in any event Hudson had to agree to the purported change in the agreement, and he
was the best person to testify about the transaction. The burden of proof was on petitioner
not only to prove that the transaction was more than it appeared to be but also to disprove
the validity of respondent's determinations. Petitioners' failure to introduce testimony of
Hudson gives rise to the presumption that if produced it would have been unfavorable to
petitioners. Wichita Terminal Elevator Co. v. Commissioner, 6 T.C. 1158 (1946), affd.
162 F.2d 513 (10th Cir. 1947).

We are left with only the unsubstantiated testimony of Charles that a rescission of
Purchase Contract I did in fact occur and that petitioners and Hudson restructured the
transfers as a like kind exchange. We cannot accept such self serving testimony to sustain
a burden of proof without substantiating documentation.

[FN14] Geiger v. Commissioner, 440 F.2d 688 (9th Cir. 1971) affg. a Memorandum
Opinion of this Court.

Decision will be entered under Rule 155.

FN10 Charles testified that petitioners were unable to find a copy of the letter either in
their own files or those of Mr. Hudson. No mention is made whether petitioners
attempted to contact Mr. Cortland's estate in an effort to locate a copy of the alleged
rescission letter.

FN11 Even a simple letter of understanding signed by petitioners and Hudson


reflecting their intent to treat the two transactions as an interdependent exchange might
have strengthened petitioners' case.

FN13 Unfortunately both parties failed to offer evidence that should have been
available to support many of their contentions. Instead their arguments were often based
on facts they assumed to be proven.

FN14 In all likelihood petitioners might have obtained the result they claim, both
transaction?wise and tax-wise, had they bargained for it at the time, but there is no direct
evidence that an exchange was even considered or discussed.
SECTION 1031 IS MANDATORY:
REV. RUL. 61-119

Since Section 1031 is mandatory, the taxpayer must be careful to avoid that section if
he desires to have recognition. Obviously, recognition is normally sought when a loss
occurs. However, it may be advantageous to have recognition even when there is a gain.
Where the taxpayer was not currently in a high tax bracket and anticipates being in a
higher bracket at a later time, it may be advantageous, considering all events, to have a
gain in the year in question. It might also be advantageous to have the recognizable
benefits of a higher basis for depreciation. Rev. Rul. 61-119 examines the question
whether a transaction will constitute a sale of used equipment and the purchase of other
new equipment or whether it is one integrated transaction, covered under Section 1031.
Can the taxpayer avoid Section 1031 in this setting?

REVENUE RULING 61-119


1961-1 C.B. 395

Advice has been requested whether a transaction of the type described below
constitutes a sale of used equipment and the purchase of new equipment or whether it is
one integrated transaction constituting an exchange with respect to which section 1031(a)
of the Internal Revenue Code of 1954 provides for the nonrecognition of gain or loss. A
taxpayer has equipment used in his trade or business for more than six months for which
his adjusted basis is $500. This used equipment has a fair market value of $1,000. Better
equipment is now available which the taxpayer desires to acquire. Such equipment has a
listed retail price of $10,000 but is regularly sold for $9,000.

Ordinarily, the taxpayer would accomplish the exchange by surrendering the old
equipment to the dealer and receiving a trade in allowance to cover part of the cost of the
new equipment. Thus, the dealer would bill the taxpayer for $8,000, representing the
$9,000 sales price of the new equipment minus the $1,000 trade-in allowance for the old
equipment. Alternatively, the dealer's invoice might reflect the new equipment at its list
price, or $10,000, in which case the trade-in allowance would be shown as $2,000,
leaving $8,000 as the balance due from the customer.

In either case, the transaction would be treated as a nontaxable exchange, in view of


section 1031(a) of the Code, which provides, in part, that no gain or loss shall be
recognized if property held for productive use in trade or business is exchanged solely for
property of a like kind to be held for the same purpose, and in view of section 1.1031(a)-
1(a) of the Income Tax Regulations, which provides, in part, that a transfer of property
meeting the requirements of section 1031(a) may be within the provision of section
1031(a) even though the taxpayer transfers in addition property not meeting the
requirements of section 1031(a) or money.

In the above situation, therefore, no gain or loss would be recognized even though the
taxpayer was allowed $1,000 in the first instance, or $2,000 in the second instance, for
the used equipment for which his basis was $500. The taxpayer's unrecognized gain on
the trade?in would be applied, in accordance with I.T. 2615, C.B. XI--1, 112 (1932), to
reduce his basis of the new equipment for depreciation purposes. Thus, the taxpayer's
basis for the new equipment would be $8,500, the purchase price less the unrecognized
gain on the used equipment. The question has been raised whether the foregoing
authorities will continue to govern the tax consequences of the transaction if, instead of
entering into a direct exchange in the manner outlined above, the parties entered into
separate contracts, one covering the sale of the old equipment and the other covering the
purchase of the new equipment.

The recognition to be accorded a particular transaction for Federal income tax purposes
depends upon the substance of the transaction rather than the form in which it is cast. The
Internal Revenue Service and the courts look to what is actually done rather than to the
formalities of the transaction or to the declared purpose of the participants in gauging its
tax consequences. See Harry H. Weiss v. Louis Stearn et al., 265 U.S. 242, T.D. 3609,
C.B.III??2, 51 (1924), and Helvering v. The F. & R. Lazarus & Co., 308 U.S. 252, Ct.D.
1430, C.B. 1939??2, 208.

The courts have held that a sale is to be disregarded where it is a step in a transaction
the purpose of which is to make an exchange, and which results in an exchange. See
Century Electric Co. v. Commissioner, 192 Fed.(2d) 155, certiorari denied 342 U.S. 954.
See also Revenue Ruling 60??43, C.B. 1960??1, 687.

In the instant case the sale of the used equipment and the purchase of the new
equipment are reciprocal and mutually dependent transactions. The taxpayer's acquisition
of the new equipment from the dealer is contingent upon the dealer taking his used
equipment and granting a trade-in allowance equal to or in excess of its fair market value.
Moreover, the dealer's acceptance of the old equipment is dependent upon the taxpayer's
purchase of the new equipment. Under these circumstances, the transfer of the old
equipment to the dealer, irrespective of the form or the technique through which the
transfer is accomplished, represents but a step in a single integrated transaction.

Accordingly, it is held that the transfer of the old equipment to the dealer and purchase
of the new equipment from him is a nontaxable exchange under section 1031 of the Code,
even though the purchaser and the seller execute separate contracts and treat the purchase
and sale as unrelated transactions for record keeping purposes. The fact that the purchase
and sale are consummated concurrently, or that the sales price of the new equipment and
the trade?in allowance for the old equipment are in excess of the price at which such
items are ordinarily sold, may serve as indication that the purchase and sale were not
intended as separate or unrelated transactions. However, the absence of either or both of
these factors, standing alone, will not be taken to indicate that separate or unrelated
transactions were consummated.

EXCHANGE OF A LIFE ESTATE FOR A REMAINDER INTEREST:


REVENUE RULING 72-601
Although in concept Rev. Rul. 72-601 indicated that a transaction involving an
exchange of a remainder interest in real estate for a life estate in real estate would qualify
under Section 1031, the unique facts of this given case eliminated the qualification.

A 70-year-old father and his son were both farmers and owners of farm real estate.
They were materially participating landlords on the farms in question (for this concept,
see Rev. Rul. 64-32, C.B. 1964, Part I, 319).

The father owned in fee simple a 100-acre farm. The son owned in fee simple a 142-
acre farm. The son conveyed to his father a life estate based on the father's life in his 142-
acre farm, reserving to himself the remainder interest. The father in return conveyed to
his son the remainder interest in the 100-acre farm, but reserved the life estate for
himself. There was no money or other boot transfer involved. The father and son were
investors in the property and not dealers.

These interests in the real property were considered life estates under state property
law; that was not an issue. Citing the Internal Revenue Code and the Regulations, the
Ruling holds that the transaction did not qualify because under Treas. Reg. Section
1.1031(a)1, [N]o gain or loss is recognized if . . .

(2) a taxpayer who is not a dealer in real estate exchanges city real estate for a ranch or
farm, or exchanges a leasehold of a few with 30 years or more to run unimproved real
estate;

The key is the "30 years or more." Since the life estate the son exchanged for a
remainder interest had a potential leasehold value of less than 30 years, it would not
qualify. The father was 70 years of age, and he received a life estate, said the Ruling, that
had an expectancy of less than 30 years, according to standard mortality tables. Thus, the
life estate received could not be considered "like-kind" to a fee interest in real estate.
Accordingly, it was held that the father's exchange in the remainder interest for a life
estate did not qualify under Section 1031.

There has been a great deal of discussion as to the implications of this Ruling. Although
it appears that the Ruling is limited to the unique facts of that case, wherein the father
was 70 years of age, other writers have expressed concern, or at least speculated as to the
future on exchanges when the government reviews in detail the unique facts of a case as
to a life estate, etc.; will the government modify its prior position, which seemed to allow
an exchange in this type of setting?

RECAPTURE:
EXCHANGES AND DEPRECIATION RECAPTURE UNDER SECTION 1245

An additional question that must be asked on an exchange is whether there will be


recapture of depreciation on the transfer of personalty. The general rule is that there is no
recapture since depreciation recapture under Section 1245 for personalty operates on the
character of the gain. That is section was designed to possibly change what would have
been capital gain, recognized under Section 1002, Section 1245 and Section 1250 to be
treated as ordinary income.

There is an exception as noted regarding Section 1250. Section 1245 follows the same
concept as Code Section 1250. Again, generally speaking, no gain would be recognized
under most Section 1031 transactions. However, where the fair market value of Section
1245 property which is transferred is greater than the fair market value of Section 1245
property that is acquired, to the extent of that difference, there can be taxable gain.[See
Section 1245(b)(4)(B).]

It should be emphasized that if Section 1245 property is transferred, there will be a


recognition of gain to the extent of the recapture rules under Section 1245. This would be
ordinary income under the recapture provisions.

As an example, where a taxpayer transfers Section 1245 property after taking


depreciation on it, and which would be subject to recapture, and it is in exchange for non-
Section 1245 property, such as the receipt of nondepreciable personalty used in the trade
or business, Section 1245(b)(4)(B) would be activated to cause the recognition of that
gain as though it were boot; thus, it would be taxed. This provision exists to prohibit a
situation where potential recapture might otherwise be eliminated by use of the exchange
technique. This would be ordinary income if the subsection were activated under the rules
noted. [See Treas. Reg. Section 1.1245-4(d)(1) and (2). See also Code Section
1245(b)(4)(A).]

To the extent there is boot received, that boot will be classified as ordinary income as
opposed to capital gain if there is a potential of Section 1245 recapture that would be
applicable.

As an additional example, assume the taxpayer transferred Section 1231 property with a
basis of $4,000, that had depreciation claimed of $1,000. Also assume the fair market
value of the property was $8,000. Assume that the taxpayer received in exchange like-
kind property with a fair market value of $6,000, and also the sum of $2,000 in cash.
Since the $1,000 in cash is boot, it will cause recognition if there is gain. There is gain
($8,000 "sales price," less an adjusted basis of $3,000 or $5,000 gain). As to the character
of the recognition, since there is potential recapture because of the prior $1,000 of
depreciation, $1,000 of depreciation, $1,000 of the $2,000 would be ordinary income. In
this case the boot was more than the potential Section 1245 ordinary income.

Code Section 1245 provides:

Section 1245 recovery property. - Subsection (a) shall not apply to the disposition of
which is section 1245 recovery property (as defined in section 1245(a)(5)).

RECAPTURE AND RELATED ISSUES: PRIVATE LETTER RULING 9243038


In this Ruling, Corporation A undertook a number of transactions, some of which
included leasing, exchanging and other related activity. The Taxpayer was concerned as
to whether the step transaction might apply to collapsed debts and deny treatment as a
tax-deferred exchange. The Ruling addressed questions as to leases by a corporation and
subsequent exchanges, along with questions of potential recapture under Code §1245 and
§1250. Other miscellaneous issues were also addressed.

The Service ruled that the three (3) main tests for application of the step transaction
include:

(1) Binding commitment test;


(2) Mutual interdependence test; and
(3) The end result.

The Ruling held that the step transaction was not violated, and the transaction would be
treated as a Code §1031 transaction with no recognition of gain because of recapture
under Code §1245 or §1250.

PRIVATE LETTER RULING 9243038


July 27, 1992

Publication Date: October 23, 1992

Dear

This is in reply to a letter from you in your capacity as authorized representative dated
May 1, 1992 and subsequent correspondence, requesting rulings under section 1031 of
the Internal Revenue Code.

You and your clients have represented that a parcel of some g acres is currently held by
Corp A, in County A. Corp A acquiredib-e property in 1977 from its sole shareholder by
contribution. property was used for agricultural uses from 1956 (when the shareholder
acquired it) to 1977. Corp A used the property chiefly for agricultural use until 1985.

In the mid-1980s, Corp A determined that the property would be more valuable for
commercial than for agricultural purposes, but it did not have the resources or expertise
to develop the property into a commercial office and industrial park. While examining
alternatives, Corp A was approached by Corp B, an unrelated real estate and construction
company with suitable expertise and interest. On August 5, 1985, Corp A and Corp B
entered into an Agreement to Ground Lease. Under the agreement Corp A agreed to enter
into a series of ground leases. The terms of all of the leases run for more than 90 years.
Also, under the agreement, Corp B agreed to develop and manage g acres of the property
over approximately 14 years.
The initial infrastructure to be developed was a parcel of h acres, and Corp B agreed to
"take down" not less than 20 acres of the property each year, on a cumulative basis, with
each "take down" in the form of a separate ground lease.

Corp B was also required to construct improvements on each parcel subject to ground
lease within 6 months of the execution of the ground lease. Each ground lease
commenced on the date of its execution, but all ground leases terminate on December 31,
2084.

Corp B then assigned the Agreement to Ground Lease to LP, a State B limited
partnership and an instrumentality of Corp B, pursuant to an Assignment of Agreement to
Ground Lease dated December 1, 1986. The Agreement to Ground Lease was amended
by an Amendment to Agreement to Ground Lease on December 28, 1988.

After entering into the Agreement to Ground Lease in 1985

Corp B designed and installed the necessary infrastructure to develop a portion of the
property into an industrial and commercial office park (the "Office Park"). Thereafter, LP
and Corp A entered into 9 separate ground leases for portions of the property. LP,
complying with the Agreement to Ground Lease, commenced construction of one or
more buildings on each parcel of the property within six months after execution of each
ground lease. The buildings were then leased to one or more third party tenants at
prevailing rental rates and on commercially reasonable terms.

In August 1990, LP requested Corp A to modify certain provisions of the Agreement


to Ground Lease. The Agreement to Ground Lease provides that Corp A, as ground
lessor, is not obligated to subordinate its fee interest in the ground lease parcels to the lien
of any mortgage encumbering the ground lessee's leasehold interest. LP took the position
that this provision, coupled with the deepening recession and stringent new real estate
lending requirements imposed upon banks, savings and loan institutions, and other
lenders (resulting from a substantial number of bank and thrift failures) had hampered the
ability of LP to procure construction financing for buildings to be constructed on the
ground lease parcels and to secure permanent financing in amounts and on terms
satisfactory to LP. Therefore, LP negotiated to restructure the original arrangements
between LP and Corp A.

On May 1, 1992, the negotiations culminated in the execution of an Agreement of


Exchange, which accomplished a complete restructuring of the original agreement. Under
the Agreement of Exchange, Corp A will convey to LP its entire fee simple interest in the
portions of the original property designated as Parcels 3, 4, 5, 6, 7, and 8, which are
subject to ground leases, and Lots 2 and 3C, which are unimproved properties not subject
to ground leases (collectively the "Corp A Exchange Parcels"). Corp A owns only the
raw land comprising the Corp A exchange parcels, none of which is depreciable property.
LP had already owned any improvements on those parcels. These parcel s are agreed to
be worth $k.
In exchange for the Corp A Exchange Parcels, LP will convey to Corp A its entire
leasehold interest in portions of the property designated as parcels 1,2,5, and 10, which
are subject to ground leases, and its ownership interest in all improvements located on
those parcels (the "LP Exchange Parcels"). These parcels are agreed to be worth $1.
Since $1 is more than $k, the difference of $m will be paid by Corp A to LP at closing.

These conveyances will result in the termination of all existing ground leases. LP will
become the fee simple owner of the Corp A Exchange Parcels and the improvements on
those parcels. Corp A will own the LP Exchange Parcels, including all improvements,
free of all leasehold interests. You have requested that the Service rule as follows:

1. The transfer by Corp A of fee simple title to the Corp A


Exchange Parcels and $m in cash to LP in exchange for the LP
Exchange Parcels constitutes an exchange eligible for
nonrecognition of gain treatment under section 1031 of the
Code by Corp A of properties held by it for productive use in a
trade or business or for investment plus cash, for like kind
properties which will be held by Corp A for productive use in a
trade or business or for investment.
2. Corp A will not be required to recognize income as a result of
the proposed exchanges under either section 1245 or section
1150 of the Code.
3. Corp A's basis in the LP Exchange Parcels (including the
improvements thereon) will be the sum of: (1) Corp A's basis in
the LP Exchange Parcels immediately prior to the exchange
(representing the existing Corp A ownership of the fee simple
title to such properties), (2) Corp A's basis in the Corp A
Exchange Parcels it will convey to LP in the exchange, and (3)
the amount of cash paid by Corp A to LP at closing. The
additions to Corp A's basis described in (2) and (3) of the
preceding sentence will be allocated first among the parcels
comprising the LP Exchange Parcels based upon their relative
fair market values, and then between the land and
improvements upon each such parcel according to their fair
market values.
4. Corp A's holding period for the LP Exchange parcels received
by Corp A in the exchange will be the same as Corp A's holding
period in the Corp A exchange parcels conveyed by Corp A to
LP in the exchange pursuant to section 1223(l) of the Code.

Section 1031(A)(1) of the Code provides that, in general, 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 a like kind which is to
held either for productive use in a trade or business or for investment.
Section 1.1031(A)-I(B) of the Income Tax Regulations provides, in part, that the words
"like kind" have reference to the nature or character of the property and not to its grade or
quality. In subsection (c) examples are provided allowing the exchange by a taxpayer
who is not a dealer in real estate of a ranch or a farm for city real estate, a leasehold of a
fee with 30 or more years to run for real estate, and improved real estate for unimproved
real estate. It is also possible to exchange investment property and cash for investment
property of a like kind.

Section 1011(a) of the Code provides, as a general rule, that the adjusted basis for
determining the gain or loss from the sale or other disposition of property, whenever
acquired, shall be the basis (determined under section 1012 or other applicable sections of
this subchapter and subchapters C, K, and P), adjusted as provided in section 1016.

Section 1031(D) of the Code provides, in part, that if property is acquired in an


exchange described in this section then the basis shall be the same as that of the property
exchanged decreased by the amount of any money received and increased in the amount
of gain or decreased by the amount of any loss that was recognized on such exchange.
For purposes of this section where as part of the consideration to the taxpayer another
party to the exchange acquired from the taxpayer property subject to a liability, such
acquisition (in the amount of the liability) shall be considered as money received by the
taxpayer on the exchange.

Section 1223(l) of the Code provides, in part, that, in determining the period for which
the taxpayer has held property received in an exchange, there shall be included the period
for which he held the property exchanged if, under this chapter, the property has, for the
purpose of determining gain or loss from a sale or exchange, the same basis in whole or
in part in his hands as the property exchanged, and the property exchanged at the time of
such exchange was a capital asset as defined in section 1221 or property described in
section 1231.

Section 1245(a)(1) of the Code provides that except as otherwise provided in this
section, if section 1245 property is disposed of the amount by which the lower of (a)
the'recomputed basis of the property, or (b) (i) in the case of a sale, exchange, or
involuntary conversion, the amount realized, or (ii) in the case of any other disposition,
the fair market value of such property, exceeds the adjusted basis of such property, shall
be treated as ordinary income.

Section 1245(a)(3) of the Code defines the term "section 1245 property" as any
property that is or has been property of a character subject to the allowance for
depreciation provided in section 167 (or subject to the allowance of amortization
provided in section 185 or section 1253(d)(2) or (3)) and is either:

(a) personal property,


(b) other property described in section 1245(a)(3)(B),
(c) so much of any real property (other than any property
described in section 1245(a)(3)(B)) that has an adjusted basis
in which there are reflected adjustments for amortization under
sections 169, 179, 185, 188, 190, 193, or 194,
(d) a single purpose agricultural or horticultural structure,
(e) a storage facility (not including a building or its structural
components) used in connection with the distribution of
petroleum or any primary product of petroleum, or
(f) any railroad grading or tunnel bore

Section 1250(a)(1)(A) of the Code provides that if section 1250 property is disposed of
after December 31, 1975, then the applicable percentage of the lower of (i) that portion of
the additional depreciation attributable to periods after December 31, 1975, in respect of
the property, or (ii) the excess of the amount realized (in the case of a sale, exchange, or
involuntary conversion), or the fair market value of such property (in the case of any
other disposition), over the adjusted,basis of such property, shall be treated as gain that is
ordinary income.

Section 1250(c) of the Code defines the term "section 1250 property" as any real
property (other than section 1245 property) , as defined in section 1245 (a) (3)) that is or
has been property of a character subject to the allowance for depreciation as provided in
section 167.

In Rev. Rul. 67-255, 1967-2 C.B. 270, it was held that the investment of the proceeds
from an involuntary conversion of land held for investment purposes in the construction
of an office building to be held for investment purposes upon land already owned by the
taxpayer does not qualify as a "like kind" replacement of the converted property within
the meaning of section 1033(g) of the Code.

In Rev. Rul. 68-394, 1968-2 C.B. 338, in which a leasehold on adjacent property was
used to replace the taxpayer's condemned real property for a mobile trailer park site, we
ruled that it is not material to the replacement that the acquisition of a more than 30 year
leasehold was on property already owned by the taxpayer. It would qualify as a "like
kind" replacement for a fee interest in real estate under either section 1031 or section
1033(g) of the Code, as long as it was acquired in an otherwise qualifying arm's-length
transaction.

In this case Corp A proposes to exchange fee interests in 1 and for long term (90+
years remaining) leases on both land and buildings held for use in a trade or business. If
these transactions were viewed as one transaction under the step transaction doctrine, (see
Commissioner v. court Holding Company, 324 U.S. 331 (1945)) the transactions could be
viewed as an exchange of the Corp A Exchange Parcels for a building on land already
owned by Corp A. Consistent with Rev. Rul. 67-255, such a building is not like kind to
the transferred property. However, we rule that the step transaction doctrine does not
apply to the facts presented in your letters. Instead, we rule that the facts are more
consistent with the holding in Rev. Rul. 68-394.

There are three main tests for application of the step transaction doctrine:
(1) the binding commitment test,
(2) he mutual interdependence test, and
(3) the end result test.

We rule that the facts presented here meet none of these tests in order to be viewed as a
step transaction. In applying the binding commitment test, we find no evidence that the
1985 transactions included a commitment, formal or informal, for Corp A and Corp B or
LP to engage in a subsequent exchange. The facts presented reveal that subsequent
events, such as the thrift institution crisis and the difficulty in LP obtaining financing
prompted Corp A and LP to restructure the original arrangements. Similarly, applying the
mutual interdependencetest, based on your representations we rule that the 1985
transactions had independent legal significance and were not dependent on the 1992
exchange. Moreover, under the end result test, based upon your representations we rule
that there was no intent that the 1985 leases were entered into from the outset so that the
1992 exchanges could be made. Consequently, the step transaction doctrine does not
prevent nonrecognition of gain or loss under section 1031.

With respect to sections 1245 and 1250, no depreciable property wi11 have been
disposed of so as to require recapture of depreciation under sections 1245(a)(1) and
1250(a)(2)(A) of the Code. Accordingly,based on the facts presented and the
representations made, we rule that:

1. The transfer by Corp A of fee simple title to the Corp A


Exchange Parcels and $m in cash to LP in exchange for the LP
Exchange Parcels constitutes an exchange eligible for
nonrecognition of gain treatment under section 1031 of the
Code by Corp A of properties held by it for productive use in a
trade or business or for investment plus cash, for like kind
properties which will be held by Corp A for productive use in a
trade or business or for investment.
2. Corp A will not be required to recognize income as a result of
the proposed exchanges under either section 1245 or section
1250 of the Code.
3. Corp Als basis in the LP Exchange Parcels (including the
improvements thereon) will be the sum of: (1) Corp A's basis in
the LP Exchange Parcels immediately prior to the exchange
(representing the existing Corp A ownership of the fee simple
title to such properties), (2) Corp A's basis in the Corp A
Exchange Parcels it will convey to LP in the exchange, and (3)
the amount of cash paid by Corp A to LP at closing. The
additions to corp A's basis described in (2) and (3) of the
preceding sentence will be allocated first among the parcels
comprising the LP Exchange Parcels based upon their relative
fair market values, and then between the land and
improvements upon each such parcel according to their fair
market values.
4. Corp A's holding period for the LP Exchange parcels received
by Corp A in the exchange will be the same as Corp A's holding
period in the Corp A exchange parcels conveyed by-Corp A to
LP in the exchange pursuant to section 1223(l) of the Code.

No opinion is expressed as to the tax treatment of the transaction under the provisions
of any other sections of the Code and regulations which may be applicable thereto, or the
tax treatment of any conditions existing at the time of, or effects from, the transaction
which are not specifically covered by the ruling. A copy of this letter should be attached
to the federal income tax return of the taxpayer for the taxable year which the transaction
covered by this letter is consummated.

This ruling is directed only to the taxpayers who requested it. Section 6110(j)(3) of the
Code provides that it may not be used or cited as precedent. Sincerely yours, Assistant
Chief Counsel (Income Tax & Accounting)

SALE OR EXCHANGE: CENTURY ELECTRIC CO.

In Century Electric Co., the court, addressing a question that seems to arise often in the
Section 1031 area, was faced with the issue of whether a transaction for tax purposes was
a sale property or whether it was an exchange.

The taxpayer, Century Electric Co., was a corporation engaged in the manufacture and
sale of electric motors. It was not a dealer in real estate. As of December 1, 1943, the
taxpayer transferred the foundry building owned and used by it for manufacturing and the
land on which it was located to William Jewell College for $150,000 with a leaseback
clause. It claimed a deductible loss on the transaction. The Commissioner of Internal
Revenue denied the loss.

The deed to the college and the leaseback were executed and delivered as provided by
a resolution of the corporation. Neither the deed nor the lease referred to each other.

The tax basis for the foundry building for the taxpayer was $531,000, with the sales
price of $150,000. Thus, the taxpayer took the position that he had a deductible loss. On
the other hand, the Tax Court held that this was an exchange of property for productive
use in trade or business, and therefore the loss deduction was denied. In other words, it
was an exchange of a fee interest for a leasehold interest.

The Court of Appeals, when reviewing the Tax Court position, held that the transaction
fell within Code §112 (predecessor to §1031).

As such, the court said that the transaction could not be separated into its component
parts for tax purposes. Tax consequences, said the court, must depend on what actually
took place and not on separate steps to reach a desired end.
The net effect was that the foundry property was used before for the transaction of the
trade or business of the taxpayer and was used after the transaction as property in the
trade or business. The Court of Appeals further referred to the Treasury Regulations
which interpret this type of position. The Court stated:

Under the Treasury interpretation, a lease with 30 years or more to run and real estate
are properties of "like-kind." With the controlling purpose of the applicable section of the
revenue code in mind, we cannot say that the words "like kind" are so definite and certain
that interpretation is neither required nor permitted. The regulation, enforced for many
years, has survived successive re-enactments of the Internal Revenue Acts and has thus
acquired the force of law.

Thus, we can see not only the importance of looking to the substance of the
transaction, as well as to the form, but also the need to consult the Regulations when
looking to an interpretation of Section 1031 (and other sections).

As far as structuring the transaction to allow it to qualify, one might conjecture a


number of alternatives. Literally speaking, if one would draw a lease that is under 30
years, then technically it would not fit within the equivalency doctrine mentioned. It
would also have helped if the lease arrangement was connected with the sale
arrangement. It would have helped if other parties were involved relative to the lease. It
would have helped if the documents were not executed on the same day. And so on.

CENTURY ELECTRIC CO.


v.
COMMISSIONER OF INTERNAL REVENUE.
51-2 U.S.T.C. Para. 9482 192 F.2d 155 (8th Cir. 1951)

RIDDICK, Circuit Judge.

The petitioner, Century Electric Company, is a corporation engaged principally in the


manufacture and sale of electric motors and generators in St. Louis, Missouri. It is not a
dealer in real estate. As of December 1, 1943, petitioner transferred a foundry building
owned and used by it in its manufacturing business and Jewell College and claimed a
deductible loss on the transaction in its tax return for the calendar year 1943. The
Commissioner of Internal Revenue denied the loss. The Commissioner was affirmed by
the Tax Court and this petition for review followed.

The opinion of the Tax Court and its findings of fact, stated in great detail, are reported
in 15 T.C. 581. Petitioner accepts the Tax Court's findings of fact as correct.

Since its organization in 1901 petitioner has been continuously successful in business.
In its income tax return for the year 1943 it reported gross sales of $17,004,839.73 and
gross profits from sales of $5,944,386.93. On December 31, 1942, petitioner owned land,
buildings, and improvements of the total depreciated cost of $1,902,552.16. On
December 31, 1943, its actual cash on hand amounted to $203,123.70 During the year
1943 it distributed cash dividends of $226,705.69 and made a contribution to Washington
University of $42,500. It also held tax anticipation notes and Series G bonds totaling
$2,000,000, readily convertible into cash and sufficient to liquidate its outstanding 1943
tax liability and its two outstanding 90?day bank notes due January 20, 1944.

Petitioner has always operated its business in large part on borrowed capital. In 1943 it
had open lines of credit with the Chase National Bank of New York of $300,000, with the
Boatmen's National Bank of St. Louis of the same amount, and with the Mercantile
Commerce Bank and Trust Company of $400,000. At the end of 1943 its outstanding
loans from the Mercantile bank amounted to $600,000 approved by the authorized
officers of the bank. Petitioner has always been able to liquidate its outstanding 90 day
bank loans as they become due either by payment or renewal.

The assessed value of petitioner's foundry building and land upon which it is located
for 1943 was $205,780. There was evidence that in St. Louis real property is assessed at
its actual value. There was also evidence introduced by petitioner before the Tax Court
that the market value for unconditional sale of the foundry building, land, and
appurtenances was not in excess of $250,000.

As of December 1, 1943, the adjusted cost basis for the foundry building, land, and
appurtenances transferred to William Jewell College was $531,710.97. The building was
a specially designed foundry situated in a highly desirable industrial location. It is
undisputed in the evidence that the foundry property is necessary to the operation of
petitioner's profitable business and that petitioner never at any time considered a sale of
the foundry property on terms which would deprive petitioner of its use in its business.

Petitioner's explanation of the transaction with the William Jewell College is that in the
spring of 1943 a vice president of the Mercantile bank where petitioner deposited its
money and transacted the most of its banking business suggested to petitioner the
advisability of selling some of its real estate holdings for the purpose of improving the
ratio of its current assets to current liabilities by the receipt of cash on the sale and the
possible realization of a loss deductible for tax purposes. Petitioner's operating business
was to be protected by an immediate long-term lease of the real property sold.

Petitioner's board of directors rejected this proposition as unsound. But in July 1943,
when a vice-president of the Mercantile bank suggested to petitioner's treasurer that it
would be a good idea for petitioner to pay off all its bank loans merely to show that it was
able to do so, petitioner interpreted this advice as a call of its bank loans. Acting on this
interpretation, petitioner borrowed from the First National Bank in St. Louis on the
security of tax anticipation notes held by it, funds with which it discharged all its bank
loans. Immediately thereafter it re?established its lines of bank credit and began
consideration of a sale of the foundry property and contemporaneous lease from the
purchaser.

On September 2, 1943, petitioner's board of directors adopted a resolution that the


executive committee of the board study the situation 'and present, if possible, a plan
covering the sale and rental back by Century Electric Company of the foundry property.'
The decision to enter into the transaction described was communicated to the Mercantile
bank, but petitioner never publicly offered or advertised its foundry property for sale. The
Tax Court found that petitioner 'was concerned with getting a friendly landlord to lease
the property back to it, as there was never any intention on the part of petitioner to
discontinue its foundry operations.'Several offers to purchase the foundry property at
prices ranging from $110,000 to $150,000 were received and rejected by petitioner.

At a special meeting of the board of directors of petitioner on December 9, 1943, the


president of petitioner reported that the officers of petitioner had entered into negotiations
for the sale of the foundry property to William Jewell College for the price of $150,000
with the agreement of said college; 'that in addition thereto said Trustees of William
Jewell College further have agreed to execute a lease of the property so purchased to
Century Electric Company for the same time and on substantially the same terms and
conditions which were authorized to be accepted by the special meeting of shareholders
of this corporation, held on the 24th day of November, 1943.' The stockholders at the
November meeting had authorized the sale of the foundry property at not less than
$150,000 cash, conditioned upon the purchaser executing its lease of the property sold for
a term of not less than 25 and not more than 95 years.

The Board by resolution approved the proposed transaction with the William Jewell
College, but on condition that 'this corporation will acquire from Trustees of William
Jewell College, a Missouri Corporation, an Indenture of Lease for a term of not less than
twenty five years and for not more than ninety five years.' The resolution set out in detail
the terms of the lease from the college to petitioner, approved the form of the deed from
the petitioner to the college, authorized the president and secretary of petitioner to
execute the lease after its execution by the trustees of the college, and directed 'that the
president and secretary of this corporation be authorized to deliver said Warranty Deed to
said purchaser upon receiving from said purchaser $150,000 in cash, and upon receiving
from said purchaser duplicate executed Indenture of Lease on the forms exhibited to this
Board.' The resolution provided that the deed and lease should be dated December 1,
1943, and effective as of that date.

The deed and the lease were executed and delivered as provided by the resolution of
petitioner's board of directors. Neither instrument referred to the other. The deed was in
form a general warranty deed, reciting only the consideration of $150,000 in cash. The
lease recited among others the respective covenants of the parties as to its term, its
termination by either the lessor or lessee, and as to the rents reserved.

As of December 31, 1942, the ratio of petitioner's current assets to its current liabilities
was 1.74. The $150,000 in cash received by petitioner on the transaction increased the
ratio of current assets to current liabilities from 1.74 to 1.80. The loss deduction which
petitioner claims on the transaction and its consequent tax savings would if allowed have
increased the ratio approximately twice as much as the receipt of the $150,000.

The questions presented are:


1. Whether the transaction stated was for tax purposes a sale of the
foundry property within the meaning of section 112 of the
Internal Revenue Code, 26 U.S.C.A. 112, on which petitioner
realized in 1943 a deductible loss of $381,710.97 determined
under section 111 of the code (the adjusted basis of the foundry
property of $531,710.97 less $150,000) as petitioner contends;
or, as the Tax Court held, an exchange of property held for
productive use in a trade or business for property of a like kind
to be held for productive use in trade or business in which no
gain or loss is recognized under sections 112(b)(1) [FN1] and
112(e)[FN2], and Regulation 111, section 29.112(b)(1) 1. [FN3]
2. Whether if the claimed loss deduction is denied, its amount is
deductible as depreciation over the 95 year term of the lease as
the Tax Court held, or over the remaining life of the
improvements on the foundry as the petitioner contends.

On the first question the Tax Court reached the right result. The answer to the question
is not to be found by a resort to the dictionary for the meaning of the words 'sales' and
'exchanges' in other contexts, but in the purpose and policy of the revenue act as
expressed in section 112. * * * * In this section Congress was not defining the words
'sales' and 'exchanges'. It was concerned with the administrative problem involved in the
computation of gain or loss in transactions of the character with which the section deals.
Subsections 112(b)(1) and 112(e) indicate the controlling policy and purpose of the
section, that is, the non recognition of gain or loss in transactions where neither is readily
measured in terms of money, where in theory the taxpayer may have realized gain or loss
but where in fact his economic situation is the same after as it was before the transaction.

For tax purposes the question is whether the transaction falls within the category just
defined. If it does, it is for tax purposes an exchange and not a sale. So much is indicated
by subsection 112(b)(1) with regard to the exchange of securities of readily ascertainable
market value measured in terms of money. Gain or loss on exchanges of the excepted
securities is recognized. Under subsection 112(e) no loss is recognized on an exchange of
property held for productive use in trade or business for like property to be held for the
same use, although other property or money is also received by the taxpayer. Compare
this subsection with subsection 112(c)(1) where in the same circumstances gain is
recognized but only to the extent of the other property or money received in the
transaction. The comparison clearly indicates that in the computation of gain or loss on a
transfer of property held for productive use in trade or business for property of a like kind
to be held for the same use, the market value of the properties of like kind involved in the
transfer does not enter into the question.

The transaction here involved may not be separated into its component parts for tax
purposes. Tax consequences must depend on what actually was intended and
accomplished rather than on the separate steps taken to reach the desired end. The end of
the transaction between the petitioner and the college was that intended by the petitioner
at its beginning, namely, the transfer of the fee in the foundry property for the 95 year
lease on the same property and $150,000.

It is undisputed that the foundry property before the transaction was held by petitioner
for productive use in petitioner's business. After the transaction the same property was
held by the petitioner for the same use in the same business. Both before and after the
transaction the property was necessary to the continued operation of petitioner's business.
The only change wrought by the transaction was in the estate or interest of petitioner in
the foundry property. In Regulations 111, section 29.112(b)(1) 1, the Treasury has
interpreted the words 'like kind' as used in subsection 112(b)(1). Under the Treasury
interpretation a lease with 30 years or more to run and real estate are properties of 'like
kind.' With the controlling purpose of the applicable section of the revenue code in mind,
we can not say that the words 'like kind' are so definite and certain that interpretation is
neither required nor permitted. The regulation, in force for many years, has survived
successive reenactments of the internal revenue acts and has thus acquired the force of
law.

The decision of the Tax Court is affirmed.

FN1. 'Sec. 112. Recognition of Gain or Loss.'(b) Exchanges solely in kind. (1) Property
held for productive use or investment. No gain or loss shall be recognized if property held
for productive use in trade or business or for investment (not including stock in trade or
other property held primarily for sale, nor stocks, bonds,notes, choses in action,
certificates of trust or beneficial interest, or other securities or evidences of
indebtededness or interest) is exchanged solely for property of a like kind to be held
either for productive use in trade or business or for investment.'

FN2. '(e) Loss from exchanges not solely in kind. If an exchange would be within the
provisions of subsection (b)(1) to (5), inclusive, or (10), or within the provisions of
subsection (l), of this section if it were not for the fact that the property received in
exchange consists not only of property permitted by such paragraph to be received
without the recognition of gain or loss, but also of other property or money, then no loss
from the exchange shall be recognized.'

FN3. 'Sec. 29.112(b)(1)?1. Property Held for Productive Use in Trade or Business or
for Investment.? As used in section 112(b)(1), the words 'like kind' have reference to the
nature or character of the property and not to its grade or quality. One kind of class or
property may not, under such section, be exchanged for property of a different kind or
class. The fact that any real estate involved is improved or unimproved is not material,
for such fact relates only to the grade or quality of the property and not to its kind or
class. * * *'No gain or loss is recognized if * * * (2) a taxpayer who is not a dealer in real
estate exchanges city real estate for a ranch or farm, or a leasehold of a fee with 30 years
or more to run for real estate, or improved real estate for unimproved real estate * * *.'

IS THE LOSS TO BE RECOGNIZED?:


BLOOMINGTON COCA-COLA BOTTLING CO.
In the Bloomington case, Judge Kerner was faced with the question of whether the Tax
Court had correctly upheld the Internal Revenue Service's position, through the
Commissioner, that in 1939 the taxpayer had sustained a loss upon the sale of real estate
which was not within the scope of Code Section 112(b),the predecessor to Section 1031.
The government argued that the loss was recognizable under this Section and affected the
corporation's computation of its income.

The taxpayer had purchased the bottling plant in 1930 in Bloomington, Illinois. In 1938
he concluded the plant was inadequate and, therefore, built a new plant. The contractor
agreed to build the new plant for a given sum of money, and to accept the other plant as
part of the payment.

Because of the way the transaction was structured, the Tax Court held that the
transaction was not a tax-deferred exchange under Code Section 112, but in fact was a
sale.

The Circuit Court reviewed the facts and concluded that the Tax Court was not in error.

The taxpayer had not carried its burden of showing that the transaction did not
constitute a sale. The Court said that in this case the contractor bought the plant in one
transaction and built the building in another, even though the two were interrelated. The
taxpayer had also argued that there was an abandonment of the old plant, and he should
be entitled to take the deduction as a result of the abandonment. The Court disagreed. The
Court followed the structure of the transaction to its conclusion.

(This case involved a consideration by the taxpayer of an excess profits tax, which is a
historical consideration. Under the circumstances, because of the calculation, it was not
in the taxpayer's interest to have the transaction treated as an exchange within Section
112.)

BLOOMINGTON COCA-COLA BOTTLING CO.


v.
COMMISSIONER OF INTERNAL REVENUE.
51-1 U.S.T.C. 9320, 189
F.2d 14 (7th Cir. 1951)

KERNER, Circuit Judge.

The question presented by this petition for review is whether the Tax Court correctly
upheld the Commissioner's determination that in 1939 the taxpayer sustained a loss upon
the sale of real estate which did not come within the scope of Sec. 112(b)(1) of the
Internal Revenue Code, 26 U.S.C.A. 112(b), but was recognizable under Sec. 112(a)
thereof for the purpose of computing its excess profits tax credit based on an average
base period net income.
The Tax Court held that the transaction was not an exchange protected from tax impact
by Sec. 112(b)(1) but was a sale which resulted in a recognizable loss. In this court
taxpayer claims 'no error with respect to the findings of facts of the Tax Court, but alleges
that the Tax Court erred in applying the law to those facts.' It makes the point that the
payment of $64,500 cash in addition to the transfer of an old bottling plant as
consideration for the construction of a new plant did not remove the transaction from the
purview of Sec. 112(b) (1) of the Revenue Act of 1938.

The material facts are that in 1930 taxpayer, at a cost of $36,000, acquired a bottling
plant in Bloomington, Illinois? allocating $30,500 to buildings and $5,500 to land. In
1938, concluding that the plant was inadequate for its needs, taxpayer decided to build a
new plant. It decided it had no use for the old plant and wished to dispose of it. With
those purposes in mind, it entered into a contract with a contractor to construct a new
plant. The new plant was completed in 1939. By the contract the contractor furnished the
necessary material and labor, and completed the building in accordance with the plans
and specifications prepared by its architect for a total of $72,500. Of this sum the
contractor was paid $64,500 in cash and accepted taxpayer's old buildings and the land
upon which the old plant was located at a valuation of $8,000, and the old building and
land were transferred to the contractor.

Lot, Cost July 1930 $5,500.00


Sold April 30, l939 1,424.55
Loss 4,075.45
Limitation (2,000.00)
Building, Cost July 1930 30,500.00
Depreciation on building to April 30,
5,113.21
1939
Net Book Value April 30, 1939 25,386.79
Sold April 30, 1939 6,575.45
$18,811.34

Schedule B of taxpayer's 1943 and 1944 excess profits tax return shows the 1939 base
period excess profits net income as follows:

1. Normal tax (or special class) net $ 2,278.25


income
2. Net capital loss used in computing 2,000.00
line 1
4. Net loss from sale or exchange of 18,811.34
property other than capital assets
deducted in computing line 1 (for
taxable years beginning after
December 31, 1937)
31. Excess profits net income $23,089.59
The Commissioner in determining the excess profits taxes for the years 1943 and 1944
adjusted the average base period net income for the year 1939 as computed by the
taxpayer by deducting the amount of $22,886.79 as a loss not coming within the scope of
Sec. 112(b)(1) of the Internal Revenue Code. This resulted in a deficiency of $8,049.19 in
1943 and $8,492.13 in 1944. The taxpayer contested this determination. The Tax Court,
finding the facts in detail, sustained the Commissioner.

The Commissioner's determination and its approval by the Tax Court that taxpayer's
disposition of the old plant constituted a sale and not an exchange of property for like
property must be considered as prima facie correct, and the burden of proving it wrong is
upon the taxpayer. We may not reverse the decision unless we can say the decision is
clearly erroneous.

It is elementary that the language of a revenue act is to be read in the light of the
practical matters with which it deals and is to be given its ordinary significance in
arriving at the meaning of the statute.

The applicable statute, 26 U.S.C.A. 112, provides:

Sec. 112. Recognition of gain or loss

(b) Exchanges solely in kind? (1) Property held for productive use or investment. No
gain or loss shall be recognized if property held for productive use in trade or business or
for investment (not including stock in trade or other property held primarily for sale, nor
stocks, bonds, notes, choses in action, certificates of trust or beneficial interest,or other
securities or evidences of indebtedness or interest) is exchanged solely for property of a
like kind to be held either for productive use in trade or business or for investment.'

And Treasury Regulations 111, Sec. 29.112(a) 1 states that to constitute an exchange
within the meaning of Sec. 112(b)(1) the transaction must be a reciprocal transfer of
property as distinguished from a transfer of property for a money consideration only.

A 'sale' is a transfer of property for a price in money or its equivalent. 'Exchange' means
the giving of one thing for another. That is to say, in a sale, the property is transferred in
consideration of a definite price expressed in terms of money, while in an exchange, the
property is transferred in return for other property without the intervention of money.
True, 'Border?line cases arise where the money forms a substantial part of the adjustment
of values in connection with the disposition of property and the acquisition of similar
properties. The presence in a transaction of a small amount of cash, to adjust certain
differences in value of the properties exchanged will not necessarily prevent the
transaction from being considered an exchange. * * * Where cash is paid by the taxpayer,
it may be considered as representing the purchase price of excess value of 'like property'
received.'

But this is not a case where the contractor exchanged a completed plant owned by the
contractor for property and money, hence the contractor at no time had like property
within the meaning of Sec. 112(b)(1) of the Revenue Act. Under these circumstances we
would not be warranted in saying that the finding and conclusion of the Tax Court are
clearly erroneous. On the contrary, we think the facts adequately support the Tax Court's
conclusion that the taxpayer's disposition of its old plant constituted a sale.

Another contention urged is that the loss which was incurred by taxpayer in 1939 on its
disposal of its old bottling plant must be disallowed under the provisions of Sec.
711(b)(1)(E), 26 U.S.C.A. 711(b)(1)(E) on the ground that the property was abandoned.
This section provides that deductions for abandonment of property shall not be allowed in
the computation of excess profits net income for the base years. And Sec. 29.23(e)?3 of
Regulations 111 provides that when, through some change in business conditions, the
usefulness in the business of some or all of the capital assets is suddenly terminated so
that a taxpayer discards such assets permanently from use in such business, it may claim
a loss as prescribed.

In considering the contention that the property had been abandoned it will be enough to
say that we agree with the Tax Court: 'The old plant was sold for a consideration of
$8,000; it was not abandoned. There are no facts established justifying a finding of
abandonment, or that the loss was due to obsolescence. The old plant was an operating
plant at the time petitioner (taxpayer) moved to its new building, and its use as a bottling
plant could have been continued. The testimony was not that the plant was abandoned,
but that its sale was determined upon. A claim of loss consequent upon the abandonment
of property must be supported by clear and convincing proof of intention to abandon and
discard the property (citing case). The record contains nothing to sustain the argument of
abandonment, and the facts established are to the contrary.

Affirmed.

CHAPTER 7:
EXCHANGING INTERESTS HELD IN AN ENTITY OR BY MORE
THAN ONE PARTY

HISTORICAL PERSPECTIVE

One of the more questionable areas in a tax-deferred exchange dealt with an exchange
of a partnership interest for a partnership interest. There have been a number of cases
litigating this particular point. One case is Estate of Rollin Meyer, Sr., which follows.

The key question in the Meyer case was whether a partnership interest, general or
limited, would qualify for a Section 1031 exchange in any instance. The Meyer court
allowed the tax-deferred exchange of general partnership interests, but emphasized that it
was important to look at the underlying assets in the partnership to see if the exchange
would qualify. However, there are a number of questions that the court did not adequately
discuss. What is the effect, for example, of potential recapture within the partnership if
there is an exchange? Although there are special rules to cover recapture under Sections
1245 and 1250, where a taxpayer moves from depreciable property to nondepreciable
property, this point does not seem clear with regard to the exchange of an interest in a
partnership.

Also, will the tax-deferred exchange result in the termination of the partnership under
Section 708(b) of the Code? Is the determination by the court correct? Under the Uniform
Partnership Act, the interest held by the partners is not realty. It is personalty, even
though the Meyer court seems to focus on the underlying assets, which are mainly real
estate. Personalty could qualify for an exchange if it otherwise meets Code Section 1031
requirements.

It is also possible to argue that the partnership transferred was a security. This point is
especially important, since securities are specifically excluded from a tax-deferred
exchange under the language of Section 1031.

However, there was other authority which would support the Meyer court. Under an
older decision, Norman Miller, parts of which appear subsequently, the court allowed a
Section 1031 exchange where there was a transfer of an interest in a tavern partnership
for an interest in an auto supply partnership. Nevertheless, I consider the Meyer decision
incorrect and highly questionable. 1

The Meyer proposition was examined in Gulfstream Land and Development Corp. v.
Commissioner. This case examined the question of an exchange of a joint venture
ownership position in real estate developments. It raised some of the same questions as
existed in the Meyer case, e.g., the issue as to whether an exchange of these types of
interests can take place under Section 1031. Gulfstream was dismissed without resolution
of the issue.

The taxpayers in Gulfstream desired a summary judgment in their favor, arguing that
the issue has been resolved. Since the Court emphasized that it would look to the
underlying assets involved, and since this was a factual test, summary judgment was not
considered appropriate in that setting. Gulfstream was dismissed.

The Government has also ruled in Rev. Rul. 78-135 that an exchange of a general
partnership interest for a general partnership interest does not constitute a Section 1031
tax-deferred exchange. I believed that the Government was correct in this view, but the
point bears analysis. (Note, below, that the Statute under Code Section 1031 makes it
clear now that an exchange of the partnership interests will not qualify under Code
Section 1031.)

THE PROBLEM

As summarized previously, the problem focuses on the qualification of an exchange of


a partnership interest for another partnership interest. Section 1031, where applicable, is
mandatory. As such, even a taxpayer who is exchanging an interest in a partnership that
has a loss would be concerned with this issue. If Section 1031 was applicable and there
was an exchange of a partnership interest for a partnership interest, the taxpayer would
generally desire to avoid the deferral and to currently recognize the loss.

POSITIONS

1. GOVERNMENT: The government, to state it succinctly,


opposed tax-deferred treatment under Section 1031 of an
exchange of a partnership interest for a partnership interest. The
summary position is that the government is opposed to an
exchange involving partnership interests, arguing they do not
qualify. It has issued Rev. Rul. 78-135 to that effect.
2. TAX COURT CASES: Two courts have held that an exchange
of a partnership interest for another partnership interest, general
in nature, will qualify under Code Section 1031. (The Code was
subsequently changed. See below.) Thus, we had the stage set
for the development of the conflict.

THE CASES:

Two cases supported the proposition that Section 1031 is applicable to this area. The
older case is Norman Miller. As discussed before, this Court allowed the Code Section
1031 treatment where there was a transfer of an interest in a tavern partnership for an
interest in an auto supply partnership.

Nevertheless, this issue did not arise in a well publicized way until the case of the
Estate of Rollin Meyer, Sr. The Court focused on an exchange of partnership interests,
and held that the tax-deferred treatment would apply where there is this type of an
exchange. However, the Meyer Court also held that Section 1031 was not applicable
where there was an exchange of a general partnership interest for a limited partnership
interest. The argument was that these interests were substantially different and, therefore,
not like-kind.

When the court allowed the tax-free treatment of an exchange of a general partnership
interest for a general partnership interest, the Court looked to the underlying assets in the
partnerships to see if the exchange should qualify.

ANALYSIS OF CASES AND RULINGS

The positions have been stated, and one could spend a great deal of time analyzing
them in detail. One might summarize some of the considerations by looking to the points
noted below. I support the Government's view on this position. (I found myself on
unfamiliar ground in this posture!)

Section 1031(a) clearly provides that securities do not constitute qualified property. If
any group can testify to the basic premise that real estate can and does constitute a
security in many contexts, it would certainly be a group such as the Real Estate Securities
and Syndication Institute of the NATIONAL ASSOCIATION OF REALTORS . Limited
partnerships have been held in many contexts to constitute a security. When one transfers
an interest in the limited partnership, this can also be constituted a security if the
underlying position is that the partnership constituted securities (see Levine, West text,
Section 572).

Under partnership law, under the Uniform Partnership Act or Uniform Limited
Partnership Act, the interest a partner owns is the interest in the partnership, and not the
underlying assets. Therefore, it is difficult to reconcile this position with a look by the
courts to the underlying assets when exchanging partnership interests; the counter to this
position is that the courts should look to the substance of the transaction and not merely
the form. However, if one looks to the substance of the transaction, it is clear that many
exchanges could take place under a posture similar to the Meyer case if one was allowed
to exchange a partnership interest for a partnership interest. Many parties argue that if the
court looks to the underlying assets, it would be no different than taxpayers exchanging
the underlying assets for underlying assets. However, this analysis leads to many other
unanswered questions. What is the potential of recapture of depreciation in this setting?
What amount of boot, if any, might be recognized for the like-kind property, where there
is an exchange of the partnership interest? What is the effect of death on the properties in
question, and so forth?

There are other arguments that could and are made by the Government, including a
direct reference to Code Section 741. This Section provides: "In the case of a sale or
exchange of an interest in a partnership, gain or loss shall be recognized to the transferor
partner." Thus, we have specific language, argues the Internal Revenue Service, which
states the gain or loss should be recognized where there is a sale or exchange of an
interest in the partnership. As a specific provision under the partnership section that has
been passed by Congress, this is one more support for the government's argument that the
exchange is not within Section 1031.

Consistent with the securities issue, one might also argue that the interests held by the
parties involved are really an intangible right or a chose in action.

Although it is stretching this definition somewhat, there is another argument by the


government relative to the interests being exchanged. If it is a chose in action, it is
specifically excluded as qualified Section 1031 property. The interest actually being
exchanged is not qualified property because it is not property "used" in the trade or
business or held for investment.

In summary, it is very clear that the government has taken a strong position, in its 1978
ruling, that it will not accept the exchange of a partnership interest for a partnership
interest as a Code Section 1031 exchange. The courts have not accepted the proposition
of an exchange of a general partnership interest for a limited partnership interest, but
there is authority for an exchange of a general partnership interest for a general
partnership interest.
It appears that the courts have previously passed over the parenthetical language of
Section 1031, which excludes an exchange of securities or chose in action, and failed to
look to the language of the statute itself to resolve this issue. Section 741 specifically
provides that an exchange of a partnership interest is a taxable event.

On the other hand, a partner might consider other alternatives to exchanging a


partnership interest. On a smaller partnership, which is controlled by a few individuals
who desire to have certain exchanges that place, it is possible to consider having the
partnerships exchange partnership property as opposed to an interest in the partnership.

The taxpayer should be cautioned to avoid a situation where there is a liquidation of the
partnership and a distribution to the partners of an interest in the partnership, followed by
an exchange transaction. This would not qualify under the Government's position.
(However, see subsequent case law herein that approves such action.)

As an example, assume that the partnership of A and B owned two office buildings. If
the partnership was liquidated, and A took one building, and B took another building, and
subsequently, a few days later, following the liquidation, A exchanged his building, A-1,
for a third party's property, the government's position is that this does not qualify for a
Section 1031 transaction. The argument for denying this exchange is that A acquired the
A-1 building with the immediate intent to follow it with an exchange. Therefore, A did
not hold the property for use in a trade or business or for investment. He acquired the
property, through the liquidation, with the intent to immediately transfer-exchange.
Therefore, it does not qualify.

This point touches on the area of what might be referred to as prearranged transfers,
which can disqualify the transaction from meeting the Code Section 1031 requirements.

Another related issue is whether, within the same partnership, a conversion of a general
partnership to a limited partnership is a nontaxable activity. The Government had ruled,
in Letter Ruling 8948063, that this was not taxable.

CAVEAT:
Code Section 1031 now prohibits the tax-deferred treatment of exchanging interests in
partnerships. Note this CAVEAT as to the following cases of Miller, Meyer and
Gulfstream.

CAPSULE HISTORY OF EXCHANGING PARTNERSHIP


INTERESTS:
LAW PRIOR TO DRA OF 1984:

There had been a question as to whether the one could have an exchange of a
partnership interest. Case law has supported in many instances an exchange of a general
partnership interest for a general partnership interest, but not an exchange of a limited
partnership interest for a limited partnership interest. The DRA addressed this issue by
eliminating this tax-deferred exchange of a partnership interest in other partnerships.
DRA OF 1984: As mentioned, the DRA had a specific provision that eliminated like-
kind exchange treatment under Code Section 1031 for exchanging interests in different
partnerships. (Exchanging within the same partnership may be permitted in proper
circumstances.)

The effective date for the exchanging of partnership interests is for transfers of property
after the date of enactment, other than exchanges which were made pursuant to a contract
entered before March 1, 1984.

Where there was a transfer on or before the date of enactment, which the taxpayer
treated as part of a like-kind exchange, and which, as a result of this DRA change, is
subject to an assessment, the period for assessing the deficiency would not expire prior to
January 1, 1988.

(The prohibition on like-kind exchanges for partnership interest does not apply to
general partnership interests which are exchanged pursuant to a plan of reorganization,
which took effect on March 29, 1984, assuming all exchanges contemplated by the
reorganization plan were completed by December 31, 1984. Code Section 6050K,
§6678(c) and §6652.)

The following discussion highlights the area of exchanging interests in partnerships,


prior to the change by the DRA of l984, noted above.

REVENUE RULING 78-135

For the government's position in opposition to Miller and Meyer, see the following
Rev. 78-135. The holding in this Ruling is consistent with the Service's nonacquiescence
in Meyer.

REVENUE RULING 78-135


1978-1 C.B. 256

'Advice has been requested whether, under the circumstances described below, gain or
loss realized on the exchange of partnership interests qualifies for nonrecognition under
section 1031(a) of the Internal Revenue Code of 1954.

A owned a 10 percent general partnership interest in partnership X and a 15 percent


general partnership interest in partnership Y. B owned a 15 percent general partnership
interest in partnership X and a 10 percent general partnership interest in partnership Y. A
and B entered into an agreement whereby A conveyed A's interest in partnership X to B
in exchange for B's interest in partnership Y.

'Section 1031(a) of the Code provides that no gain or loss shall be recognized if
property held for productive use in a trade or business or for investment (not including
stock in trade or other property held primarily for sale, nor stocks, bonds, notes, choses in
action, certificates of trust or beneficial interest, or other securities or evidences of
indebtedness or interest) is exchanged solely for property of a like kind to be held either
for productive use in trade or business or for investment.

The language in the parenthetical clause of section 1031(a) of the Code in part
encompasses all types of equity interests in financial enterprises other than by direct
ownership of the underlying property. Because a partnership interest represents such an
equity interest, it comes within the ambit of the parenthetical clause of section 1031(a).

Moreover, section 741 of the Code provides, in part, that in the case of a sale or
exchange of an interest in a partnership gain or loss shall be recognized to the transferor
partner. Thus, section 741, which requires recognition of gain or loss, is in conformity
with the parenthetical clause of section 1031(a), which excepts exchanges of equity
interests in financial enterprises from nonrecognition under section 1031.

'In the instant case, both A and B have transferred property of a type that is described in
the parenthetical clause of section 1031(a) of the Code. Accordingly, any gain or loss
realized by A and B on the exchange of such property does not qualify for nonrecognition
under section 1031(a).

'The holding in this revenue ruling is consistent with the Service's nonacquiescence in
Estate of Rollin E. Meyer, 58 T.C. 311 (1972), nonacq., 1975--1 C.B. 3, aff'd per curiam,
503 F.2d 556 (9th Cir. 1974).

ESTATE OF ROLLIN E. MEYER, SR., DECEASED,


ROLLIN E. MEYER, JR., EXECUTOR,
AND HENRIETTA G. MEYER, SURVIVING WIFE, PETITIONERS
v.
COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
ROLLIN E. MEYER, JR., AND MARJORIE B. MEYER, PETITIONERS
v.
COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
74-2 U.S.T.C. Para. 9676, 503 F.2d 556 (9th Cir. 1974)
aff'g per curiam 58 T.C. 311

No gain was recognized upon the exchange of a general partnership interest in one
California partnership for a general partnership interest in a California limited partnership
where before and after the exchange both partnerships were going concerns principally
engaged in renting apartments. Sec. 1031, I.R.C. 1954. However, an exchange of a
general partnership interest for a limited partnership interest is not an exchange of
property of a like kind for purposes of sec. 1031(a), I.R.C. 1954.

OPINION

The facts were stipulated and are so found, but we refer below only to those facts
pertinent to the remaining contested issue, namely, whether certain transfers of partial
partnership interests for interests in another partnership are exchanges on which no gain
shall be recognized under section 1031(a).[FN1]

Rollin E. Meyer, Sr. (hereafter Meyer, Sr.), who died in 1966, and his wife, Henrietta
G. Meyer, filed joint income tax returns for the years involved. Rollin E. Meyer, Jr.
(hereafter Meyer, Jr.), is the executor of his father's estate. Meyer, Jr., filed joint returns
with his wife Marjorie B. Meyer for the same years. At the time of filing of the petition in
docket No. 3014-69 Henrietta G. Meyer resided in San Francisco, Calif., and at the time
of filing of the petition in docket No. 3015-69 Meyer, Jr., and Marjorie B. Meyer resided
in Hillsborough, Calif.

In 1963, the father and the son were equal partners in the California partnership of
Rollin E. Meyer &Son, and on December 31, 1963, each exchanged portions of their
partnership interests pursuant to separate written agreements bearing that date for part
interests in the Hillgate Manor Apartments, a California limited partnership, as indicated
below:

Meyer, Sr.'s new 15-percent interest in the Hillgate partnership was that of a limited
partner. No 'boot' was received by Meyer, Sr., or by his son in either of the transactions.

Meyer, Jr., exchanged interests with the Meyer and Young Building Corp., a California
corporation and a 20-percent general partner of Hillgate. Meyer, Sr., traded for the entire
interests of three individuals, Aldean Meyer Haeder, Laura Meyer Van Camp, and
William H. Young, each 5 percent limited partners of Hillgate. Both of the written
agreements recited that the adjusted book values (after depreciation but before deductions
for encumbrances) of the Hillgate and Rollin E. Meyer & Son partnerships were
$800,000 and $365,000, respectively.

The Rollin E. Meyer & Son partnership was formed in 1948 and conducted business in
California for more than 6 months after the December 31, 1963, exchange. Meyer, Sr.,
and Meyer, Jr., were the only partners from the inception of the partnership until the date
of the exchange. The Hillgate partnership was formed in March 1961 and is still in
existence. During 1963 and afterwards both partnerships had as their principal activities
the ownership and operation of rental apartments in and about San Francisco.

Petitioners contend that the two exchanges were tax-free under section 1031(a).

The Commissioner contends that both of the exchanges are excepted from
nonrecognition because the partnership interests which were exchanged are choses in
action, a type of property excluded by the parenthetical clause in section 1031(a). As to
Meyer, Sr.'s transaction only, the Commissioner further contends in the alternative that an
exchange of a general partnership interest for a limited partnership interest evidently is
not an exchange of property of a like kind.

Through his first contention the Commissioner has set for himself the considerable task
of demonstrating the congruence of the legal meanings of the terms 'partnership interest'
and 'choses in action' under California law. Blodgett v. Silberman, 277 U.S. 1 (1928), and
McClennen v. Commissioner, 131 F.2d 165 (C.A. 1, 1942), the cases upon which he
chiefly relies, dealt with the characterization of the interest of a deceased partner, and it
appears than an interest of this kind is little more than the personal representative's
enforceable right to an accounting and cash liquidation. We cannot conclude on the basis
of those authorities that the interests herein, consisting of the much more extensive rights
of the living partners of undissolved partnerships, are also categorizable as choses in
action. In our view, however, the clause excluding exchanges of stock, bonds, etc., is not
called into play by the facts of this case and so we decline to hold that the partnership
interests involved were 'choses in action,' as used in the statute.

Shortly after the original version of section 202(c)(1) of the Revenue Act of 1921 (the
predecessor of sec. 1031(a)) was enacted, it became clear that taxpayers owning
investment securities which had appreciated in value were exchanging them for other
securities without being tagged with taxable gains. This was regarded as an abuse,
especially in view of the fact that no statute provided for recognition of any cash boot that
might have been received in connection with such portfolio transactions. H. Rept. No.
1432, 67th Cong., 4th sess. (1923) (letter of Secretary Mellon).[FN2] By the Act of
March 4, 1923, among other things the parenthetical clause, originally enacted in section
202(c)(1), was expanded to include not only stock in trade and other property held
primarily for sale but also stocks, bonds, notes, choses in action, etc.

We are not dealing with trading in investment securities or similar intangibles. The
transactions of December 31, 1963, were exchanges of proprietary (partnership) interests
in one small business solely for proprietary (partnership) interests in a second small
business, before and after which both businesses were going concerns engaged in the
same principal activity.[FN3]

The Commissioner does not contend that the interest Meyer, Jr., surrendered and the
interest he received were not property of a like kind. We are confident that Meyer, Jr.'s
exchange is within the purview of section 1031(a), and we so hold, as was done in Miller
v. United States, an unreported case (S.D. Ind. 1963, 12 A.F.T.R.2d 5244, 63-2
U.S.T.C.par. 9606).

But the exchange by Meyer, Sr., of his general partnership interest for a limited
partnership interest presents a closer question.

The State of California has adopted the Uniform Partnership Act and the Uniform
Limited Partnership Act, and both laws were in effect at all times pertinent to this case.
The differences in the characteristics of the interest of a general partner and that of a
limited partner are considerable. The familiar notions that a limited partner, unlike a
general partner, is not personally liable for partnership debts and that he is entitled to
priority in liquidation are the law in California. Cal. Corp. Code Ann., secs. 15501,
15507, and 15523(1) (West 1955). Also, absent agreement to the contrary the death of a
limited partner does not work a dissolution of the limited partnership. Cal. Corp. Code
Ann., secs. 15521 and 15519 (West 1955). There are other distinctions. See Cal. Corp.
Code Ann., secs. 15502 and 15517 (West 1955).

The variousness of the natures of the general and the limited partnership interest is
substantial enough to warrant invocation of the principle calling for strict construction of
the exceptions to the rule that where gain is involved it will be recognized and taxed
when it is realized. Midfield Oil Co., 39 B.T.A. 1154, 1157 (1939), acq. 1939-2 C.B. 25;
Ethel Black, 35 T.C. 90, 94 (1960); sec. 1.1002-1(b), Income Tax Regs. The exchange of
an interest in a general partnership for a limited partnership interest is not an exchange 'of
property of like kind.' We hold that section 1031(a) does not apply to Meyer, Sr.'s
exchange.

Our decision herein is confined to a situation where both partnerships owned the same
type of underlying assets-- in this case, rental real estate. We also wish to emphasize that
the parties have simply stipulated that the partnership interests involved were 'general' or
'limited.' We express no opinion as to what our views would be if other types of
underlying assets were involved, if there were variations in the business of the
partnerships, or if we had before us the details of the particular undertakings by the
partners and were in a position to determine whether such stipulated descriptive terms
were accurate.

Reviewed by the Court.

Decisions will be entered under Rule 50.

DAWSON, J., dissenting in part: I think the majority has illogically bifurcated identical
exchanges of 'property' which occurred simultaneously. The purpose of section 1031(a) is
to defer recognition of gain or loss where a taxpayer makes a direct exchange of property
with another party. Leo A. Woodbury, 49 T.C. 180, 197 (1967), acq. 1969-2 C.B. xxv. In
the past the courts have consistently attempted to focus on the actual substance of the
transactions effected, notwithstanding the myriad of techniques used. Cf. Frederick R.
Horne, 5 T.C. 250 (1945) (collapsing a closely timed purchase and sale of a commodity
exchange seat to deny a claimed loss); Alderson v. Commissioner, 317 F.2d 790 (C.A. 9,
1963), reversing 38 T.C. 215 (1962) (finding a 'like kind exchange' where a sale was
transformed into an exchange when the prospective buyer, with substantial assistance
from the taxpayer, was able to acquire and convey other suitable farm property to the
taxpayers in an exchange rather than a straight sale); Coastal Terminals, Inc. v. United
States, 320 F.2d 333 (C.A. 4, 1963) (holding a sec. 1031(a) exchange took place where
an oil company received options for land and materials for construction of three inland
terminal facilities and an operating terminal from the taxpayer and carried out this
construction, thereafter transferring the completed facilities back to the taxpayer in
exchange for a deepwater terminal held by the taxpayer); Redwing Carriers, Inc. v.
Tomlinson, 399 F.2d 652 (C.A. 5, 1968) (combining separately stated purchases and
sales of new and used trucks by a parent corporation and its subsidiary to deny a claimed
loss where in substance there was merely an exchange under sec. 1031(a)); and Leslie Q.
Coupe, 52 T.C. 394 (1969), acq. 1970-1 C.B. xv (permitting nonrecognition-of- gain
treatment where a contract of sale for certain farm property was reformed so as to permit
the taxpayers to exchange their property with third parties who in turn conveyed this
property to the purchaser under the original sales contract for cash). That course has not
been followed here.

In this case the majority opinion specifically points out that what is of crucial
importance to its finding that an exchange of one general partnership interest for another
such interest qualifies as a 'like kind' exchange under section 1031(a) is the fact that the
underlying assets of each partnership, i.e., rental real estate, are the same. The identical
rationale is applicable to the exchange by Meyer, Sr., of his part of the general
partnership interest for a limited interest in the Hillgate partnership. But, rather than
apply this logic to both exchanges, the majority has opted to distinguish one transfer from
the other on the basis of the different characteristics of the general and limited partnership
interests exchanged. Such distinctions cannot constitute the focal point of this issue,
given the majority's ratio decidendi * * * * for holding the trading of general partnership
interests to be a 'like kind' exchange. The exchange of the limited partnership interest for
the general partnership interest here involved appears to me to be no more than an
exchange of 'like kind' property of different quality, grade, or value. Sec. 1.1031(a)-
(1)(b), Income Tax Regs. [FN1]

The majority treads gingerly on this issue and at the conclusion of the opinion indicates
that if the facts were more detailed regarding the actual undertakings of the limited
partner here involved, a different result might obtain. I cannot agree with such hedging.
The transaction which occurred on December 31, 1963, left Meyer, Jr., and Meyer, Sr.,
with smaller interests in the Rollin E. Meyer &Son partnership and newly acquired
interests in the Hillgate Manor Apartments, a California limited partnership. The
stipulated facts indicate the partnerships owned the rental property constituting their
underlying assets and therefore the interests acquired by Meyer, Sr., and Meyer, Jr. were
partial fee interests. [FN2] I would require no more for the exchange by Meyer, Sr., to
qualify for nonrecognition-of-gain treatment under section 1031(a).[FN3]

FN1. It should be noted that although the regulations provide that an exchange of
different classes of property does not qualify for nonrecognition-of-gain treatment,
Webster's New Collegiate Dictionary (1963 ed). defines class as 'a division or rating
based on grade or quality.'

FN2. Had Meyer, Sr., formed a corporation to which he transferred his general
partnership interest and then had that corporation exchange part of its general partnership
interest for a general partnership interest in Hillgate, under the majority's holding in this
case, such an exchange should qualify for nonrecognition-of-gain treatment. As a result
of the above transaction, Meyer, Sr., could end up with limited liability as a shareholder
of the new corporation, could effect a tax-free exchange of the partnership interests, and
might be able to retain the tax benefits of partnership status by having the new
corporation make an election under subch. §to be taxed as an electing small business
corporation, so long as no more than 20 percent of that corporation's gross receipts come
from rental or other types of passive investment income. Sec. 1372(e)(5).
FN3. Compare Rev. Rul. 72-199, 1972-1 C.B. 228, permitting nonrecognition of gain
under sec. 1036 where two classes of common stock are exchanged although one class
has voting, preemptive, and broader stock dividend rights.

PRIVATE LETTER RULING 7948063

This is in reply to a letter dated November 15, 1978, submitted by your authorized
representative, in which he requests a ruling regarding the federal income tax
consequences of a proposed amendment of the partnership agreement of M to convert the
partnership from a general partnership to a limited partnership.

M was formed as a general partnership in *** The original partners were A and her
three sons B, C, and D. Upon formation, the partnership was engaged and has continued
to be engaged in the business of ranching and of cutting and selling timber. In *** D died
and his partnership interest was distributed to a trust for the benefit of his children. In
***. A was placed under the conservatorship of B and C. The partners' interests in the
partnership and their share of the profits and losses of M are as follows:

The partnership has no liabilities at the present time and does not anticipate that it will
incur any liabilities prior to the time of the conversion. The partnership's taxable year
ends on December 31.

The parties propose to amend the partnership agreement to convert the general
partnership to a limited partnership under the Uniform Limited Partnership Act of state N
which corresponds in all material respects to the Uniform Limited Partnership Act. The
certificate of limited partnership indicates that each limited partner will contribute to the
partnership a specified portion of the general partnership. The amounts are as follows:

The general partners will contribute the remaining one percent interest in the general
partnership to the limited partnership. The general partners, taken together, will have at
all times during the existence of the partnership at least a one percent interest in each
material item of partnership income, gain, loss, deduction or credit.

It has been represented that the aggregate deductions to be claimed by the partners as
their distributive shares of partnership losses for the first two years of operation of the
limited partnership will not exceed the amount of equity capital invested in the limited
partnership.

It has been further represented that the limited partnership agreement will be amended
to provide that a creditor who makes a nonrecourse loan to the limited partnership will
not have or acquire, at any time as a result of making the loan, any direct or indirect
interest in the profits, capital, or property of the limited partnership other than as a
secured creditor.

Based on the information submitted and representations made, we conclude as follows:


The conversion of the general partnership into a limited partnership will not constitute a
sale or exchange of a partnership interest by any of the partners. No gain or loss will be
recognized in connection with the conversion except to the extent that any decrease in a
partner's share of the liabilities of the partnership, or any decrease in a partner's individual
liabilities by reason of assumption by the partnership of such liabilities, exceed the
adjusted basis of the partner's interest in the partnership. Section 752(b) of the Internal
Revenue Code of 1954.

Upon conversion of the general partnership into a limited partnership there will be no
change to the adjusted basis of each partner's interest in the partnership unless there is a
change in any of the partner's shares of the liabilities of the partnership or there is an
assumption of liabilities by a partner or the partnership. Sections 705, 733, and 752 of the
Code.

Section 708 of the Code states that a partnership is considered as continuing if it is not
terminated. A partnership is terminated only if (1) no part of any business, financial
operation, or venture of the partnership continues to be carried on by any of its partners in
a partnership, or (2) within a 12-month period there is a sale or exchange of 50 percent or
more of the total interest in partnership capital and profits. There is no sale or exchange
upon the conversion and the business will be continuing. Thus, there is no termination of
the partnership.

The limited partnership has associates and an objective to carry on business and divide
the gains therefrom. Therefore, in order not to be classified as an association taxable as a
corporation, the limited partnership must not have a preponderance of the following
corporate characteristics: continuity of life, centralization of management, limited
liability and free transferability of interests. Section 301.7701--2(a)(2) and (3) of the
Procedure and Administration Regulations.

Since the limited partnership is organized under and operated subject to a statute
corresponding to the Uniform Limited Partnership Act, it lacks the corporate
characteristic of continuity of life. Section 301.7701--2(b)(3) of the regulations.

The limited partnership will lack the corporate characteristic of limited liability,
provided that the general partners have substantial assets (other than their interests in the
limited partnership) which can be reached by the general creditors of the limited
partnership.

Since the limited partnership will lack the corporate characteristics of limited liability,
so long as the general partners maintain substantial assets, and continuity of life, the
limited partnership will not have more corporate than noncorporate characteristics.
Therefore, provided that the creation and conduct of the limited partnership are in
substantial compliance with all applicable state statutes pertaining to limited partnerships,
it will be classified as a partnership for federal income tax purposes.
The conclusion stated above, regarding the classification of the limited partnership as a
partnership for federal income tax purposes is subject to the requirements of Rev. Proc.
74--17, 1974--1 C.B. 438. If the requirements of Rev. Proc. 74--17 fail to be met at any
time, this ruling will have no force and effect retroactive to the date of issuance.

Except as specifically ruled above, no opinion is expressed as to the federal income tax
consequences of the transaction under any other provision of the Internal Revenue Code.

GULFSTREAM LAND & DEVELOPMENT CORP.

This case reviews the concept of exchanging interests in partnerships. It appeared to


look to the underlying assets of the partnership when determining whether the exchange
of an interest in one partnership for an interest in another joint venture would qualify.
(Obviously, this case predates the change in the Code which now prohibits a tax-deferred
treatment under Code Section 1031 of the exchanging partnership interest in one
partnership for another partnership.)

GULFSTREAM LAND and DEVELOPMENT CORPORATION and


SUBSIDIARIES, PETITIONERS
v.
COMMISSIONER of INTERNAL REVENUE, RESPONDENT
71 T.C. 587 (1979)

OPINION

GOFFE, Judge:
The Commissioner determined deficiencies in the Federal income tax of petitioners for
the taxable years ended September 30, 1973, and September 30, 1974, in the respective
amounts of $272,354 and $2,183,413. We have this matter before us on petitioners'
motion for partial summary judgment. [FN1]

Two issues are presented:

(1) Whether any material facts are in issue so as to preclude a


decision on the substantive issue; and
(2) Whether the exchange of an interest in one joint venture for an
interest in another joint venture qualifies for nonrecognition
treatment pursuant to section 1031(a), I.R.C. 1954, [FN2]
where both joint ventures were formed to develop and improve
land, to build homes on the land, and to sell the homes.

Pursuant to Rule 121, Tax Court Rules of Practice and Procedure, petitioners filed an
affidavit with exhibits in support of their motion. Petitioners' affidavit and the pleadings
contain the facts used for the purpose of this motion. Rule 121(b), Tax Court Rules of
Practice and Procedure. Relevant facts from petitioners' affidavit and the pleadings
follow.
Petitioners filed a consolidated return for the taxable year ended September 30, 1974,
with the Office of the Internal Revenue Service, Chamblee, Ga. The controversy with
which this motion is concerned involves three of the corporations which were party to
such return, namely Gulfstream Republic Properties, Inc. (hereinafter Gulfstream
Republic), Gulfstream University, Inc. (hereinafter Gulfstream University), and their
common parent corporation, Gulfstream Land & Development Corp. (hereinafter
Gulfstream). Gulfstream, a Delaware corporation, had its principal office in Plantation,
Fla. and owned 100 percent of the outstanding shares of both Gulfstream Republic and
Gulfstream University during the taxable year in issue. Gulfstream is a publicly held
corporation and its stock is listed and traded on the American Stock Exchange.

In June 1971, Republic Properties, Inc., which is a Florida corporation unrelated to


petitioners, and Gulfstream entered into an agreement whereby Gulfstream agreed to sell
to Republic Properties, Inc., a one-half interest in approximately 300 acres [FN3] of land
located in Plantation, Fla. Pursuant to the same agreement, Republic Properties, Inc., and
Gulfstream each agreed to transfer their respective one-half interests in those 300 acres to
a joint venture later designated the Nob Hill Co. Proceeding within the terms and
conditions of the joint venture, Gulfstream assigned its entire interest in the Nob Hill Co.
to its wholly owned subsidiary, Gulfstream Republic. Most prominent among the terms
and conditions of the joint venture were these two: (1) That the joint venturers (2) that the
joint venturers agreed to share equally in the profits and losses. Neither joint venturer's
potential liability was limited and no other characteristics of a "limited partnership" were
evident.

In June 1972, All Seasons Development Corp., which is a Florida corporation unrelated
to petitioners, and Gulfstream entered into an agreement whereby Gulfstream agreed to
sell to All Seasons Development Corp. a one-half interest in approximately 216 acres of
land located in Plantation, Fla. Pursuant to the same agreement, All Seasons
Development Corp. and Gulfstream each agreed to transfer their respective one-half
interests in those 216 acres to a joint venture later designated the Plantation Hills Co.
Proceeding within the terms and conditions of the sales agreement, Gulfstream
transferred its entire interest in the Plantation Hills Co. to its wholly owned subsidiary,
Gulfstream University. Most prominent among the terms and conditions of the joint
venture were these two:

(1) That the joint ventures agreed to contribute capital in equal


amounts; and
(2) that the joint venturers agreed to share the profits in the same
proportion as they contributed capital, [FN4] and to share the
losses equally. Neither joint venturer's potential liability was
limited and no other characteristics of a "limited partnership"
were evident.

Republic Properties, Inc., and All Seasons Development Corp. were both controlled by
the same individual. His corporations agreed to manage the development and
construction and sale functions related to both joint ventures.
Under the agreement which created the Nob Hill Co., no terms specified the type of
development contemplated. Under the agreement which created the Plantation Hills Co.,
the following development was contemplated:

1. The one hundred seventeen (117) acres zoned for single family
residence shall be completely developed within four (4) years
after the date of the closing as provided herein;
2. The sixty-eight (68) acres zoned for townhouses shall be
completely developed within five (5) years after the date of the
closing as provided herein;
3. The thirty-one (31) acres zoned for multiple dwelling shall be
completely developed within seven (7) years after the date of
the closing as provided herein.
LONG

This 1981 Tax Court case reviewed the question of the validity of exchanging
partnership interests.

This case involved a Texas partnership and a Georgia joint venture. The question was
whether the activities of exchanging interests in these two groups constituted an exchange
within Code §1031 or whether such activity of exchanging interests in a partnership and a
joint venture would be disqualified under the theory that they were not partnerships, that
they were actually taxable under Code §741 dealing with the sale or exchange of a
partnership interest.

The Court held that the transaction qualified as a tax-deferred exchange from the
standpoint of like-kind property. However, because of debt relief, the taxpayers were
forced to recognize the gain notwithstanding that the properties were held to be like-kind
property within Code §1031.

Following both the Long and Pappas cases is a review of the Long and Pappas
decisions and the implications of exchanging partnership interests as a result of these
decisions.

ARTHUR E. and SELMA LONG, PETITIONERS


v.
COMMISSIONER of INTERNAL REVENUE, RESPONDENT
DAVE and BERNETTE N. CENTER, PETITIONERS
v.
COMMISSIONER of INTERNAL REVENUE, RESPONDENT
77 T.C. 1045 (1981)

SCOTT, Judge:
Respondent determined deficiencies of $91,323 and $10,658 for the calendar years
1975 and 1976, respectively, in the Federal income tax of Arthur and Selma Long and
deficiencies in the amount of $153,443 and $4,761 for the calendar years 1975 and 1976,
respectively, in the Federal income tax of Dave and Bernette Center.

After concessions by the parties, the issues for decision are: (1) Whether the exchange
of an interest in a Texas general partnership for an interest in a Georgia joint venture
qualifies for nonrecognition treatment under section 1031(a), I.R.C. 1954; [FN1] (2) if
the exchange does fall within section 1031(a), whether gain should be recognized to the
extent of the nonqualifying property received in the exchange as provided in section
1031(b); (3) if gain is recognized, whether the basis of the property received should be
increased by the full amount of the gain recognized pursuant to section 1031(d);

Some of the facts have been stipulated and are found accordingly.

Arthur and Selma Long (husband and wife) and Dave and Bernette Center (husband
and wife) were residents of the State of Georgia at the time of the filing of their petitions
in this case. Each of these couples filed joint Federal income tax returns for the calendar
years 1975 and 1976 with the Internal Revenue Service Center in Chamblee, Ga.

ARTHUR LONG and Dave Center (petitioners) were successful executives employed
in Atlanta, Ga., during the years relevant to this case. Each petitioner kept his books and
records on the cash basis for the years here in issue.

During the years 1974 and 1975, petitioners were members of a Texas partnership,
known as Lincoln Property Co. No. Five of Atlanta, Ga. (Lincoln Property), which
owned property in the Atlanta, Ga., area. The principal place of business of Lincoln
Property was located in Atlanta, Ga. The partnership kept its books and records and filed
its income tax returns on the cash basis method of accounting, using a calendar year. It
filed its Forms 1065, U.S. Partnership Return of Income, for the calendar years 1974 and
1975 with the Internal Revenue Service Center, Chamblee, Ga.

During the years 1974, 1975, and 1976, petitioners were members of a Georgia joint
venture, known as Venture Twenty-One, which owned property in Atlanta, Ga. The
principal place of business of the joint venture was located in Atlanta, Ga. The joint
venture kept its books and records and filed its income tax returns on the cash basis
method of accounting, using a calendar year. It filed its Forms 1065 for the calendar
years 1974, 1975, and 1976 with the Internal Revenue Service Center, Chamblee, Ga.

I. Lincoln Property Partnership

The Lincoln Property partnership was a general partnership formed on September 30,
1965, by the Robert T. Crow Trust (Trammell Crow, trustee), Ewell G. Pope, and Frank
C. Carter for the purpose of engaging in the business of acquiring and holding for
investment real property located in the cities of East Point and Atlanta, Ga. In early 1966,
the partners began making plans to develop the property owned by the partnership and on
January 10, 1966, the Citizens & Southern National Bank (Citizens & Southern) agreed
to lend the partners $232,000 in proportion to their interests in the Lincoln Property
partnership. On August 12, 1966, Citizens & Southern, on the basis of an application
filed by the parties, approved a construction and mortgage loan in the amount of
$1,500,000 to Lincoln Property. The proceeds of the loan were to be used in the
construction of the Franciscan Apartments which consisted of a 160-unit garden
apartment complex comprised of two-story buildings plus a separate clubhouse.
Trammell Crow guaranteed the payment of that portion of the loan outstanding in excess
of $1,200,000.

On August 18, 1966, the partners, Trammell Crow, trustee, Pope, and Carter entered
into a construction loan agreement with Citizens & Southern for the financing of the
construction of the Franciscan Apartments complex. This agreement provided, among
other things, that permanent financing would be obtained from Teachers Insurance &
Annuity Association of America (Teachers Insurance) upon completion of the
apartments.

After additional financing from Teachers Insurance had been arranged and all rights
had been transferred to Teachers Insurance from Citizens & Southern, the partners, on
November 1, 1967, agreed with Teachers Insurance to consolidate the deeds and the
notes outstanding on the Franciscan Apartments into a consolidated loan in the amount of
$1,875,000 to be held by Teachers Insurance. The document executed, entitled "First
Supplement to Security Deed," stated that an additional parcel of land was conveyed to
Teachers Insurance as security for the debt, and certain terms and conditions of the
mortgage were amended. In paragraph 6, the agreement stated that notwithstanding any
prior provision to the contrary, in the event that Teachers Insurance should take action to
collect the indebtedness due, it was to first foreclose on the secured property. If that was
insufficient to pay the indebtedness, Trammell Crow was personally liable only to the
extent that the foreclosure price plus the balance of the debt exceeded $1,500,000.
Otherwise, there was no personal liability on the part of Crow, Pope, or Carter.

On December 18, 1967, Citizens & Southern approved a construction loan in the
amount of $1,275,000 to Trammell Crow, trustee, Pope, and Carter for the purpose of
constructing phase III of the Franciscan Apartments. Under the terms of the agreement,
Teachers Insurance was to accept the responsibility for the permanent financing upon the
completion of phase III of the apartments. As of December 18, 1967, phases I and II of
the Franciscan Apartments consisted of 200 completed apartments. As of January 15,
1968, the principal amount of the mortgage held by Teachers Insurance on the Franciscan
Apartments was $3,150,000.

During early 1968, petitioners were looking for investment opportunities and the
Lincoln Property partnership was brought to their attention by Herb Dickson, who at that
time was executive vice president of Citizens & Southern. The apartment complex
appeared to petitioners to be an excellent investment because the apartments had a
waiting list of over a year in length and the Lincoln Property partners represented that
they would guarantee petitioners a stated cash flow each year.
On or about April 5, 1968, petitioners invested $275,000 each in the Lincoln Property
partnership. On April 5, 1968, they executed an Amended Partnership Agreement of
Lincoln Property along with Crow, Pope, and Carter. The amended partnership
agreement (agreement) provided that after the combined contribution of $550,000 of
Long and Center, the capital account of each partner would be as follows: Crow,
$550,000; Pope, $275,000; Carter, $275,000; Long, $275,000; and Center, $275,000. The
agreement also stated that---

The parties agree that the combined capital accounts of partners Crow, Pope, and Carter
will be equal to the total of the combined accounts of partners Long and Center by
January 1, 1970. If this equalization has not taken place on or before December 31, 1969,
on January 1, 1970 such equalization shall be deemed to have taken place.

The agreement provided that partners Long and Center were to each receive a minimum
guaranteed payment of $27,500 per year from June 1, 1968, to March 1, 1974, and
$13,750 from June 1, 1974, to March 1, 1983. Similar guaranteed payments were to be
made to Crow, Pope, and Carter. After January 1, 1970, all cash flow in excess of the
guaranteed payments and all profits and losses of the partnership were to be distributed to
the partners in proportion to their partnership interests which were as follows: Crow, 25
percent; Pope, 12.5 percent; Carter, 12.5 percent; Long, 25 percent; and Center, 25
percent. Partners Crow, Pope, and Carter also jointly and severally agreed that if there
were insufficient cash flow in any year, to pay the full guaranteed payments to partners
Long and Center, they would contribute sufficient funds to the partnership to enable the
payments to be made, with Crow, Pope, and Carter contributing 50 percent, 25 percent,
and 25 percent, respectively. The agreement stated that "Such contributions shall increase
the respective capital accounts of such partners, but shall not alter the partner's interests
in profits and losses of the partnership." For tax purposes, the partnership deductions
resulting from the guaranteed payments to partners Long and Center were to be shared by
Crow, Pope, and Carter in the same proportions as their above-stated contributions, and
the deductions resulting from the guaranteed payments to partners Crow, Pope, and
Carter were to be shared equally by partners Long and Center.

The partners agreed that the total cost of completing the Franciscan Apartments was not
to exceed $4,250,000. In addition, partners Long and Center could not be required to
contribute capital for the completion of the apartments in excess of their total initial
contribution of $550,000.

Other provisions in the agreement included the right of partners Long and Center to
designate the method of depreciation to be used by the partnership; that all partners agree
that the partnership will continue until June 1, 1988, or until the partnership is dissolved
by the unanimous approval of all of the partners; and the restriction of an assignment of
an interest in the partnership without a written offer having first been made to the
partnership and to the partners which offer shall last 60 days after the receipt of the offer
by the partnership. The agreement stated that it was to be governed by the laws of the
State of Texas and "Except to the extent the Texas Uniform Partnership Act is
inconsistent with the provisions of this Partnership agreement, the provisions of such Act
shall apply to the Partnership created thereby."

The agreement provided that the partnership property was to be held for investment and
that the property was not to be sold or transferred for 5 years. After 5 years, the property
could be sold and Long and Center were guaranteed a return of $550,000 plus 12-percent
interest on their average capital account less all payments made to them by the
partnership.

If the partnership was terminated, the agreement provided that the partnership shall be
dissolved and the partnership business wound up and all of its properties distributed in
liquidation as soon as possible. The proceeds from the liquidation of the partnership were
to be applied in order of priority.

On July 18, 1969, petitioners executed a power of attorney in favor of Crow, Pope, and
Carter, so that they could then convey full fee simple title in the Franciscan Apartments
to Teachers Insurance. On July 18, 1969, Crow, Pope, and Teachers Insurance entered
into an agreement entitled "Second Supplement to Security Deed." This agreement
recited that Crow, Pope, and Carter had executed a third security deed note in the amount
of $1,328,835.86 payable to Teachers Insurance and that the parties now wanted to
consolidate the terms of the total debt of $3,150,000 and expand the coverage of the lien
on the apartments so that it applied to the total indebtedness. Paragraph 6 of the first
supplement to security deed was deleted. In its place, the parties agreed that in the event
of default, Teachers Insurance was to foreclose first on the secured property but if the
proceeds were insufficient to satisfy the outstanding indebtedness, then Crow, Pope, and
Carter were not personally liable. However, the provision did state that the agreements
therein were not to affect or impair the liens on the property or the warranty of title made
by the grantors "nor shall anything in this paragraph contained affect or impair any
Guaranty relating to this indebtedness made for the benefit of the Grantee." Finally, on
that same date, July 18, 1969, Crow, Pope, and Carter executed an agreement entitled
"Security Deed Note No. 3." The agreement stated that Crow, Pope, and Carter jointly
and severally promised to pay Teachers Insurance $1,328,835.86, with interest payments
only on a monthly basis for the balance of 1969 and thereafter, monthly payments of
principal and interest of $9,694.48 with complete repayment due August 1, 1993. The
note was secured by a first security deed to the Franciscan Apartment complex. The
balance due on this note as of May 9, 1975, was $1,191,458.21. In a document entitled
"Third Supplement to Security Deed and First Supplement to Assignment of Leases and
Rents" dated June 2, 1970, which was intended only to modify and not to replace the
security deed as previously amended, petitioners Center and Long conveyed all their
right, title, and interest in the Franciscan Apartments to Teachers Insurance. The
agreement stated that---

Long and Center shall not be personally liable on account of or pursuant to any event of
default committed by Crow, Pope and Carter or any other person liable under any
evidence of said consolidated indebtedness or any part thereof secured by the Amended
Security Deed or other related loan documents.
On February 19, 1973, the partners, Crow, Pope, Carter, and petitioners Long and
Center executed an amendment to the partnership amendment of Lincoln Property Co.
The purpose of this amendment was to provide a moratorium on the guaranteed payments
due partners Long and Center under the partnership agreement dated April 5, 1968.
Partners Crow, Pope, and Carter asked for the moratorium because the partnership was
having difficulty renting the apartments and the cash operating expenditures were
exceeding the income produced from the Franciscan Apartments properties. The
amendment stated that the intent of the parties was---

solely to provide for a "moratorium" on the guaranteed payments to all partners for the
payments due March 1, 1973 and June 1, 1973 and the quarters relating thereto, and to
provide for the payment of said guaranteed payments at a later date without any reduction
in the total amount of payments or any impairment of the obligation of partners CROW,
POPE and CARTER to contribute funds needed to make such payments and this
amendment shall be construed in conformity with such intent.

On March 31, 1975, all of the partners of Lincoln Property executed an agreement
entitled "Amendment to Partnership Agreement of Lincoln Property Company No. Five
of Atlanta, Georgia." The purpose of the amendment was to relieve Crow, Pope, and
Carter from the obligation of guaranteeing the funds for the guaranteed payments to Long
and Center, and, in return, Long and Center's share of the liabilities was to be reduced.
Accordingly, the guaranteed payment provision was eliminated.

The partnership agreement dated April 5, 1968, provided that the cash flow, after the
guaranteed payments, and all profits and losses of the partnership were to be distributed
to the partners in proportion to their partnership interests. However, the amendment dated
March 31, 1975, separated the treatment of the distribution of profits from the
distribution of losses. It provided that after January 1, 1970, all cash flow after
guaranteed payments and all profits in the partnership were to be distributed according to
the partners' interests in the partnership which were as follows: Crow, 25 percent; Pope,
12.5 percent; Carter, 12.5 percent; Long, 25 percent; and Center, 25 percent.

The losses of the partnership incurred after December 31, 1974, were not to be
distributed to the partners in proportion to their interests in the partnership, but rather
were to be distributed to the partners in proportion to their respective share of partnership
liabilities. In this regard, the partnership liabilities were reallocated as follows:

Partnership liabilities equal to the greater of $750,000 or 50% of the partnership's


excess indebtedness shall be allocated to partners Center and Long. The excess
indebtedness of the partnership for any fiscal year shall be determined by subtracting the
amount of mortgage indebtedness on partnership real property ("Mortgage Indebtedness")
as of the end of the last fiscal year from the product obtained by multiplying the "cash
flow" of the partnership for its last fiscal year by 10. Partners Crow, Pope and Carter
shall be allocated all partnership liabilities less partnership liabilities hereinabove
allocated to Center and Long. For the purposes of this subparagraph only, "cash flow" of
the partnership shall mean cash revenues received by the partnership less cash
disbursements for interest expense on Mortgage Indebtedness.

At the conclusion of the amendment, the partners stated that---

All other terms, conditions and provisions set forth in the Partnership Agreement shall
remain in full force and effect and shall not be amended or modified except as
specifically set forth herein. The partners hereby reaffirm and agree to be bound by all of
the terms and conditions of the Partnership Agreement.

III. The Exchange

Following the moratorium agreement executed in 1973 regarding the guaranteed


payments to petitioners from the Lincoln Property partnership, the financial problems of
that partnership continued. Over a period between 1973 and 1975, petitioners Long and
Center met with Frank Carter, one of the other partners, on several occasions to express
their concern about their potential liability on the Franciscan Apartments. For a period of
at least 6 months to a year prior to May 9, 1975, petitioners tried to figure several
different ways to get out of the partnership. In early 1975, the Lincoln Property
partnership began to default on its monthly mortgage payments to Teachers Insurance,
and no payments were made between March 31, 1975, and May 9, 1975. [FN2] The
discussions concerning a splitup of the partnership continued during the first part of 1975.
Partners Crow, Pope, and Carter began having problems among themselves and at one
point in the discussions they threatened to simply walk away from the partnership.

As of March 31, 1975, there were no definite agreements among the parties respecting
a splitup of the Lincoln Property partnership although a number of possibilities had been
discussed. Because of the large cash deficiencies and the large amount of debt, none of
the partners wanted to remain in the Lincoln Property partnership. On the other hand,
because the Lindbergh Apartments was a valuable piece of property, none of the partners
were interested in giving up their interests in Venture Twenty-One. Sometime after
March 31, 1975, the partners agreed that they would exchange their respective
partnership interests on May 9, 1975. After completion of the exchange, Long and Center
would own a 100-percent interest in Lincoln Property. Petitioners were of the view that
although Venture Twenty-One had a negative cash flow, the Lindbergh Apartments
would prove to be a valuable piece of property because it was in a good neighborhood
and there had been talk of locating a Marta site near the apartments. Sometime prior to
the date of the trial of this case, petitioners had sold the Lindbergh Apartments for $1
million and about a year or so later, the persons who purchased the property from
petitioners had resold the apartments for $1,200,000.

On May 9, 1975, CPC as grantors and Center and Long as grantees executed an
agreement entitled "Assignment of Partnership Interest." In the agreement, the grantors
assigned all of their rights, title, and interest in Venture Twenty-One to Center and Long.
The agreement also provided that the grantors and grantees agreed to prorate between
themselves as of the date of the agreement, the 1975 real estate taxes on the Venture
Twenty-One property. On closing, petitioners paid Crow, Pope, and Carter the sum of
$11,015 as their share of the property taxes. Also, the grantors were to pay all Georgia
transfer taxes on the conveyance of their general warranty deed.

A similar agreement regarding the assignment of petitioners Long and Center's 50-
percent partnership interest in Lincoln Property to Crow, Pope, and Carter was executed
by the parties on the date of the exchange, May 9, 1975.

As part of the acquisition of the 50-percent interest of CPC in Venture Twenty-One,


petitioners Long and Center assumed the liability jointly and severally for a promissory
note in the principal amount of $400,000 which CPC had borrowed on behalf of Venture
Twenty-One under the terms stated in the promissory note dated May 7, 1975. The
agreement for the assumption of the debt was dated May 9, 1975. Mr. Leonard Berger,
the holder of the promissory note, also executed a release of CPC from any and all
obligations arising out of the promissory note which release was dated May 9, 1975.

On their 1975 Federal income tax returns, petitioners did not report any gain on the
exchange of their interests in Lincoln Property for the interests in Venture Twenty-One.

In the statutory notices of deficiency, respondent determined that petitioners each


realized a long-term capital gain of $459,469 on their exchange of their 25-percent
interests in Lincoln Property in return for 25-percent interests in Venture Twenty-One.
[FN3]

In the statutory notice of deficiency issued to petitioner Long, respondent determined


that for the calendar year 1975 petitioner had a taxable gain of $207,950, due to the
exchange of partnership interests, instead of a capital loss of $1,000 as claimed on his
return. Accordingly, his income for the calendar year 1975 was increased by $208,950.
Because there was no capital loss carryover from 1975 to 1976, respondent determined
that petitioner Long had taxable capital gains for the calendar year 1976 in the amount of
$6,725 instead of a capital loss of $1,000 claimed on the return. Accordingly, his income
for the calendar year 1976 was increased by $7,725. Respondent also determined that
petitioner Long was liable for the minimum tax on tax- preference items in the amount of
$8,713 for the calendar year 1975. Finally, due to the increase in taxable income for
1975, respondent determined that petitioner Long was not eligible for income averaging
for the calendar year 1976.

In the statutory notice of deficiency issued to petitioner Center, respondent determined


that he had a taxable capital gain for the calendar year 1975 of $225,794 on the exchange
of the partnership interests on May 9, 1975. As petitioner Center reported a capital loss of
$1,000 on his return, his income for the calendar year 1975 was increased by $226,794.
Finally, respondent determined that petitioner Center was liable for the minimum tax on
tax-preference items in the amount of $1,097 for the calendar year 1975 and that due to
the increase in his taxable income for the calendar year 1975, he was not eligible for
income averaging in the calendar year 1976.

OPINION

In order to determine whether the exchange by petitioners of their interest in Lincoln


Properties for the interest of CPC in Venture Twenty-One is a like kind exchange, it is
necessary to determine the nature of petitioners' interest in Venture Twenty-One.
Respondent argues that Venture Twenty-One is a joint venture and not a partnership for
the purpose of determining whether there was a like-kind exchange. In the alternative,
respondent argues that Venture Twenty-One is a limited partnership. If respondent
prevails on this issue, it would follow that the exchange was of a general partnership
interest for a limited partnership interest (or a non-partnership interest) and, therefore, the
exchange would not qualify as a like kind exchange under section 1031(a). Estate of
Meyer v. Commissioner, 58 T.C. 311 (1972), affd. per curiam on this issue 503 F.2d 556
(9th Cir. 1974). (Emphasis by Author.)

Respondent contends that Venture Twenty-One, as a joint venture, is not a partnership


for the purposes of section 1031 because the joint venture agreement specifically stated
that "The parties hereto intend for this undertaking to be the creation and establishment of
a Joint Venture, rather than the creation and establishment of a partnership." The labels
applied to a transaction for purposes of State law are not binding for Federal tax
purposes. * * * *

Since a joint venture falls within the definition of a partnership for Federal income tax
purposes, and the facts we have found clearly show that Venture Twenty-One satisfies
the other requirements, we conclude that Venture Twenty- One is properly to be treated
as a partnership for all Federal income tax purposes including section 1031. * * * *

Respondent argues that if Venture Twenty-One is a partnership, petitioners' 50-percent


interest therein was a limited partnership interest because of the following facts:
petitioners were not personally liable on the mortgages of the partnership; the joint
venture agreement provided that they would not be required to make any further
contributions to capital; and the joint venture agreement stated that petitioners were to
recover their initial investment of $150,000 plus 12 percent upon dissolution and
liquidation of the joint venture. Respondent does not argue that Venture Twenty-One was
formed as a limited partnership in compliance with Georgia law and clearly it was not.
[FN4] Since Venture Twenty-One was not a limited partnership under Georgia law, and
had many attributes of a general partnership, it is properly to be considered a general
partnership in determining whether the exchange of an interest therein qualifies under
section 1031. * * * *

From the facts we have set forth it is clear that petitioners' interests in Venture Twenty-
One have all the indicia of general partnership interests. In fact, there were many
similarities between the Lincoln Property partnership agreement and the Venture Twenty-
One agreement, and respondent and petitioners both agree that Lincoln Property was a
general partnership.

I. Like-Kind Exchange

Having determined that the exchange was of a general partnership interest for a general
partnership interest, it is necessary to determine whether the exchange qualifies for
nonrecognition treatment under section 1031(a). Respondent argues that it does not
qualify because (1) a partnership interest is excluded from the benefits of section 1031(a)
[FN5] by the parenthetical language within that provision as it constitutes an evidence of
interest; (2) section 741 is a specific provision in subchapter K which requires
recognition of gain or loss on the sale or exchange of a partnership interest and it
preempts the area; and (3) the underlying assets of the partnerships were not of a like
kind.

In response to respondent's contentions, petitioners rely on two prior decisions of this


Court--- Estate of Meyer v. Commissioner, supra, a Court-reviewed opinion, and
Gulfstream Land & Development v. Commissioner, supra, which they contend require a
decision in their favor. The facts of both cases are very similar to those of the instant
case. In Meyer, a son and father exchanged their California general partnership interests
for a general and a limited interest, respectively, in a California limited partnership. Prior
to and after the exchange, both partnerships were principally engaged in the ownership
and operation of rental apartments in San Francisco, Calif. After a careful review of the
legislative history from which evolved the current list of property precluded from the
benefits of section 1031 by the parenthetical exclusion, we rejected respondent's
argument that a partnership interest could be characterized within the parenthetical as a
"chose in action." We did so because the transactions at issue did not involve the trading
of investment securities or similar intangibles which Congress had intended to exclude,
but rather "were exchanges of proprietary (partnership) interests in one small business
solely for proprietary (partnership) interests in a second small business, before and after
which both businesses were going concerns engaged in the same principal activity."
Estate of Meyer v. Commissioner, supra at 313 (fn. ref. omitted).

Respondent abandoned his "chose in action" argument in Gulfstream and instead


characterized the exchanged partnership interests as "evidences of * * * interest" which
also are within the parenthetical clause of section 1031(a). In Gulfstream, Gulfstream
Land & Development Corp. (Gulfstream) was the common 100-percent parent of
Gulfstream Republic (GR) and Gulfstream University (GU), and it owned two tracts of
land consisting of 300 acres and 216 acres, respectively. In 1971, Gulfstream agreed to
sell a one-half interest in the 300 acres to an unrelated corporation, Republic Properties,
Inc. (Republic), and both corporations agreed to form a joint venture designated Nob Hill
Co., to which they agreed to sell a one-half interest in the 216 acres to an unrelated
corporation, All Seasons Development Corp. (All Seasons), and both corporations agreed
to transfer their one-half interests to a joint venture formed by them designated
"Plantation Hills Co." Gulfstream later transferred its interest to its subsidiary, GU. Both
joint ventures were formed to develop and improve the land, building primarily single-
family residential homes. Thereafter, GR exchanged its joint venture interest in the Nob
Hill Co. for the joint venture interest held by All Seasons. The result of this exchange was
that Gulfstream's two subsidiaries, GR and GU, were coventurers in the Plantation Hills
Co., and the unrelated companies, Republic and All Seasons, were coventurers in the Nob
Hill Co.

Once again, we rejected respondent's argument that the exchange of partnership


interests was within the parenthetical exclusion of section 1031(a). We held that Meyer's
broad analysis of the legislative history of the parenthetical was not a specific rejection of
respondent's characterization of a partnership interest as a "chose in action," but rather
was a more general conclusion that a general partnership interest was simply not the type
of property intended by Congress to fall within the parenthetical exclusion. In the instant
case, respondent again makes a detailed argument based on the legislative history of the
parenthetical. We decline respondent's offer to overrule our two prior cases and,
accordingly, conclude that a partnership interest is not excluded from the benefits of
section 1031.

Although the exchange of partnership interests is not excluded from section 1031,
before nonrecognition treatment is allowed, we must determine whether the exchange
qualifies under the operative language of section 1031(a). This determination is made,
according to Meyer and Gulfstream, by examining both the exchange and the partnership
interests themselves. This analysis emanates from the concluding paragraph in Meyer in
which we expressed no opinion on a transaction where there were differing types of
underlying assets involved or where the two partnerships were not engaged in the same
principal activity. Gulfstream expanded on these concerns expressed in Meyer, and we
stated therein that in order to prevent the use of the partnership form to convert an
otherwise nonqualifying exchange into a qualifying one, we would apply the judicial
doctrine of substance over form and look through to the underlying assets. In making this
analysis, it should be emphasized that the determination of whether the exchange initially
qualifies as like kind under section 1031(a) will be applied to the partnership interests and
not on a partnership-asset-by-partnership-asset approach. * * * *

Although the exchange of the partnership interests herein satisfies the like-kind
requirement, we must also analyze the underlying assets of the partnerships to make sure
that the substance of the transaction comports with the form. As we stated in Gulfstream,
we must look through the interests to the assets to make sure that the exchange of
partnership interests does not shield a transaction which could not have otherwise
qualified under section 1031(a). First, it is beyond dispute that the predominate
underlying properties of both partnerships were substantially the same, as they were both
residential rental apartment complexes held for investment. However, respondent argues
that the receipt by petitioners of the 50-percent interest in Venture Twenty-One, which
listed among its total assets of $1,006,406, investments in the amount of $400,000, and
the great disparity in the amount of mortgages encumbering the respective partnership
property, transforms the exchange into one of non-like- kind property for which there is
full recognition of gain.
Respondent's argument that the imbalance in the amount of mortgages causes the
exchange to fall outside section 1031 is without merit. As will be discussed more fully
below, the excess of liabilities relieved over liabilities assumed constitutes "other
property or money" (boot) under section 752(d) and section 1031(b). Sec. 1031(d); sec.
1.1031(b)-1(c), Income Tax Regs. Where boot is involved, section 1.1031(a)-1(a),
Income Tax Regs., provides that an exchange will not be totally excluded from section
1031 because nonqualifying property is also received in the exchange. Rather, the
transaction still remains as an exchange described in section 1031(a), except that section
1031(b) operates to require recognition of gain to the extent of the boot received. [FN6]

However, we do agree with respondent that since the $400,000 of investments held by
Venture Twenty-One were derived from the $400,000 note signed 2 days before the
exchange, it appears that the partnership form may in fact have been used to shield
nonqualifying property from recognition. If a liability and a matching investment are
incurred by a partnership before an exchange in order to equalize the transaction, and the
amount of boot is computed not on an asset-by-asset approach but through the application
of the recognition provisions of section 751 and 752 in subchapter K, which provisions
respect the partnership entity, then the investments would not be counted as boot received
because neither section 751 nor 752 would specifically require recognition. This is
precisely the situation we are presented with herein. The $400,000 liability will increase
the partners' basis in Venture Twenty-One under section 752(a) and section 722. One-half
of the liabilities, or $200,000, constitutes a liability assumed by petitioners Center and
Long which is offset against the Lincoln Property liabilities relieved. Sec. 1.1031(b)-1(c),
Income Tax Regs. As there is no corresponding provision in subchapter K to require
recognition of gain for the one-half of investments held by Venture Twenty-One, which
are received in the exchange, petitioners Center and Long have reduced their boot
received in the amount of $200,000 by simply borrowing $400,000 and holding the
proceeds as investments pending completion of the exchange.

It is obvious that the borrowing of money and retaining the proceeds so close in time to
an exchange can produce great tax benefits for exchanging partners. This is precisely the
type of abuse which brought us in Gulfstream to remind taxpayers that we will not ignore
the underlying substance of a partnership exchange. Once again, we repeat that we will
carefully scrutinize each transaction to protect the spirit of section 1031 and make sure
that the substance accurately reflects the form.

In the instant case, a careful analysis leads us to conclude that the $400,000 of liabilities
was incurred by Venture Twenty-One in an attempt to avoid boot to petitioners in the
exchange. However, this fact does not cause the exchange to fall outside the provisions of
section 1031. As will be more fully discussed below, the operation of section 1031(b)
requires full recognition of the gain in this case.II. Recognition of Gain

Meyer and Gulfstream only addressed the question of whether an exchange of


partnership interests qualifies as a like-kind exchange under section 1031. Neither party
has directed our attention to, nor have we found any cases which have dealt with, the
problem of whether gain realized on a partnership exchange should be recognized to the
extent of boot received as provided in section 1031(b) and, if so, exactly how the amount
of boot received should be computed. The two alternatives are: (1) On a partnership-
asset-by-partnership- asset basis as if the entity itself did not exist; cf. Williams v.
McGowan, 152 F.2d 570 (2d Cir. 1945); or (2) on a partnership entity basis which would
result in recognition only to the extent provided in subchapter K, namely sections 751
and 752.

In Meyer and Gulfstream, we held that in order to be entitled to nonrecognition


treatment under section 1031(a), the requirements of that section were to be applied to
partnerships as entities rather than on an aggregate theory in which the entity would be
disregarded and the exchange would be tested on an asset-by-asset basis. [FN7] We
recognize that in Gulfstream, in addition to a comparison of the partnership interests
exchanged, we also looked through the partnership to the underlying assets in
determining whether the exchange met the requirements of section 1031(a). However, the
examination of the underlying assets is aimed at preventing any abuse of section 1031(a)
when partnership interests are exchanged, rather than adopting the aggregate theory in
determining whether the requirements of section 1031(a) are initially met. We reaffirmed
our entity approach when we stated that "section 1031(a) focuses on the assets actually
exchanged, which are partnership interests and not the underlying assets of the
partnerships." * * * *

Because we have predominently relied upon the entity theory of partnerships in our
analysis of whether the exchange qualified under section 1031(a), we conclude that the
determination of gain recognized under section 1031(b) should also be based on the
entity theory. In addition to the consistency resulting from this approach, in our view, it is
the correct approach for the following reasons: (1) It respects the special recognition
provisions within subchapter K, sections 751 and 752(d), which become operative upon
the "sale or exchange" of a partnership interest; (2) due to the requirement that the
underlying assets of each partnership be of like kind, there is a substantial probability that
the balance sheets of the exchanged partnerships will be similar, thus reducing any
inequities which might otherwise result from the entity approach; [FN8] and (3)
numerous technical problems which would arise if the aggregate approach were adopted
are avoided, such as the computation of the adjusted basis of the various partnership
properties, the computation of a partner's basis in his partnership interest, and the
allocation of such basis adjustments among the partnership assets. [FN9]

Based on our conclusion that the entity approach is proper, the amount of the boot
received will be computed according to the provisions in subchapter K. We will first
consider the treatment of liabilities of the exchanged partnerships under section 752.
Section 752(a) [FN10] provides that an increase in a partner's share of the liabilities of a
partnership will be treated as a contribution of money by that partner to the partnership,
thus increasing the partner's basis in his partnership interest under section 722. Section
752(d) [FN11] provides that upon the sale or exchange of a partnership interest, liabilities
will be treated in the same manner as liabilities outside the partnership context. Under
this section, the rule of Crane v. Commissioner, 331 U.S. 1 (1947), is applicable when a
partnership interest is sold or exchanged. Under the holding in the Crane case, because a
taxpayer's basis in property is increased by the amount of liabilities secured by the
property, whether the property is taken subject to the liabilities or the liabilities are
assumed, the relief of liabilities is included in the amount realized upon disposition of the
property. See Tufts v. Commissioner, 70 T.C. 756, 768-769 (1978), revd. 651 F.2d 1058
(5th Cir. 1981).

III. Step-Up In Basis

The next question presented is whether petitioners are entitled to a step-up in the basis
of their partnership interests for all or any part of the gain recognized. The resolution of
this issue is necessary in order to determine the proper amount of depreciation on the
Venture Twenty-One assets after the exchange. [FN23] Petitioners contend that they are
entitled to a full step-up in basis under the following statutory analysis. Section 1031(d)
[FN24] provides that the basis of petitioners' 50-percent partnership interest in Venture
Twenty-One received in the exchange is equal to the basis in the property exchanged, a
50-percent partnership interest in Lincoln Property, plus the gain recognized on the
exchange. However, as a result of the exchange of a 50-percent interest, Venture Twenty-
One terminated under section 708(b)(1)(B). [FN25] The effect of the termination is that
the partnership makes a liquidating distribution to petitioners in which no gain or loss is
recognized to the partners under section 731(a) or to the partnership under section 731(b).
[FN26] The bases of the partnership assets distributed are then stepped up as provided in
section 732(b) to equal the adjusted basis of the partners' interest in the partnership,
reduced by any money received. [FN27] Thereafter, a new partnership is deemed to be
formed by petitioners and it is entitled to this stepped-up basis under section 723 upon the
constructive contribution of that property by petitioners. Rather than dissolve and wind
up this new partnership, they continued to operate it together as 50-percent owners.

On the other hand, respondent argues that petitioners are not entitled to a full step-up in
basis equal to the amount of gain recognized.

We fail to see how petitioners' negative capital account produced this "phantom gain"
much less how this will allow petitioners a tax-free bailout from Lincoln Property. In
computing petitioners' basis in their partnership interests, we used the alternative method
authorized under section 705(b) and section 1.705-1(b), Income Tax Regs. Under this
method, their basis equaled their negative capital account plus their share of the
liabilities. Accordingly, their basis in both partnerships was reduced to the extent of their
negative capital account. This reduction had the effect of increasing the amount of gain
realized on the exchange of their Lincoln Property interests and decreasing the adjusted
basis in their original 50-percent interest in Venture Twenty-One. Having utilized this
method, respondent cannot now reasonably contend that petitioners' negative capital
account has been somehow transformed into "phantom gain" which will allow petitioners
to escape tax because of the deductions which produced their negative capital account.
We fully agree with petitioners' analysis of the relevant statutes and their conclusion that
they are entitled to a full step-up in basis as provided in section 1031(d) due to the
recognition of gain on the exchange of partnership interests.
Although the basis increase is mandated under the statute, it is apparent that petitioners'
new basis in Venture Twenty-One provides them with a tax benefit which will be realized
over the remaining life of the Venture Twenty-One assets.

Finally, the taxpayer has paid the tax at the time of the exchange on the increase in gain
due to this relief of liabilities in the larger partnership.

Decisions will be entered under Rule 155.

FN4. Georgia has adopted the Uniform Limited Partnership Act. Ga. Code Ann. sec.
75-402 provides that "A limited partnership is a partnership formed by two or more
persons under the provisions of section 75-403." Ga.Code Ann. sec. 75-403(1) states that
those persons desiring to form a limited partnership must sign a certificate which shall
contain 14 enumerated items and then have it filed in the office of the clerk of the
Superior Court of the county in which the principal place of business is located. Ga. Code
Ann. sec. 75-403(2) provides that a limited partnership is also formed if there has been
substantial compliance with the above-stated requirements.

FN5. Sec. 1031(a) provides as follows:

SEC. 1031.
EXCHANGE OF PROPERTY HELD FOR PRODUCTIVE USE OR
INVESTMENT.
(a) NONRECOGNITION OF GAIN OR LOSS FROM EXCHANGES SOLELY IN
KIND.
No gain or loss shall be recognized if property held for productive use in trade or
business or for investment (not including stock in trade or other property held primarily
for sale, nor stocks, bonds, notes, choses in action, certificates of trust or beneficial
interest, or other securities or evidences of indebtedness or interest) is exchanged solely
for property of a like kind to be held either for productive use in trade or business or for
investment.

FN6. Sec. 1031(b) provides as follows:

(b) GAIN FROM EXCHANGES NOT SOLELY IN KIND.


If an exchange would be within the provisions of subsection (a), of section 1035(a), of
section 1036(a), or of section 1037(a), if it were not for the fact that the property received
in exchange consists not only of property permitted by such provisions to be received
without the recognition of gain, but also of other property or money, then the gain, if any,
to the recipient shall be recognized, but in an amount not in excess of the sum of such
money and the fair market value of such other property.

FN7. For a historical discussion of these two competing theories, see J.Crane & A.
Bromberg, Law of Partnership, sec. 3 (1968); 1 W. McKee, W.Nelson & R. Whitmire,
Federal Taxation of Partnerships and Partners, par.1.02 (1977); 1 A. Willis, Partnership
Taxation, secs. 2.01-2.04 (2d ed.1976).
FN8. If additional consideration was received in the exchange which was not
partnership property, the nonqualifying property would most certainly be classified as
boot under sec. 1031(b). Furthermore, all contributions of property to a partnership and
indebtedness incurred at or near the time of the exchange will be carefully scrutinized, as
we have done herein, to insure that such activities are not undertaken for tax-avoidance
purposes, and we will not hesitate to apply other judicially created theories such as the
"sham" and "step transaction" doctrines. Cf. Crenshaw v. United States, 450 F.2d 472
(5th Cir. 1972).

FN9. For a general discussion, see Chromow, "Tax-Free Exchanges of Partnership


Interests: Gulfstream Land and Rev. Rul. 78-135 Impose Constraints," 57 Taxes 651
(1979).

FN10. Sec. 752(a) provides as follows:

(a) INCREASE IN PARTNER'S LIABILITIES .---


Any increase in a partner's share of the liabilities of a partnership, or any increase in a
partner's individual liabilities by reason of the assumption by such partner of partnership
liabilities, shall be considered as a contribution of money by such partner to the
partnership. In addition, sec. 752(c) provides that---For purposes of this section, a
liability to which property is subject shall, to the extent of the fair market value of such
property, be considered as a liability of the owner of the property.

FN11. Sec. 752(d) provides as follows:(d) SALE OR EXCHANGE OF AN INTEREST


.---In the case of a sale or exchange of an interest in a partnership, liabilities shall be
treated in the same manner as liabilities in connection with the sale or exchange of
property not associated with partnerships.

FN12. Sec. 1031(d) provides in part as follows: For purposes of this section, section
1035(a), and section 1036(a), whereas part of the consideration to the taxpayer another
party to the exchange assumed a liability of the taxpayer or acquired from the taxpayer
property subject to a liability, such assumption or acquisition (in the amount of the
liability) shall be considered as money received by the taxpayer on the exchange.

FN13. Sec. 1.1031(b)-1(c), Income Tax Regs., provides as follows: (c) Consideration
received in the form of an assumption of liabilities (or a transfer subject to a liability) is
to be treated as "other property or money" for the purposes of section 1031(b). Where, on
an exchange described requires property subject to a liability, then, in determining the
amount of "other property or money" for purposes of section 1031(b), consideration
given in the form of an assumption of liabilities (or a receipt of property subject to a
liability) shall be offset against consideration received in the form of an assumption of
liabilities (or a transfer subject to a liability).

CAVEAT: A REMINDER
The Deficit Reduction Act of l984 prohibits the tax-deferred exchange treatment under
Code §1031, as to partnership interests.

Code §1031, as to this issue, now states a rule that eliminates the question of the
possibility of exchanging interests in partnerships in a tax-deferred manner. They will not
qualify under Code Section 1031. That Section now provides:

"This subsection shall not apply to any exchange of interests in partnership." See Code
Section 1031(a)(2)(D).

PAPPAS

This 1982 Tax Court decision addresses the question that was faced only a year earlier
in the Tax Court in the Long case, namely the issue of whether a partnership interest,
general in nature, can be exchanged for another general partnership interest and come
within Code §1031.

Although we have seen from the decisions in various courts, as reviewed in this text,
the question examined as to exchanging partnership interests, the issue has not been clear.

However, as a result of the Long and Pappas cases, it appears that the courts were
supporting the proposition of exchanging a general partnership interest for a general
partnership interest, subject to the assets of each partnership being substantially similar.

In the Pappas case, the taxpayer exchanged a general partnership interest in Parkview.
As mentioned, the Court allowed an exchange by the taxpayer of interest in one
partnership for an interest in another partnership.

What complicates this case even more so is the method in which the taxpayer acquired
some of the interests in question, namely through services performed. Also, there is a
question as to how "like" the partnerships were as to the assets held. In any event, the
Court held that such a transaction was qualified within Code §1031. The Court referred to
the Meyer decision, Gulfstream Land, Long and Miller, all as discussed in this Section of
the text.

See the Pappas case following these comments. The comments provide a detailed
examination and review of this entire area of exchanging partnership interests. Note that
these were pre-DRA of 1984!

PETER N. PAPPAS, PETITIONER


v.
COMMISSIONER of INTERNAL REVENUE, RESPONDENT
PETER N. PAPPAS and MARLENE PAPPAS, PETITIONERS
v.
COMMISSIONER of INTERNAL REVENUE, RESPONDENT
GOFFE, Judge:
The Commissioner determined deficiencies and additions to tax in petitioners' Federal
income tax for the taxable years 1973, 1976, 1977, and 1978 as follows:

Taxable Year
Sec. 6653(a) Petitioner Deficiency
1973 Peter N. Pappas $4,423.00 $ 221.15
1976 Peter N. Pappas 37,254.90 1,862.75
1977 Peter N. and Marlene Pappas 3,550.50 -0-
1978 Peter N. and Marlene Pappas 1,021.93 -0-

Upon appropriate motion, the cases were consolidated for trial, briefs, and opinion.

Due to concessions by the parties, the issues which remain for our consideration are:

(1) Whether petitioner PETER N. PAPPAS exchanged a general


partnership interest in Parkview Terrace or a limited
partnership interest in Kenosha Limited Partnership for a
general partnership interest in the St. Moritz Hotel partnership;
(2) whether the exchange of partnership interests qualifies for
nonrecognition treatment pursuant to section 1031, I.R.C. 1954;
(3) whether petitioner received "boot" on the exchange;
(4) whether petitioner acquired the St. Moritz Hotel with the intent
to demolish it; and
(5) whether petitioner is liable for an addition to tax under section
6653(a) for the taxable years 1973 and 1976.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The stipulation of facts and
exhibits attached thereto are incorporated herein by this reference.

Petitioner resided at Lake Geneva, Wis., when he filed his petition herein, and he and
his wife also resided there when they filed their joint petition herein. Petitioner is a
structural engineer and works as a manager, developer, and consultant on real estate
ventures.

Petitioner began living in the St. Moritz Hotel in 1973. At that time, he managed the
hotel for the St. Moritz Hotel partnership, the partners of which were Drs. Konstantine
George (George), Thomas Pagedas (Pagedas), and Gregory Topetzes (Topetzes). George
owned a one-half general partnership interest in the partnership, while Pagedas and
Topetzes owned the remaining one-half general partnership interest.

In 1973, George and Topetzes also hired petitioner to oversee the development and
subsequent operation of the Elmwood Terrace Apartment project (Elmwood). On January
1, 1976, they gave him a one-third general partnership interest in Elmwood as payment
for his work on the project. Then, on or about January 2, 1976, petitioner exchanged his
newly acquired interest in Elmwood for George's one-half general partnership interest in
the St. Moritz Hotel partnership.

Prior to 1976, petitioner acquired an interest in another real estate development project,
the Parkview Terrace partnership (Parkview). He, Frank D. Ruffalo, and John R.
Huxhold formed Parkview by oral agreement pursuant to which Pappas received his one-
third general partnership interest in exchange for services, while the others received their
one-third general partnership interests in exchange for real estate. Parkview began
constructing two apartment buildings shortly after June 21, 1976.

On July 1, 1976, petitioner executed an agreement with the other partners in the St.
Moritz Hotel partnership, Topetzes and Pagedas, whereby petitioner assigned to them his
one-third general partnership interest in Parkview, and they assigned to him their one-half
general partnership interest in the St. Moritz Hotel partnership. At the time of the
exchange, the value of the St. Moritz Hotel partnership interest was $74,750, of which
$13,500 was attributable to furniture and equipment. All of the assets of Parkview and St.
Moritz were property of "like kind" within the meaning of section 1031(a) except the
furniture and equipment.

On July 1, 1976, petitioner, Topetzes, and Pagedas signed a certificate of limited


partnership creating the Kenosha Limited Partnership (Kenosha) for 5 years. The
certificate recited that Kenosha was formed to hold the one-third interest in Parkview
which Topetzes and Pagedas contributed, in exchange for a 49-percent limited
partnership interest each in Kenosha. Petitioner was named as its general partner, and he
contributed services in exchange for a 2-percent general partnership interest. Thus, after
the transactions on July 1, 1976, petitioner owned the St. Moritz Hotel and a 2-percent
general partnership interest in Kenosha which, in turn, owned a one-third general
partnership interest in Parkview. Pagedas and Topetzes each owned a 49-percent limited
partnership interest in Kenosha.

In 1974, George, Topetzes, and Pagedas, partners of the St. Moritz Hotel partnership,
were not happy with the existing hotel. They wanted to construct a new building on the
property and engaged petitioner to secure approval from the proper zoning authorities.
Petitioner, on behalf of the partnership, applied to the Lake Geneva City Plan
Commission. The application was denied on January 20, 1975.

Petitioner, on behalf of the partnership, nonetheless hired an architect to prepare


preliminary sketches for a new hotel. Petitioner had these plans rendered in the form of a
presentation drawing and 8"' X 10"' color and black- and-white prints. He then reapplied
on September 9, 1975, on behalf of the partnership. Despite petitioner's preparations, the
building commissioner rejected the new application on the same date that it was filed.
Petitioner, on behalf of the partnership, immediately submitted a notice of appeal to the
Lake Geneva Board of Appeals (board). Also about this time, the Geneva Lake
Environmental Agency began an environmental impact study of the effect of the
construction of a new hotel. [FN3]

The board convened on October 7, 1975, and considered the appeal. Its members were
uncertain whether they had the right to issue a variance, so they referred the application
to the city attorney for his opinion. In November, they received his opinion which they
did not find satisfactory, so they suggested to him that he meet with petitioner's attorney
to "clarify the whole situation." In January 1976, when the board was still undecided,
petitioner and George exchanged general partnership interests, as explained above, so
that petitioner became the owner of a one-half interest in the St. Moritz Hotel partnership.

By February 1976, the board concluded that it needed further legal advice and
requested another opinion from the city attorney. It received the opinion on April 15,
1976, but felt that the opinion did not indicate the action which it should take on the
appeal. Finally, on June 10, 1976, the board reviewed the appeal once more. Its members
were still reluctant to grant or deny the request for constructing the new hotel and they
advised petitioner and his attorney to submit a new application for appeal. [FN4] On July
1, 1976, Topetzes and Pagedas transferred their general partnership interests in the St.
Moritz Hotel partnership to petitioner, as set forth above, so that petitioner became the
sole owner of the hotel.

The application was finally approved on January 17, 1977. Its terms, however, required
the city plan commission to review and approve all building proposals and any changes
thereon. At that time, petitioner had neither financing nor plans to build a new hotel.
Instead, he requested an architectural firm to estimate the cost of adding multilevel
parking to the existing structure.

In December 1978, petitioner stated to an Internal Revenue Service agent that he would
like to build a new hotel if he could find interested parties and adequate finances. At the
time of trial, however, the hotel had not been demolished and was still occupied by guests
and by permanent residents such as petitioners.

In 1975, petitioner received a general partnership interest in Parkview in exchange for


his services as described above. He reported the value of the interest as income because
his accountant told him it was proper to do so.

In 1976, petitioner received a general partnership interest in Elmwood as payment for a


construction fee as described above. Beginning in 1972, Elmwood provided Pappas with
Forms 1099 for the fees it paid him. In 1976, however, Elmwood failed to issue to him a
Form 1099 covering the partnership interest in Elmwood. Petitioner properly reported all
income for which he received a Form 1099. He did not report as income the value of the
Elmwood partnership interest in 1976 but now concedes that he should have done so.

Two accountants assisted and advised petitioner on the preparation and filing of his
1976 income tax return, and one of them signed as preparer. The accountants did not
discuss the proper reporting of the construction fee and the receipt of the partnership
interest with petitioner.

On his individual income tax return for the taxable year 1976, petitioner reported no
gain from the exchange of partnership interests. He filed that return in June 1977. He
filed his return for the taxable year 1973 on June 19, 1974.

Petitioners claimed deductions on their income tax returns for the taxable years 1976,
1977, and 1978 for depreciation of the St. Moritz Hotel property.

Petitioner, on his income tax return for the taxable year 1976, reported no income from
the receipt of a general partnership interest in Elmwood which he received in that year for
performing personal services.

In the statutory notice of deficiency mailed to petitioner for the taxable years 1973 and
1976, the Commissioner disallowed a net operating loss which petitioner carried back
from 1976 to 1973 because the adjustments made by the Commissioner to petitioner's
income tax liability for 1976 eliminated the net operating loss. He determined, further,
that petitioner earned income upon the receipt of the general partnership interest in
Elmwood which he failed to report, and such failure gave rise to imposition of the
addition to tax under the provisions of section 6653(a) for the taxable years 1976 and
1973. He determined, further, that petitioner acquired the St. Moritz Hotel with the intent
to demolish it and, therefore, was entitled to no deductions for depreciation of the hotel.

The Commissioner made the following determination in his statutory notice of


deficiency as to the exchange of partnership interests in the taxable year 1976:

There were two exchanges of partnership interests during the year: 50% in St. Moritz
partnership was received for 331;3% interest of Elmwood and 50% of St. Moritz was
received for a 98% interest in the Kenosha Limited Partnership. The gains from these
transactions were not reported on the return. Internal Revenue Code section 741 states
that in the case of an exchange of an interest in a partnership gain shall be recognized to
the transferor partner.

OPINION

The first issue to be decided is whether petitioner must recognize income during 1976
as a result of exchange of partnership interests and/or the creation of the Kenosha
partnership.

In our findings of fact, we have set forth in detail the transactions which took place. For
convenience, they may be summarized as follows. In January 1976, petitioner exchanged
a one-third general partnership interest in Elmwood for a one-half general partnership
interest in St. Moritz. In July 1976, petitioner exchanged a one-third general partnership
interest in Parkview for a one-half general partnership interest in St. Moritz. Also in July
1976, petitioner contributed services, and two others contributed the one-third general
partnership interest they acquired from petitioner in Parkview to form a new limited
partnership, Kenosha, in which petitioner became a 2-percent general partner and the
others became limited partners, owning the other 98 percent.

We shall first examine the transactions under the provisions of section 1031(a). [FN5]
In general, that section provides that gain or loss will not be recognized upon the
exchange of property held for productive use or investment provided that the properties
exchanged are of like kind. The parties agree that the partnership interests exchanged
were held for investment or productive use, but they disagree as to whether they were of
like kind.

It is well established that, in general, an exchange of general partnership interests is an


exchange of property of like kind, but that an exchange of a general partnership interest
for a limited partnership interest is not an exchange of property of like kind. Estate of
Meyer v. Commissioner, 58 T.C. 311 (1972), affd. 503 F.2d 556 (9th Cir. 1974);
Gulfstream Land & Development v. Commissioner, 71 T.C. 587 (1979); Long v.
Commissioner, 77 T.C. 1045 (1981); Miller v. United States, an unreported case (S.D.
Ind. 1963, 12 AFTR 2d 5244, 63-2 USTC par. 9606).

First, respondent contends that a partnership interest is an "evidence of interest"


described in the parenthetical language of section 1031(a); therefore, gain from both of
the exchanges of partnership interests in 1976 must be recognized. Respondent's position
has been rejected by us in Gulfstream Land & Development v. Commissioner, supra, and
Long v. Commissioner, supra, and we continue to reject it here.

Respondent also takes the position that petitioner, in substance, formed Kenosha by
himself and then transferred the two 49-percent limited partnership interests in that
partnership, rather than the general partnership interest in Parkview, in exchange for the
one-half general partnership interest in St. Moritz. Respondent thus seeks to "collapse"
the transactions on the theory that the form does not comport with the substance. We
have found the facts to be otherwise. The transactions are supported by stipulated,
uncontroverted documents. There is an agreement dated July 1, 1976, between petitioner,
Topetzes, and Pagedas in which petitioner unmistakably assigned his one-third general
partnership interest in Parkview to Topetzes and Pagedas and in which they just as
unmistakably assigned to petitioner their one-half general partnership interest in St.
Moritz. The agreement contains no reference to Kenosha.

The certificate of limited partnership for Kenosha dated July 1, 1976, recites that it was
formed to hold a one-third interest in Parkview contributed to the partnership by Topetzes
and Pagedas. Petitioner could not have transferred a 98-percent limited partnership
interest in Kenosha to Topetzes and Pagedas because he could not have created a "one
man" partnership under Wisconsin law, [FN6] and even if he could have, it would not
have constituted a partnership under section 1.761, Income Tax Regs.

There is no evidence in the record that would lead us to the conclusion that the
substance of the transactions was different than the form. [FN7] We conclude, therefore,
that in both January and July, petitioner exchanged general partnership interests for
general partnership interests and such exchanges come within the nonrecognition
provisions of section 1031(a). Estate of Meyer v. Commissioner, supra; Gulfstream Land
& Development v. Commissioner, supra; Long v. Commissioner, supra.

Respondent next argues that section 741 [FN8] requires that gain or loss be recognized
when partnership interests are exchanged, notwithstanding section 1031. He contends that
section 741 and section 1031 are conflicting exchange provisions, and that section 741
overrides section 1031 because it is a more specific section. * * * *

Sections 1031 and 741 are not in conflict. Neither of them is an "exchange" provision,
as respondent suggests. Section 1031 is a nonrecognition provision. It provides that gain
or loss realized on certain exchanges will not be recognized. Section 741 is a
characterization provision. It provides that a partnership interest is to be treated as a
capital asset, except as otherwise provided in section 751.

Section 741 does provide that "In the case of a sale or exchange of an interest in a
partnership, gain or loss shall be recognized to the transferor partner." (Emphasis added.)
This language, however, does not transform section 741 into a specific recognition
provision which overrides the nonrecognition provision of section 1031 and the general
recognition provision, section 1002. As we pointed out in Pollack v. Commissioner, supra
at 146, cases decided prior to the enactment of section 741 held that the sale of a
partnership interest was the sale of a share of each of the underlying assets of the
partnership, not the sale of a capital asset, i.e., the interest in the partnership. The
enactment of section 741 codified the treatment to be the sale of a capital asset. Pollack v.
Commissioner, supra. The legislative history of section 741 emphasizes characterization,
not recognition. The House committee report states:

[S]ection [741] provides that the sale or exchange by a partner of his interest in the
partnership shall be treated generally as the sale or exchange of a capital asset. Any gain
or loss shall be treated as capital gain or loss unless the partnership has unrealized
receivables or fees, or inventory or stock in trade which had substantially appreciated or
depreciated in value, as defined in section 751. If section 751 is applicable, a portion of
the gain or loss shall be treated as ordinary income or loss. [H. Rept. 1337, 83d Cong., 2d
Sess. A232 (1954). Emphasis added. See also S. Rept. 1622, 83d Cong., 2d Sess. 376
(1954).] * * * *

The regulations do not support respondent's position. There is nothing in the regulations
under section 1031 which implies that section 741 overrides section 1031.

In both Gulfstream Land & Development v. Commissioner, supra, and Long v.


Commissioner, supra, the respondent similarly argued that section 741 overrode section
1031 and in both cases that argument was rejected, at least by implication. In Gulfstream,
we reaffirmed our adoption of the entity concept of a partnership and stated that we
would look to the underlying assets of the partnership for the purpose of determining
whether any specific types of assets excluded by the parenthetical clause from the
operation of section 1031(a) were involved (see 71 T.C. at 595-596)---a course which
would clearly have been unnecessary if section 741 applied. Similarly, in Long, we said
that we would look to the provisions of subchapter K to determine the existence and
computation of the "boot" to be recognized under section 1031(b) (see 77 T.C. at 1072,
1082), and we pursued that course without any reference to section 741.

Accordingly, we hold that section 741 does not prevent exchanges which come within
the terms of section 1031(a) from being accorded nonrecognition treatment.

We are still left with the problem of whether the presence of the furniture and
equipment of the St. Moritz Hotel partnership falls within either of the two areas carved
out of section 1031(a) by Gulfstream and Long.

The Commissioner, in the statutory notice of deficiency, determined that both of the
exchanges were taxable. At trial, petitioner conceded that the exchange on January 2,
1976, of petitioner's interest in the Elmwood general partnership for a one-half interest in
the St. Moritz general partnership was taxable and respondent conceded that petitioner
sustained a short-term capital loss in the amount of $497.59. In addition, at trial
respondent raised as an alternative adjustment that, if we should find the exchange on
July 1, 1976, of petitioner's general partnership interest in Parkview for the remaining
one- half general partnership interest in St. Moritz to be nontaxable, then we should apply
the "boot" provisions of section 1031(b) to the extent of one-half of the value of the
personal property in the St. Moritz Hotel which was owned by that partnership. The
parties stipulated that at the time of the exchange on July 1, 1976, the value of Pagedas'
and Topetzes' one-half general partnership interest in the St. Moritz Hotel partnership
was $74,750, of which $13,500 was attributable to furniture and equipment. The parties
also stipulated that, except for the furniture and equipment, all of the assets of the
Parkview and St. Moritz partnerships were property of "like kind" within the meaning of
section 1031(a).

Clearly, the furniture and equipment, to which respondent points, is not stock in trade,
as may have existed in Gulfstream Land & Development, and therefore cannot be
excluded from nonrecognition under section 1031(a) and considered "boot" under section
1031(b). As far as subchapter K is concerned, neither party has raised any issue as to the
applicability of subchapter K, aside from section 741. Under these circumstances, we
decline to explore the extent to which section 751(c) would require depreciation recapture
under sections 1245 and 1250 in respect of the depreciable property which was included
in the assets of both Parkview and St. Moritz. [FN9] Cf. Long v. Commissioner, supra at
1081-1082.

Accordingly, we find that neither the parenthetical exclusion clause of section 1031(a)
nor the provisions of section 751 are applicable. Petitioner therefore need not recognize
any gain from the exchange of his general partnership interest in Parkview for the one-
half general partnership interest in the St. Moritz Hotel partnership except for liabilities
assumed taxable as "boot" at $2,942.94. [FN10]
Decisions will be entered under Rule 155.

FN5. SEC. 1031.


EXCHANGE OF PROPERTY HELD FOR PRODUCTIVE USE OR
INVESTMENT.
(a) NONRECOGNITION OF GAIN OR LOSS FROM EXCHANGE SOLELY IN
KIND.

No gain or loss shall be recognized if property held for productive use in trade or
business or for investment (not including stock in trade or other property held primarily
for sale, nor stock, bonds, notes, choses in action, certificates of trust or beneficial
interest, or other securities or evidences of indebtedness or interest) is exchanged solely
for property of a like kind to be held either for productive use in trade or business or for
investment.

FN7. shall be recognized to the transferor partner. Such gain or loss shall be considered
as gain or loss from the sale or exchange of a capital asset * * * * .

FN9. We are satisfied that neither partnership held other types of "unrealized
receivables" or inventory.

PRIVATE LETTER RUL. 8912023

Consistent with prior positions, even before the modification of Code §1031,
eliminating the ability to exchange interests in other partnerships, tax-deferred, this
Private Letter Rul. reaffirmed the posture that it is possible to exchange, tax-deferred
under Code §1031, an interest in one partnership for an interest in the same partnership.

PRIVATE LETTER RULING 8912023

This is in response to your letter dated September 29, 1988, concerning whether gain or
loss on the exchange of certain interests in the same partnership qualifies for
nonrecognition under section 1031(a) of the Internal Revenue Code.

The information submitted discloses that Partnership X was formed as a limited


partnership under the Uniform Limited Partnership Act of State. X is engaged in the
business of owning and operating commercial rental real estate. The limited partners of X
are A, B, C, D, E, F, G and H. The general partner of X is Corporation Y. The
shareholders of Y are A, B and C, each of whom is also a limited partner in X.

Under the terms of the partnership agreement, no limited partner may voluntarily
withdraw from the partnership. However, the general partner may withdraw for purposes
of corporate liquidation on the condition that a successor general partner is elected.

Y intends to liquidate under section 333 of the Code and to distribute its assets to A, B
and C. Upon liquidation, one or more of the shareholders of Y will exchange their
general partner interest in X for a limited partner interest in X, in order to avoid unlimited
liability. Each partner's profits, losses and capital will remain the same after the
exchange. The business of X will continue to be carried on after the exchange.

It is further contemplated that one or more of the limited partners will exchange their
limited partnership interest in X for a general partner interest in X. Each partner's profits,
losses and capital will remain the same after the exchange. The reason for the exchange
of limited partnership interests for general partnership interests is to broaden participation
and to reduce the need to seek a replacement general partner after death, resignation or
removal.

Section 1031(a) of the Code provides, in part, that no gain or loss shall be recognized if
property held for productive use in a trade or business or for investment (not including, in
part, stocks, bonds, notes, choses in action, certificates of trust or beneficial interests, or
other securities or other evidences of indebtedness or interest) is exchanged solely for
property of a like kind which is to be held either for productive use in a trade or business
or for investment.

Section 1031(a)(2)(D) of the Code provides that the nonrecognition provisions under
section 1031(a) shall not apply to any exchange of interests in a partnership.

Section 1.1031(a)-1(b) of the Income Tax 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 Tax Reform Act of 1984, Pub. L. No. 98-369, section 77, 1984-3 (Vol. 1) C.B.
103, amended section 1031 by adding subparagraph (a)(2)(D) to the Code. The legislative
history of section 1031(a)(2)(D) indicates that Congress considered whether the like-kind
provisions were originally intended to apply to exchanges in partnership interests. Under
prior law, the statute, by its own terms, did not apply to exchanges of stock, certificates of
trust or beneficial interests, or other securities or evidences of indebtedness or interest.
These exclusions prevented taxpayers from trading investment interests so as to take
advantage of like-kind treatment on dispositions of appreciated property. Congress
believed that partnership interests typically represent investment interests similar to those
items previously excluded from like-kind treatment and should therefore also be excluded
from such treatment. In reaching this decision, Congress was particularly concerned by
the use of like-kind exchange rules to facilitate the exchange of interests in tax shelter
investments for interests in other partnerships. Under this arrangement, taxation of the
gain in an interest in a 'burned out' tax shelter partnership -- i.e., a partnership which has
taken substantial deductions for nonrecourse liabilities without actually paying off such
liabilities, and hence without the partners suffering real economic loss -- could be able to
be avoided if the interest was exchanged, tax-free, for an interest in another partnership.
Congress believed that such abuses and hardships are best prevented by specifically
excluding partnership interests from the like-kind exchange rule. Congress intended,
therefore, to deny like-kind treatment to the exchange of interests in different
partnerships and not to deny like-kind treatment to the exchange of interests in the same
partnership. H.R. Rep. No. 98-432, 98th Cong., 2d Sess., pt. 2 (1984), pp. 1231-1234.

In this case, the business of X will continue after the exchange of partnership interests.
A, B, C, D, E, F, G and H will remain partners in X, and each partner's profits, losses and
capital will remain the same after the exchange. The proposed exchange of one or more
general partnership interests for limited partnership interests, and limited partnership
interests for general partnership interests, in the same partnership, is no more than an
exchange of 'like-kind' property of different quality, grade or value. See section
1.1031(a)- 1(b).

Accordingly, based solely on the information presented, we conclude that any gain or
loss realized by the partners on the proposed exchange of partnership interests will
qualify for nonrecognition under section 1031(a) of the Code. However, no opinion is
expressed as to the federal tax consequences of the transaction discussed above under
section 333 of the Code or about any other provision of the Code.

This ruling is directed only to the taxpayer who requested it. Section 6110(j)(3) of the
Code provides that it may not be used or cited as precedent. Sincerely yours,

RECIPROCAL EXCHANGE OF LIMITED GENERAL PARTNERSHIP


INTERESTS
PRIVATE LETTER RULING 8944043

This Ruling revoked Private Letter Ruling 8912023, which previously allowed an
exchange of partnership interests, general and limited. Such exchange is no longer
allowed as a result of the modification of the Code under Code §1031(a)(2). However, an
exchange within the same partnership can take place. See Appendix 1 and Treasury Reg.
§1.1031(a)-1.

PRIVATE LETTER RULING 8944043


Section 1031 -- Like-Kind Exchanges

Publication Date: November 3, 1989

Dear

This is in reference to a private letter ruling (PLR 8912023) issued to you on behalf of
X and interested parties dated December 22, 1988. PLR 8912023 considered whether the
gain or loss realized by the partners of a partnership, X on the reciprocal exchange of
limited and general partnership interests qualifies for nonrecognition treatment under
section 1031 of the Internal Revenue Code.

This is to advise you that the Internal Revenue Service has reconsidered PLR 8912023.
Consequently, PLR 8912023 is hereby revoked and may no longer be relied upon as of
the date of this letter.
A copy of this letter is being sent to each interested party in accordance with the Power
of Attorney and Declaration of Representative on file with this office.

This ruling is directed only to the taxpayer who requested it. Section 6110(j)(3) of the
Code provides that it may not be used or cited as precedent. Sincerely yours,

****

However, see Appendix 1 as to Proposed Treas. Reg. §1.1031(a)-1, allowing such


exchange within the same partnership.

EXCHANGE OF INTERESTS IN PARTNERSHIPS:


PRIVATE LETTER RULING 9741017

This Private Letter Ruling raised the issue of the propriety of using Code §1031 to
exchange interests in partnerships. Although prior case law had allowed such exchanges
in such circumstances, a modification of the Code, which was noted in the Ruling, makes
it clear that such exchanges are not qualified under Code §1031.

PRIVATE LETTER RULING 9741017

Internal Revenue Service (I.R.S.)


1997 WL 625718 (I.R.S.)
Issue: October 10, 1997
July 10, 1997

Dear __

This is in response to the request dated November 12, 1996, submitted on behalf of
Taxpayer by ***, seeking a ruling that an exchange of certain interests will qualify as an
exchange of like-kind property subject to nonrecognition pursuant to §1031 of the
Internal Revenue Code. In connection with the aforementioned ruling request the
Taxpayer also requested a ruling that the interests which are the subject of the proposed
exchange, will not be considered interests in a partnership within the meaning of §761,
because an exchange of partnership interests is not eligible for nonrecognition treatment
under §1031.

Based on the facts and analysis presented below, we conclude that the interests to be
exchanged do represent interests in a partnership. Therefore, because the exchange is an
exchange of interests in a partnership, it cannot qualify for nonrecognition treatment
under §1031.

The information submitted discloses that each of the brothers, A and B, owns a one-half
interest in Taxpayer, which itself owns ten rental real properties. A and B have
responsibility for making major decisions regarding their properties. Management of the
properties is performed by a property management corporation of which A and B are
equal stockholders, but are no longer employees. A and B represent that they have never
executed any partnership agreement regarding Taxpayer or considered themselves to be
anything other than equal owners of the properties. For the five consecutive tax years
19x1 to 19x5, however, all net income and losses of Taxpayer relating to the properties
have been reported on Form 1065, a Partnership Return.

A and B represent that irreconcilable differences have developed between them


regarding their ownership of the properties. Moreover, A and B are considering estate
planning issues relating to the properties. To address those issues, A and B propose a
like-kind exchange between themselves involving nine of the properties. After the
exchange, six of the properties will be owned entirely by B, and three will be owned by
A. The tenth property will continue to be owned by A and B as co-owners.

Section 1031(a)(1) of the Code provides generally 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.

Section 1031(a)(2)(D) provides that this subsection shall not apply to any exchange of
interests in a partnership.

Section 761 provides that the term "partnership" includes a syndicate, group, pool, joint
venture, or other unincorporated organization through or by means of which any
business, financial operation or venture is carried on, and which is not a corporation,
trust, or estate.

Section 1.761-1(a) of the Income Tax Regulations provides that a joint undertaking
merely to share expenses is not a partnership. For example, if two or more persons jointly
construct a ditch to drain surface water from their properties, they are not partners. Mere
co-ownership of property that is maintained, kept in repair, and rented or leased does not
constitute a partnership. For example, if an individual owner, or tenants in common, of
farm property lease it to a farmer for cash rental or a share of the crops, they do not
necessarily create a partnership thereby. Tenants in common, however, may be partners if
they actively carry on a trade, business, financial operation, or venture and divide the
profits thereof. For example, a partnership exists if co-owners of an apartment building
lease space and in addition provide services to the occupants either directly or through an
agent.

In Rev.Rul. 75-374, 1975-2 C.B. 261, two parties each own an undivided one- half
interest in an apartment project. A management company retained by the co- owners
manages the building. Customary tenant services such a heat and water, unattended
parking, trash removal, normal repairs, and cleaning of public areas are furnished at no
additional charge. Additional services, such as attendant parking, cabanas, and gas and
electricity are provided by the management company for a separate charge. The ruling
holds that the furnishing of customary services in connection with the maintenance and
repair of an apartment project will not render co-ownership a partnership. The furnishing
of additional services by the owners or through an agent will render a co- ownership a
partnership. The revenue ruling concludes that since the management company is not an
agent of the owners and the owners did not share the income earned from the additional
services, the owners were not furnishing services. Therefore, the owners are to be treated
as co-owners and not partners under section 761.

Without making a determination under Rev.Rul. 75-374 regarding A's and B's joint
business activities relating to the properties, we note a crucial test under case law of
whether the co-owners of property intended to create a partnership, as evidenced by their
actions, notwithstanding the lack of characterization of their relationship. See Estate of
Levine, 72 T.C. 780, 785 (1979). In this instance, we believe that Taxpayer's filing of
partnership tax returns for several tax years indicates an intention to be taxed as a
partnership. Accordingly, we conclude that A's and B's co-ownership of Taxpayer
constitutes a partnership under section 761(a) and the regulations thereunder rather than a
mere co-ownership.

Since an exchange of partnership interests can not qualify for deferral under section
1031(a)(1) by reason of section 1031(a)(2)(D) we can not rule that the transaction
qualifies for deferral as a like-kind exchange.

PARTNERSHIPS:
TECHNICAL ADVICE MEMORANDUM 9818003
1998 WL 212407

In this Technical Advice Memorandum, the question was whether the exchange
qualified as a Code §1031 tax-deferred exchange where the partnership, the taxpayer,
transferred the relinquished property, but the replacement property was deeded directly to
the partners of the partnership (taxpayer) to liquidate their interests in the partnership.

The TAM concluded that it was not a qualified Code §1031 exchange. The Ruling
states that, although there is authority for the position (see Revenue Ruling 90-34) that it
is possible to have a transfer by a partnership and a replacement in the names of the
partners in liquidation, the TAM noted that "The relevant inquiry here is whether the
transaction is an exchange with respect to taxpayer, not with respect to the partners of the
taxpayer." Therefore, the Memorandum included that it was not a qualified exchange
under Code §1031.

The Memorandum also concluded that what the taxpayer-partnership received was cash
and certain other real properties that were then transferred to the partners.

TAM 9818003

Internal Revenue Service (I.R.S.)


Technical Advice Memorandum
Issue: May 1, 1998
December 24, 1997
ISSUE

Whether there is an exchange that qualifies Taxpayer for nonrecognition as a like-kind


exchange under §1031 of the Internal Revenue Code where Taxpayer, a partnership,
transfers the relinquished property, but the titles for the replacement properties are
directly deeded to certain partners of Taxpayer in liquidation of their partnership
interests.

CONCLUSION

Taxpayer did not engage in an exchange so as to qualify for nonrecognition under


§1031(a)(1) of the Code.

FACTS

Taxpayer, a partnership, owned the Relinquished Property and leased it to A, a limited


partner of Taxpayer. After leasing the Relinquished Property for approximately 14 years,
Taxpayer and A entered into a contract for the sale of the Relinquished Property to A for
$w.

Section 9.4(a) of the partnership agreement provided that upon dissolution and
liquidation of Taxpayer the managing partner could effect one or more deferred like-kind
exchanges under §1031 through a qualified intermediary. The provision allowed each
partner to designate one or more properties which Taxpayer would acquire using the
respective partner's share of the net proceeds from the sale of the property. It further
stated that none of the individual partners would be considered agents of the partnership
for any purpose relating to the deferred like-kind exchange. If the purchase price of a
replacement property exceeded that partner's share of the proceeds from the property sale
that partner was required to provide the additional funds.

Shortly before the sale was to occur, Taxpayer entered into an exchange agreement
with Intermediary, a bank, to act as an intermediary in a deferred exchange of the
Relinquished Property. Intermediary assigned its interest in the exchange agreement to A.
A purchased the Relinquished Property for $w. After paying closing costs and paying off
the debt on the Relinquished Property, Taxpayer received net proceeds of $x. Of this
amount, $y was transferred to the Exchange Trust at Intermediary, and $z was distributed
to certain partners, including A, in payment for their partnership interests. The Exchange
trust subsequently disbursed funds to the closing agents of the other partners to acquire
replacement real properties on their behalf which were deeded directly to the individual
partners in liquidation of their partnership interests.

LAW AND ANALYSIS

Section 1031(a)(1) of the Internal Revenue Code provides generally 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.

Section 1.1002-1(d) of the Income Tax Regulations provides that ordinarily, to


constitute an exchange, the transaction must be a reciprocal transfer of property, as
distinguished from a transfer of property for a money consideration only.

Taxpayer has not established that the transaction is a exchange with a reciprocal
transfer of property. Taxpayer transferred the Relinquished Property, but received no
reciprocal transfer of replacement property.

In Carlton v. United States, 385 F.2d 238 (5th Cir.1967), taxpayers, who had given an
option on their ranch property, negotiated to acquire other ranch property, intending to
effect a tax-free exchange. The optionee contracted to buy other property and assigned
the contract to taxpayers at the time of sale of taxpayers' ranch. The Fifth Circuit Court of
Appeals held that the transaction did not qualify as a tax-free exchange since title to the
replacement property never vested in the optionee. Since the optionee never had any
property of like kind to exchange, the transfer of the ranch constituted a sale despite the
taxpayers' intentions to execute an exchange.

In order for Taxpayer to qualify for nonrecognition treatment under §1031, the
transaction must be in the form of an exchange. Because a sale and a purchase may have
the same end result as an exchange, in order for the requirement that the transaction
qualify as an exchange to have any meaning, the form of an exchange must be followed.
See Carlton, supra. In Taxpayer's case, there was no transfer of replacement property to
Taxpayer so as to complete an exchange. Instead, Taxpayer received cash, and various
real properties were transferred to its partners in payment for the Relinquished Property.

Taxpayer cites Rev. Rul. 90-34, 1990-1 C.B. 154, as authority for its position that the
direct deeding of the replacement properties to partners of Taxpayer does not affect the
status of the transaction as an exchange by Taxpayer. However, Rev. Rul. 90-34 is
distinguishable from Taxpayer's case. The revenue ruling held that X's transfer of
property to Y, in exchange for property of a like kind, qualifies as to X for
nonrecognition of gain or loss under §1031 even though legal title to the property
received by X is never held by Y. In the revenue ruling Y is the person that receives
property and transfers the replacement property to X.

The partners, as recipients of the replacement properties, stand in the same relative
position in this transaction as X does in Rev. Rul. 90-34. Taxpayer stands in the same
relative position as Y in that revenue ruling. The relevant inquiry here is whether the
transaction is an exchange with respect to Taxpayer, not with respect to the partners of
Taxpayer.

Further, Rev. Rul. 77-297, 1977-2 C.B. 302, dealt in part with B, an accommodating
buyer that acquired replacement property and then transferred the replacement property
in exchange for the relinquished property. Rev. Rul. 77- 297 held that as to B, the
exchange of ranches does not qualify for nonrecognition of gain or loss under §1031
because B did not hold the replacement property for productive use in a trade or business
or for investment. See also Rev. Rul. 75-291, 1975-2 C.B. 332, which held that §1031
does not apply to a taxpayer who acquired property solely for the purposes of exchanging
it for like kind property.

It is inappropriate to extend Rev. Rul. 90-34 to Taxpayer and its partners. In order for
this revenue ruling to apply, the partners would have to be viewed as exchanging their
partnership interests in Taxpayer for replacement properties. However, it is Taxpayer that
is seeking nonrecognition of gain on the transfer of the Relinquished Property, not
nonrecognition of gain on an exchange of the partners' partnership interests in Taxpayer.
It is also clear that Taxpayer, and not the partners of Taxpayer, transferred the
Relinquished Property. Moreover, even if viewed as an exchange by the partners of
Taxpayer, the exchange would fail to qualify for nonrecognition because §1031(a) does
not apply to any exchange of an interest in a partnership. § 1031(a)(2)(D).

A copy of this technical advice memorandum is to be given to the taxpayer(s). Section


6110(j)(3) of the Code provides that it may not be used or cited as precedent.

PRIVATE LETTER RULING 8237017

This Ruling discusses the application of Code Section 1031 in an exchange of working
interests for overriding royalties in the same property.

PRIVATE LETTER RULING 8810034

This Ruling looks to property involved in an exchange to determine whether


it is like-kind and, therefore, qualifying under Code §1031. This includes an
examination of leases in excess of thirty (30) years or more to run under the
lease, depreciable property, condominiums, cooperatives and other property.

PRIVATE LETTER RULING 8810034

This is in reply to a letter dated August 5, 1987, submitted on behalf of the


Partnership, requesting rulings that a proposed transaction qualifies as a like-
kind exchange under Section 1031 of the Internal Revenue Code.

The information submitted indicates that Partnership holds interest in a parcel


of real estate and several multi-unit apartment buildings located on the real
estate. The apartment buildings are owned by the Partnership under two forms
of ownership: (1) some of the land and apartment units are owned in a fee
simple, and (2) some of the land and apartment units are part of a stock
cooperative organized under the laws of State X known as the 'Cooperative'.
At the time the Cooperative was created, it entered into proprietary leases for
a term of ninety-nine (99) years (the 'Leases') with each of its shareholders.
Each of the leases has in excess of 92 years remaining in the term, and all of the
leases, representing all of the units owned by the Cooperative, have been
assigned to the Partnership by the previous owners. In addition, the Partnership
owns all of the membership shares in the Cooperative.

In order to obtain refinancing more readily, and to ease the administrative


difficulties encountered in operating the units, the Partnership proposes to
exchange its ownership interest in the cooperative apartment units for direct
ownership of the real estate in a condominium form or as a fee simple interest.
The exchange would occur through the liquidation of the cooperative and the
exchange of the Partnership's cooperative stock and interest in the proprietary
leases for the condominium interest received in liquidation.

Section 1031(a) of the Code provides that no gain or loss shall be recognized
if property held for productive use in trade or business or for investment (not
including stocks, bonds, notes, choses in action, certificates of trust or
beneficial interest and certain other types of property not here pertinent) is
exchanged solely for property of a like kind to be held either for productive use
in a trade or business or for investment.

Section 1.1031(a)-1(c) of the Income Tax Regulations provides, in part, that


no gain or loss is recognized if a taxpayer who is not a dealer in real estate
exchanges a leasehold of a fee with 30 years or more to run for real estate.

Rev. Rul. 55-749, 1955-2 C.B. 295, holds that where, 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 under section 1031(a) of the Code provided the requirements of that
section as to holding for productive use in a trade or business or for investment
are satisfied.

Given the unique nature of tenant-stockholder's interest, consisting of


leasehold rights linked with stock ownership, it is an oversimplification to
regard the tenant-stockholder as merely a stockholder with an interest in the
realty (see 15A Am Jur 2d, Condominiums and Cooperative Apartments,
section 78 (1976)), and it is, therefore, incorrect to regard a tenant-stockholder's
interest as falling within the parenthetical language of section 1031(a)
excluding stocks, choses in action, certificates of beneficial interest, etc. from
favorable treatment under that provision. In the present case, because the
tenant-stockholder's interest includes a lease the term of which exceeds 30
years (See section 1.1031(a)-1(c) of the regulations, supra) and because this
interest is characterized as a real property interest under state law (See In re
Pitts' Estate, 218 Cal. 184, 22 P. 2d 694 (Cal. 1933), cited with approval in
California Coastal Commission v. Quanta Investment Corporation, 170 Cal.
Rptr. 263, 113 Ca. App. 3d 579 (Cal. Ct. of Appeal 1980)) the tenant-
stockholder's interest should be characterized as a real property interest for
purposes of section 1031. See Rev. Rul. 55-749, supra, as to the effect of state
law in characterizing property interests for purposes of section 1031. Compare
Rev. Rul. 86-40, 1966-1 C.B. 227, in which the Internal Revenue Service relied
on New York law in holding that the interest held by a taxpayer in a New York
cooperative apartment is not considered real property for purposes of section
2515(a) of the Code. Moreover, the California statute (West's Ann. Cal. Civ.
Code, Section 783) and Rev. Rul. 77- 423, 1977-2 C.B. 352, treat a
condominium interest as the ownership of real property.

Section 1250(a) of the Code provides for ordinary income treatment with
respect to a portion of the gain from the disposition of certain depreciable real
property. For purposes of section 1250, a leasehold of land is considered real
property. Section 1.1250-1(e)(3) of the regulations.

Section 1250(d)(4) of the Code provides, in part, that where property is


disposed of and gain is not recognized in whole or in part under section 1031,
then the amount of gain treated as ordinary income under section 1250(a) shall
not exceed the greater of (i) the amount of gain recognized on the disposition,
increased by the amount determined under section 1033(a)(2)(A) or (ii) the
excess of the gain taken into account under section 1250(a) over the fair market
value of the section 1250 property acquired in the transaction.

The partnership's presently held interest as tenant-stockholder, and the


'condominiums' to be received in the exchange, are both real property interests
representing the same physical property. Therefore, the surrender of
Partnership's stock in Cooperative in exchange for a condominium interest in
the same property constitutes a nontaxable exchange of properties of a like-
kind under section 1031(a), provided that the properties are held for productive
use in a trade or business or for investment.

The basis in the 'condominiums' received by Partnership will be determined


under section 1031(d) of the Code. The holding period of the 'condominiums '
received by Partnership will include Partnership's holding period in the stock of
cooperative held as tenant- stockholder, provided Partnership's interest as a
tenant-stockholder was a capital asset or property described in section 1231.
See section 1223(1) of the Code.
Because Partnership will not recognize gain under section 1031 of the Code,
Partnership will not treat any gain as ordinary income under section 1250(a) of
the Code. See section 1250(d)(4).

This ruling is directed only to the taxpayer who requested it. Section
6110(j)(3) of the Code provides that it may not be used or cited as precedent.
Except as specifically ruled on above, no opinion is expressed as to the federal
tax consequences of the transaction described above under any other provision
of the Code. Sincerely yours,

EXCHANGES BETWEEN OR AMONG RELATED PARTIES:


PRIVATE LETTER RUL. 8803053

In this Private Letter Ruling, the Treasury opines that there can be exchanges between
related parties; in this case a partnership and brothers were involved. As long as the
property is like-kind and otherwise meets the requirements of Code §1031, the fact that it
was between related parties did not destroy the exchange. (However, 1989 legislation
impacted this Rule. See infra this Chapter.)

If there is any boot received, that could generate a taxable amount, limited by the
maximum of realized gain.

PRIVATE LETTER RULING 8803053

This is in response to a letter dated June 17, 1987, submitted by your authorized
representative, requesting rulings under sections 1012 and 1031 of the Internal Revenue
Code of 1986 on behalf of PR1 and Trusts.

PR1 is a general partnership formed under the laws of State. The partners of PR are
brothers, P and R.

PR1 owns Properties that consist of three rental apartment houses. The apartment
houses were purchased in 1982, 1983, and 1984, respectively, and are held for productive
use in PR1's trade or business. The fair market value of each apartment house exceeds its
basis in the hands of PR1.

TR1, TR2, and TR3 were created by TT1, one for the benefit of each of his three
children. The trustees of TR2 and TR3 are TT2 and TT4. The Trustees for TR1 are TT2
and TT5. TT5 is not related to any one involved in the exchange or Trusts.

TR4, TR5, and TR6 were created by TT2, one for the benefit of each of his three
children. The trustees of these trusts are his wife TT3 and TT1.

PR1 proposes to transfer the Properties to a partnership or joint venture, PR2, to be


formed by the Trusts in exchange for PR2 property. The property received by PR1 in the
exchange will also be held for productive use in PR1's trade or business and will be equal
in value to the Properties (the 'Replacement Property'). The indebtedness encumbering
the Replacement property is expected to be not less than the indebtedness incumbering
sic the Properties. PR2 will acquire the Replacement Property from an unrelated third
party. It is expected that PR2 will incur debt to purchase the Replacement Property. Such
debt will be personally guaranteed by TT1 and TT2.

After acquiring the Properties from PR1, PR2 will convert them to cooperative status
by transferring each property to a separate cooperative housing corporation within the
meaning of section 216(b) of the Code.

Section 1031(a) of the Code provides, in general, 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 that is to be
held either for productive use in a trade or business or for investment.

Section 1031(b) of the Code provides that if an exchange would be within the
provisions of subsection (a) if it were not for the fact that the property received in
exchange consists not only of property permitted by such provisions to be received
without the recognition of gain, but also of other property or money, then the gain, if any,
to the recipient shall be recognized, but in an amount not in excess of the sum of such
money and the fair market value of such other property.

Section 1031(c) of the Code provides that if an exchange would be within the
provisions of subsection (a) if it were not for the fact that the property received in
exchange consists not only of property permitted by such provision to be received
without the recognition of gain or loss, but also of other property or money, then no loss
from the exchange shall be recognized.

Section 1031(d) of the Code provides, in part, that if property was acquired on an
exchange described in this section, then the basis shall be the same as that of the property
exchanged, decreased in the amount of any money received by the taxpayer and increased
in the amount of gain or decreased in the amount of loss to the taxpayer that was
recognized on such exchange.

Section 1012 of the Code provides that the basis of property shall be the cost of such
property, except as otherwise provided in this subchapter and subchapters C, K, and P.
The cost of real property shall not include any amount in respect of real property taxes
that are treated under section 164(d) as imposed on the taxpayer.

Rev. Rul. 72-151, 1972-1 C.B. 225, dealt with a situation in which a taxpayer
exchanged rental property (consisting of land and buildings) with the taxpayer's wholly
owned corporation for rental farm property (consisting of land, buildings, and
machinery). Although the transfer did not qualify as a like kind exchange under section
1031(a) of the Code, due to the inclusion of non-like kind property, the exchange did
constitute a section 1031(b) exchange. The revenue ruling noted that had there been a
loss realized on the transaction such loss would not be recognized by the taxpayer under
the provisions of sections 1031(c) and 267.

Rev. Rul. 72-151 extends the nonrecognition principle of section 1031(a) of the Code to
exchanges between related parties. Although Rev. Rul. 72-151 applies to section 1031(b),
due to the existence of non-like kind property in the exchange, there is nothing to indicate
an exchange between related parties would not be good under section 1031(a) if only like
kind property is involved.

Based on the information submitted and the representations made, our rulings are as
follows:

(1) The transfer by PR1 of the Properties to PR2 in exchange for


the Replacement Property owned by PR2 will qualify for non-
recognition treatment under section 1031(a) of the Code, and
no gain will be recognized by PR1 upon the transfer and
exchange
(2) If any boot is received by PR1 in the exchange, it will be
recognized to the extent required by section 1031(b) of the
Code.
(3) The basis of the Replacement Property received by PR1 will be
equal to PR1's basis in the Properties as adjusted, if appropriate,
as provided in Section 1031(d) of the Code.
(4) The basis of the Property in the hands of PR2 will be equal to
the amount paid for the Replacement Property.

No opinion is expressed as to the consequences of the transaction under any other


provision of the Code. This ruling is directed only to the taxpayers who requested it.
Section 6110 of the Code provides that it may not be used or cited as precedent.

In accordance with the power of attorney on file, a copy of this ruling is being sent to
your authorized representative. Sincerely yours, * * * *

EXCHANGES BETWEEN RELATED PARTIES


PRIVATE LETTER RULING 9517005

See also Private Letter Ruling 9517005 as to exchanges between related parties but
involving tenancy in common.

PRIVATE LETTER RULING 9517005

Section 1031 -- EXCHANGE of property held for pre Service holds that such circular
transactions may constitute valid like-kind EXCHANGES within the meaning of section
1031.
In four of the five EXCHANGES proposed involving the Marital Trust (i.e., with A
Corp, B Corp, X and Y) the parties will be transferring and/or receiving real property
subject to a share of an existing mortgage. In each of such transactions, the Marital Trust
is transferring property subject to a share of an existing mortgage and, in its transactions
with A Corp and B Corp, the Marital Trust is receiving back property subject to existing
mortgages. Under section 1031(D) of the Code and the related regulations cited above,
the relief of liability on a mortgage, whether by its assumption by another party or by
transfer of property subject to a mortgage, equates to the receipt of cash or other property
for which gain must be recognized. Furthermore, the relief of liability as to the Marital
Trust is offset by the amount of any liability to which the property it receives is subject.

Under section 1031(F) of the Code, recognition of gain from the EXCHANGE of real
property between related parties is triggered (with some exceptions noted above) when
either of the parties within two years disposes of the interest acquired in the
EXCHANGE. Some, if not all, of the parties to the proposed EXCHANGES are related
for purposes of section 1031(F). However, section 23(a) of the Settlement Agreement
gives substantial assurances that none of the parties will make any subsequent disposition
of the EXCHANGE property which will trigger gain recognition under section 1031(F).

All of the properties to be EXCHANGED in the proposed transactions are held by two
or more of the parties as tenants in common. The legislative history of section 1031(F) of
the Code suggests that a fractional interest in a fee, i.e., a tenancy in common, is of like
kind to a fee interest in real property. [FN5]

Therefore, the Marital Trust will recognize no gain or loss in its EXCHANGES with A
Corp, B Corp, X, Y or Z in connection with the Settlement Agreement except to the
extent required by application of section 1031(B) of the Code relating to the receipt of
money or other property, including relief from mortgage debt, in connection with the
EXCHANGE. As to the mortgage debt, no gain will be recognized with respect to such
transfers except to the extent of the excess, if any, of liabilities transferred over liabilities
assumed by the Marital Trust. The scope of this ruling is limited to the land, buildings
and fixtures constituting real property under local law and has no application to the
transfer of tangible personal property, if any, located in or on the real properties to be
transferred, where such tangible personal property does not constitute a fixture under
local law.

No opinion is expressed as to the tax treatment of this item(s) (or transaction(s)) under
the provisions of any other section of the Code or regulations which may be applicable
thereto, or the tax treatment of any conditions existing at the time of, or effects resulting
from, the item(s) (or transaction(s)) described which are not specifically covered in the
above ruling.

If it is later determined that the values of the properties EXCHANGED are not
approximately equal, there may be a basis for holding that part of the consideration for
the EXCHANGE was the receipt of non-like-kind property or may have involved an
EXCHANGE of a chose in action, a relinquishment of a chose in action or be taxable as
some other form of income. We express no opinion on the factual question of the relative
values of the EXCHANGE properties. In this connection, we note that section
1031(A)(2)(F) of the Code states that section 1031 shall not apply to any EXCHANGE of
a chose in action.

We make no commitment to entertain ruling requests regarding the application of


section 1031(F)(2)(C) of the Code to any given case.

A copy of this letter should be attached to the federal tax return for the year in which
the item(s) (transaction(s)) in question occurs. This ruling is directed only to Taxpayer
who requested it. Section 6110(j)(3) of the Code provides that it may not be used as
precedent. Sincerely, Assistant Chief Counsel (Income Tax & Accounting)

* * Chief Branch 5

FN1 The Foundation was organized as a not-for-profit corporation under the laws of
the District of Columbia. Under such laws, the Foundation is prohibited from issuing
stock (D.C.Code §29-527). Accordingly, the Foundation has not issued stock.

FN2 The inter vivos trust was yet another trust set up by M in 1939 for the benefit of G
and the sons.

FN3 The only exception is the property designated as Tract 12, which consists of a
ground lease that has less than thirty years remaining in its term, and improvements.
However, Taxpayer represents that prior to closing on the transactions at issue, the
ground lease on Tract 12 will be extended so that its remaining term (as of the date of
closing) will exceed thirty years. Furthermore, the rights of the lessee under the lease will
be transferred along with the improvements thereon in the EXCHANGE. All other
transfers will involve fee simple interests in land, together with any and all buildings and
fixtures located thereon.

FN4 As a simpler illustration of a circular transfer pattern, consider a transaction


involving hypothetical traders A, B, and C. A circular EXCHANGE could consist of C
acquiring the lot owned by B, B acquiring the lot owned by A and A acquiring the lot
owned by C.

FN5 See S. Print No. 101-56, 101st Cong., 1st Sess. 152 (1989), which makes mention
with evident approval of "a transaction involving an EXCHANGE of undivided interests
in different properties that results in each taxpayer holding either the entire interest in a
single property or a larger undivided interest in any of such properties."

EXCHANGES BETWEEN RELATED PARTIES:ESTATE AND TRUST:


PRIVATE LETTER RULING 9543011

Under this Private Letter Ruling, an exchange was allowed within Code §1031, even
though it involved related parties as to an estate and trust.
PRIVATE LETTER RULING 9543011

1995 WL 632170 (I.R.S.)


Internal Revenue Service (I.R.S.)
Private Letter Ruling
Issue: October 27, 1995
July 24, 1995

Dear ____

This responds to the letter dated January 26, 1995, requesting private letter rulings (to
prior correspondence dated August 30, 1994, December 21, 1994, January 12, 1995 and
January 18, 1995 and to subsequent correspondence dated May 23 and 25, 1995 and June
7, 1995) concerning the application of the like- kind EXCHANGE rules to proposed
transactions. Taxpayer is the Estate. The following facts are represented:

M and G were married in 1929 and had three sons, X, Y and Z. M accumulated
substantial holdings in real estate. In 1937, M established a trust (the 1937 Trust) for the
benefit of G for life with the remainder to be distributed to the sons, per stirpes, 21 years
after the death of G. The 1937 Trust holds various interests in real property. In 1948, M
established the Foundation, an entity exempt from income tax under section 501(c)(3) of
the Internal Revenue Code and a private foundation within the meaning of section 509(a)
of the Code. [FN1] M died in 1964. M's will bequeathed one-half of his residuary estate
to the Foundation, one-quarter to the Marital Trust (established under the will of M) and
the balance to the sons in equal shares.

M's will also granted G a general power of appointment over the corpus of the Marital
Trust exercisable by will. In default of the exercise of such power, the corpus was to pass
in equal one-third shares to the sons. In 1967, G released her power of appointment as to
one-forth of the Marital Trust corpus, in partial settlement of a dispute with the sons
concerning the termination distribution of a certain inter vivos trust. [FN2] The one-
quarter share of the Marital Trust vested in the sons in 1967 and each son's one-third
share of the vested one-quarter interest in the Marital Trust is referred to as (that son's)
"Vested Share." In 1990, one of the sons, X, assigned his Vested Share to W, who in
1991 further assigned a portion of the Vested Share to the Federal Deposit Insurance
Corporation (FDIC). The remaining three-fourths of the Marital Trust (the "Non-Vested
Share") remained subject to G's general power of appointment.

A Corp is a holding company, created by M, which owns directly or indirectly full or


partial interests in real property. One-third of the stock of A Corp is owned by the Marital
Trust and the other two-thirds is owned by the Foundation. A Corp owns all of the stock
of B Corp which, in turn, owns certain real property assets. In addition, the Marital Trust,
the Foundation, the 1937 Trust, A Corp, B Corp and the sons own, as tenants-in-
common, several other properties in various combinations and proportions.
G died in 1988. By will, she gave the bulk of her estate and appointed the Non-Vested
Share of the Marital Trust to the Foundation.

In June 1989, X and Y initiated a will contest in probate court, alleging that G lacked
testamentary capacity and had been unduly influenced by the appointed personal
representatives of her estate. However, this action was stayed pending the outcome of a
second lawsuit filed by X and Y in probate court in August 1989. This second suit alleges
that, by appointing the Foundation, G had not validly exercised her power of appointment
over the Non- Vested Share. X and Y claimed that the power was not exercisable in favor
of a corporation, such as the Foundation. This latter contest is referred to as the
"construction proceeding." In April 1991, the probate court granted X's and Y's motion
for summary judgment, ordering immediate distribution of the Non-Vested Share of the
Marital Trust to the sons pursuant to the default provisions of the power of appointment.
The Foundation appealed this decision and enforcement of the order was stayed.

In December 1993, the parties to both civil suits entered a Settlement Agreement
which, by its terms, would terminate the litigation between them and substantially
eliminate the common ownership of properties by the parties. To achieve this result as to
the Estate, the following three EXCHANGES are proposed:

1. In EXCHANGE for the 1937 Trust's transfer to the Estate of


b% of T-2, the Estate will transfer to the 1937 Trust a% of T-1.
2. In EXCHANGE for X's transfer to the Estate of d% of T-3, the
Estate will transfer to X c% of T-1.
3. In EXCHANGE for Y's transfer to the Estate of d% of T-3, the
Estate will transfer to Y c% of T-1.

Taxpayer further discloses that most of the properties to be received by the Marital
Trust and the Estate in such EXCHANGES will be distributed by the Marital Trust and
Estate within a short period to the Foundation, to the sons, to W, and to the FDIC as
provided in the Settlement Agreement. Such transfers, coupled with the distribution of
the residue of the Estate and remainder of the Non-Vested Share of the Marital Trust to
the Foundation, would terminate the Marital Trust and the Estate for federal income tax
purposes.

Taxpayer also makes the following general representations:

1. All relinquished properties are held by Taxpayer either for


investment or for productive use in a trade or business and all
replacement property will be held for one of the same purposes.
2. All property to be EXCHANGED is real property.
3. The fair market values of the properties subject to this ruling
were determined by independent appraisal to which all parties
agreed to be bound. The parties utilized such appraisals to
determine that the fair market values of the properties to be
EXCHANGED were approximately equal.
Section 1031(A)(1) of the Internal Revenue 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.

The simultaneous transfers of like-kind properties, of approximately equal value, is


treated as an EXCHANGE. In this case, Taxpayer is simultaneously EXCHANGING real
property held for investment solely for other real property to be held for investment. All
of the properties to be EXCHANGED in the proposed transactions are held by two or
more of the parties as tenants in common. The legislative history of section 1031(F) of
the Code suggests that a fractional interest in a fee, i.e., a tenancy in common, is of like
kind to a fee interest in real property. [FN3] Hence, this transaction involves like-kind
property within the meaning of section 1031(A) of the Code.

Therefore, the Estate will recognize no gain or loss in its EXCHANGES with X, Y and
the 1937 Trust, in connection with the Settlement Agreement. The scope of this ruling is
limited to the land, buildings and fixtures constituting real property under local law and
has no application to the transfer of tangible personal property, if any, located in or on the
real properties to be transferred, where such tangible personal property does not
constitute a fixture under local law.

No opinion is expressed as to the tax treatment of this item(s) (or transaction(s)) under
the provisions of any other section of the Code or regulations which may be applicable
thereto, or the tax treatment of any conditions existing at the time of, or effects resulting
from, the item(s) (or transaction(s)) described which is (are) not specifically covered in
the above ruling.

If it is later determined that the values of the properties EXCHANGED are not
approximately equal, there may be a basis for holding that part of the consideration for
the EXCHANGE was the receipt of non-like-kind property or may have involved an
EXCHANGE of a chose in action, a relinquishment of a chose in action or be taxable as
some other form of income. We express no opinion on the factual question of the relative
values of the EXCHANGE properties. In this connection, we note that section
1031(A)(2)(F) of the Code states that section 1031 shall not apply to any EXCHANGE of
a chose in action.

A copy of this letter should be attached to the federal tax return for the year in which
the item(s) (transaction(s)) in question occurs. This ruling is directed only to Taxpayer
who requested it. Section 6110(j)(3) of the Code provides that it may not be used as
precedent.

Sincerely,

Assistant Chief Counsel (Income Tax & Accounting) David L. Crawford Chief Branch
5
This document may not be used or cited as precedent. Section 6110(j)(3) of the Internal
Revenue Code.

FN1 The Foundation was organized as a not-for-profit corporation under the laws of
the District of Columbia. Under such laws, the Foundation is prohibited from issuing
stock (D.C.Code §29-527). Accordingly, the Foundation has not issued stock.

FN2 The inter vivos trust was yet another trust set up by M in 1939 for the benefit of G
and the sons.

FN3 See S. Print No. 101-56, 101st Cong., 1st Sess. 152 (1989), which makes mention
with evident approval of "a transaction involving an EXCHANGE of undivided interests
in different properties that results in each taxpayer holding either the entire interest in a
single property or a larger undivided interest in any of such properties." PLR 9543011,
1995 WL 632170 (I.R.S.)

Under the Revenue Reconciliation Act of 1989, Code §1031 was amended to provide
for two (2) basic areas of change. The first area covers the issue of attempting to do
exchanges between related parties.

If an exchange is made between related parties, as that term "related parties" is defined
in the Code, the exchange can be effective, but a subsequent exchange will destroy the
Initial exchange of the Subsequent exchange occurs within two (2) years of the Initial
exchange. In other words, this prevents a transfer by A to B, both related parties to each
other, with B undertaking a Subsequent exchange for the holding period for B is less than
two (2) years from the time B acquired the property from A.

This means that some of the cases that are mentioned in the text about transfer and
retransfer, and any other activity within two (2) years, may be suspect, subject to the
qualifications noted in the quote, which are listed below.

The second area deals with eliminating as like-kind property an exchange of property in
the United States for an exchange of property that W: otherwise be like-kind, but is
located outside of the United States.

RELATED PARTIES:
PRIVATE LETTER RULING 9926045
(FSA-FIELD SERVICE MEMORANDUM 9926045),
1999 WL 448256

Under this Private Letter Ruling, the taxpayer was attempting to separate the position of
the taxpayer from that of the taxpayer's controlled corporation. The taxpayer owned
timber land. The corporation owned timberland. They were undertaking a tax-deferred
exchange. Although this is allowed under Code §1031, assuming the requirements are
otherwise met, the question was whether this would violate the related party rule under
Code §1031(f)(1) when the corporation cut the timber within two (2) years.
The Ruling concluded that it would not violate the related party rule, and, therefore, it
was a qualified exchange.

FOR EDUCATIONAL USE ONLY


Copr. © West 1999 No Claim to Orig. U.S. Govt. Works

PRIVATE LETTER RULING 9926045

Internal Revenue Service (I.R.S.)


Private Letter Ruling
Issue: July 2, 1999
April 2, 1999
1999 WL 448256 (I.R.S.)

Section 1031:
Exchange of Property Held for Productive Use or Investment

Dear _____:

This responds to your letter, dated August 19, 1998, requesting a private letter ruling as
to the application of §1031 of the Internal Revenue Code ("Code") to the proposed
transaction.

Facts

Taxpayer is an individual who was married to K. Together, they acquired substantial


acreage in timberlands for investment. They divorced in Year 1, but continued holding
this acreage as co-tenants. K died in Year 2.

Taxpayer and K's estate are now tenants-in-common, each holding an undivided one-
half interest in 39,000 acres of timberland, consisting of approximately 120 parcels.
About 25 percent of this acreage supports valuable "old-growth" douglas fir. The
remainder supports less valuable young timber.

M Corp is a State X holding company that conducts business through a number of


wholly-owned subsidiaries that are engaged principally in owning and managing
timberlands, harvesting timber and manufacturing and selling various wood products. M
Corp also holds an option to acquire K's undivided one-half interest in the 39,000 acres of
timberlands. It will exercise this option once the value of the property is ascertained.

M Corp has two classes of authorized stock, voting common and nonvoting common.
All 112 shares of voting common are held by L, the son of K and Taxpayer. Of the
150,186.791 shares, now issued and outstanding of nonvoting common, Taxpayer owns
33,369 shares and L owns 6,692.525. The majority of the remaining shares is held in trust
by L for the benefit of the lineal descendants of Taxpayer. Because all shares of the
voting common and most shares of the nonvoting common are owned by Taxpayer or by
or for her "family" (as that term is defined in §267(c)(4) of the Code), either directly or
by attribution pursuant to §267(c)(2), Taxpayer is considered the owner of more than 50
percent of the value of the outstanding stock of M Corp. Therefore, M Corp and
Taxpayer are related persons pursuant to ss 267(b) and 1031(f)(3) of the Code.

Taxpayer has objected and continues to object to any but minimal cutting of
timberlands during her lifetime. She desires to hold the old-growth timberlands strictly as
investment property. On the other hand, M Corp wants to exploit the timberlands,
especially the old-growth timber, in the furtherance of its timber business. To
accommodate the conflicting interests of both co-tenants, once M Corp has acquired K's
interest in the timberlands, the parties propose to enter into a like-kind exchange of
portions of their respective undivided interests in the old-growth timberlands. After the
exchange, each party will be the sole owner of one-half of such timberlands. M Corp will
begin harvesting timber from its wholly-owned portion of the old-growth timberlands
pursuant to elections under §631 of the Internal Revenue Code. [FN1] The remaining
timberlands will continue in joint ownership. M Corp has no present intention of selling
outright any timberland it receives in the exchange.

M Corp is entering into the exchange with Taxpayer because it is in the forest products
business and thus has a business interest in harvesting timber on the old-growth
timberlands. By exercising its option, M Corp will acquire an undivided one-half interest
in the timberlands. Given Taxpayer's opposition to an immediate harvest, M Corp could
not harvest the timber while it was still held in co-tenancy with Taxpayer. By entering
into the exchange transaction with Taxpayer, M Corp will acquire sole discretion as to
whether to hold or dispose of timber on its wholly-owned portion of the old-growth
timberlands.

Taxpayer is entering into the exchange because she does not wish to have current
income from cutting, or otherwise disposing of, the timber. The exchange will allow her
to accommodate the business needs of M Corp while continuing to hold her portion of the
timberlands for investment.

Issues
1. Will the exchange by Taxpayer with M Corp, a related party, of
her undivided one-half interest in a portion of the old-growth
timberlands, which is held for investment, for a 100 percent
interest in one-half of such timberlands, also to be held for
investment, constitute a like-kind exchange under §1031 of the
Code?
2. Will the planned cutting by M Corp of the timber on its one-half
of the old-growth timberlands, pursuant to elections under §631
of the Code, within two years of the exchange, require
recognition of gain pursuant to §1031(f)(1) of the Code?
Law and Analysis
Section 1031(a)(1) 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.

Exchanges of undivided interests in multiple parcels of real estate for 100 percent
ownership of one or more parcels of the same real estate qualify as valid like-kind
exchanges. See Rev. Rul. 79-44, 1979-1 C.B. 265 (transfer of interests in farm land by
two tenants-in-common converting two jointly owned parcels into two individually
owned parcels); Rev. Rul. 73-476, 1973-2 C.B. 300 (exchanges by three part-owners of
three parcels of real estate for separately held 100 percent interests in the same parcels).
Also, timberlands may be exchanged for other timberlands under §1031 of the Code. See
Rev. Rul. 72-515, 1972-2 C.B. 466 (exchange of timberlands supporting timber of
differing quality and quantity).

Section 1031(f)(1) of the Code generally provides that if (A) a taxpayer exchanges
property with a related person, (B) there is nonrecognition of gain or loss to the taxpayer
under this section with respect to the exchange and (C) before the date 2 years after the
date of the last transfer which was part of such exchange-(i) the related person disposes
of such property, or (ii) the taxpayer disposes of the property received in the exchange
from the related person which was of like kind to the property transferred by the
taxpayer, there shall be no nonrecognition of gain or loss under this section to the
taxpayer with respect to such exchange; except that any gain or loss recognized by the
taxpayer by reason of this subsection shall be taken into account as of the date on which
such subsequent disposition occurs.

Section 1031(f)(2)(C) of the Code provides that there shall not be taken into account
any disposition "with respect to which it is established to the satisfaction of the Secretary
that neither the exchange nor such disposition had as one of its principal purposes the
avoidance of [f]ederal income tax."

The legislative history of §1031(f)(2)(C) identifies several situations intended to qualify


under this provision. The Senate Finance Committee listed, among others, "a transaction
involving an exchange of undivided interests in different properties that results in each
taxpayer holding either the entire interest in a single property or a larger undivided
interest in any of such properties...." S. Prt. No. 101-56 at 152 (1989).

The proposed transaction between Taxpayer and M Corp is an exchange of undivided


interests in old-growth timberlands. Essentially, this will be a partition of jointly-owned
property enabling each party, as sole owners of their respective parcels in the old-growth
timberland, to determine whether to hold, use or dispose of the property. The legislative
history of §1031(f)(1) indicates that Congress did not intend for this subsection to apply
to a subsequent disposition under these circumstances. Therefore, any disposition by M
Corp of its interests in the old-growth timberlands will not trigger application of
§1031(f)(1) because the exchange between Taxpayer and M Corp qualifies under
§1031(f)(2)(C). Accordingly, we need not consider the question of whether cutting
timber constitutes a disposition of the exchanged properties.

Conclusions
1. The exchange by Taxpayer with the related party, M Corp, of her
undivided interest in a portion of the old-growth timberlands, held
for investment, for a 100 percent interest in one-half of such
timberlands also to be held for investment, will constitute a like-
kind exchange under §1031 of the Code.
2. The planned cutting by M Corp of the timber on its wholly-
owned old- growth timberlands, acquired in the exchange,
pursuant to an election under §631 of the Code, within two years
of the exchange, will not trigger recognition of gain or loss under
§1031(f)(1) of the Code.
Caveats and Limitations

Except as specifically ruled above, no opinion is expressed as to the federal tax


treatment of the transaction under any other provisions of the Code and the Income Tax
Regulations that may be applicable or under any other general principles of federal
income taxation. No opinion is expressed as to the tax treatment of any conditions
existing at the time of, or effects resulting from, the transaction that are not specifically
covered by the above ruling.

This ruling is directed only to the taxpayer(s) who requested it. Section 6110(j)(3) of
the Code provides that it may not be cited as precedent.

Sincerely yours,
Assistant Chief Counsel (Income Tax & Accounting)

FN1. Under §631(a), a taxpayer may elect, on a return for a taxable year, to treat the
cutting during such taxable year of timber, owned for more than a year, as the sale or
exchange of such timber during such year. Under §631(b), in the case of timber held for
more than a year, for which the owner (taxpayer) retains an economic interest, the
difference between the amount realized from the disposal of such timber and the adjusted
depletion basis thereof, shall be considered as though it were gain or loss on the date of
sale (disposal) of such timber; and the date of disposal of such timber shall be deemed the
date such timber is cut; but if payment is made to the owner under the contract before
such timber is cut the owner may elect to treat the date of such payment as the date of
disposal of such timber.

This document may not be used or cited as precedent. Section 6110(j)(3) of the Internal
Revenue Code.

RELATED PARTIES:
PRIVATE LETTER RULING 9929009
(FSA-FIELD SERVICE MEMORANDUM 9929009),
1999 WL 525830

The following Field Service Advisory and Private Letter Ruling addressed the issue as
to whether the government, in an exchange of equipment and parts between a corporation
and a related taxpayer, can be challenged even if it does not literally violate the related
party rule under Code §1031(f). Because of the timing of his case, prior to Code
§1031(f), and for other reasons, the government acknowledged that Code §1031(f) would
not prohibit this transaction. However, the Service asserted the position that it could so
challenge such transactions as a result of a tax avoidance position.

FOR EDUCATIONAL USE ONLY


Copr. © West 1999 No Claim to Orig. U.S. Govt. Works

PRIVATE LETTER RULING 9929009

FSA 9929009
Internal Revenue Service (I.R.S.)

Field Service Advisory


Issue: July 23, 1999
April 15, 1999
1999 WL 525830 (I.R.S.)

INTERNAL REVENUE SERVICE NATIONAL OFFICE


FIELD SERVICE ADVICE MEMORANDUM FOR
FROM DEBORAH A. BUTLER ASSISTANT CHIEF COUNSEL
(FIELD SERVICE) CC:DOM:FS

SUBJECT:

Like Kind Exchange between Parent and Subsidiary

This Field Service Advice responds to your request dated January 13, 1999, wherein
you asked that we reconsider aspects of our earlier advice of November 25, 1996,
regarding the subject taxpayer. This Field Service Advice is not binding on Examination
or Appeals and is not a final case determination. This document may not be cited as
precedent.

ISSUE:

Whether the Service can take the position that an exchange of certain equipment among
corporations within Taxpayer's consolidated group does not qualify as a tax-free
exchange under I.R.C. §1031.

CONCLUSION:
The Service could correctly, as a matter of law and policy, challenge nonrecognition
treatment here and assert that the transactions involved do not qualify under section 1031.

FACTS:

Taxpayer owns, operates, leases and sells Equipment and Equipment parts. In Year 1,
Taxpayer and Corp. A entered into an agreement for the sale of Y used Equipment. The
transfer of X of that used Equipment is in issue here.

Taxpayer's basis in the Equipment had been substantially reduced by depreciation over
the years by the time it had agreed to sell the used Equipment to Corp. A. Thus,
purportedly, in order to avoid a large gain on the sale of this Equipment, Taxpayer
entered into "tax-free" exchange agreements with two of its subsidiaries whereby the
used Equipment of Taxpayer was swapped for certain new Equipment recently purchased
directly by the subsidiaries from an individual shareholder.

The new Equipment had a relatively high basis compared to the long- depreciated basis
of the old Equipment. The subsidiaries then transferred the Equipment to Corp. A to
satisfy Taxpayer's obligation under the sales agreement with Corp A. The subsidiaries
apparently recognized and reported the minimal gain made on the transfer to Corp. A of
the old Equipment (which now carried a much higher basis in the hands of the
subsidiaries). If allowed, therefore, the transaction enabled Taxpayer to avoid the large
gain inherent in a direct sale of its used Equipment as well as to escape any required
recapture of depreciation taken on that Equipment.

LAW AND ANALYSIS:

Section 1031(a) 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 a like kind which is also to be held for productive use
in a trade or business or for investment. The "touchstone" of section 1031 is the
requirement that "there be an exchange of like-kind properties rather than a cash sale"
and reinvestment of proceeds. Young v. Commissioner, T.C. Memo. 1985-221.

An exchange is not limited to reciprocal transfers between two parties. Multiple-party


and "accommodating" party exchanges are certainly allowed. [FN1] Where a party acts as
a mere conduit or agent for the taxpayer, however, the exchange is not cognizable under
section 1031. Coupe v. Commissioner, 52 T.C. 394, at 406 (1969). Similarly, passing the
property to a "sham" or "strawman" also fails the test. See Garcia v. Commissioner, 80
T.C. 491, at 500-01 (1983).

As we discussed in our earlier memorandum, Congress has recognized the inherent tax-
avoidance motivations of exactly the type of transaction presented here. It passed section
1031(f) to end those possibilities by requiring a longer holding period for the related
party swap to be allowed nonrecognition. Section 1031(f), however, was not in effect for
the year in issue; consequently, it is unavailable to challenge this deal. We note also that
even under new section 1031(f), related party exchanges are not universally barred. Such
swaps merely carry a longer holding requirement.

Where a wholly-owned subsidiary purchased new trucks from a manufacturer, while its
parent sold its used trucks to the same manufacturer, the transaction was treated as
merely a tax-free exchange between the related corporations and not as a separate sale
and purchase. Redwing Carriers, Inc. v. Tomlinson, 399 F.2d 652 (5 superth Cir. 1968).
In Redwing Carriers, it was the Government successfully seeking to invoke section 1031
treatment. The swapping parties' interrelationship, however, was never made an issue.

There are numerous other instances where related parties attempting to effect a section
1031 transaction went unchallenged on that particular ground. See, e.g., Coastal
Terminals, Inc. v. United States, 320 F.2d 333 (4 superth Cir 1963); Rev. Rul. 72-151,
1972-1 C.B. 225 (sole shareholder and corporation); Rev. Rul. 72-601, 1972-2 C.B. 467
(father and son). Moreover, in Boise Cascade Corp. v. Commissioner, T.C. Memo. 1974-
315, the Service argued, and the court's opinion acknowledged, that the parent/subsidiary
relationship of the swapping parties in and of itself had no effect on the availability of
section 1031 treatment to the transaction involved.

CASE DEVELOPMENT, HAZARDS, AND OTHER CONSIDERATIONS:

FN1. In the accommodating buyer cases, the buyer, under taxpayer's specific direction,
buys the property that the taxpayer wishes to acquire before the exchange takes place. In
those circumstances, the exchange qualifies under section 1031 for the taxpayer but not
with respect to the accommodating buyer. That is because the buyer did not acquire the
property it eventually passed on to the taxpayer with the requisite holding intent. Rev.
Rul. 77-297, 1977-2 C.B. 304.

This document may not be used or cited as precedent. Section 6110(j)(3) of the Internal
Revenue Code.

RELATED PARTIES:
PRIVATE LETTER RULING 9931002
(FSA-FIELD SERVICE MEMORANDUM 9931002),
1999 WL 589318

The issue in this Field Service Advice was whether the taxpayer could undertake a tax-
deferred transaction or whether it violated Code §1031(f) as to related parties. The
government held that the related party rule applied. However, part of the issue was
whether the adjustment, because of an early disposition, would take place in the year of
disposition, or a different year.

The government held that the adjustment should take place ". . . in the year the
replacement property is disposed of notwithstanding the fact that an adjustment could
have been made in a prior year under Section 1031(f)(4)." Thus, the government
contended that the taxable income would come into play in the year the replacement
property was disposed; this was controlled under Code §1031(f)(1).

FOR EDUCATIONAL USE ONLY


Copr. © West 1999 No Claim to Orig. U.S. Govt. Works

PRIVATE LETTER RULING 9931002


FSA 9931002

Field Service Advisory


Issue: August 6, 1999
April 12, 1999
1999 WL 589318 (I.R.S.)

This Field Service Advice responds to your memorandum dated January 13, 1999.
Field Service Advice is not binding on Examination or Appeals and is not a final case
determination. This document is not to be cited as precedent.

ISSUE(S):
1. Whether Taxpayer was entitled to nonrecognition of gain
treatment under I.R.C. §1031(a) in Year 2 on the exchange of
Property X for an interest in Property Z.
2. Whether there are grounds either under section 1031(f)(1), or
under another theory for including the gain on the exchange of
Property X in Year 3.
CONCLUSION(S):
1. Taxpayer was not entitled to nonrecognition of gain on the
exchange of Property X for an interest in Property Z in Year 2
under section 1031(a) because the transaction was structured to
avoid the purposes of section 1031(f). Therefore, Taxpayer is
subject to an adjustment in Year 2.
2. Although under section 1031(f)(4) it is proper to recognize the
gain from the exchange of Property X in Year 2, we believe that,
under the circumstances presented in this case, section 1031(f)(1)
also supports an argument that the gain may be included in Year
3.
FACTS:

We rely on the facts set forth in your memorandum of January 13, 1999.

Father is a real estate developer. Father and his four children have interests in several
related entities involved in developing real estate.

Prior to Year 1, E, a corporation owned by Father, purchased Property X from an


unrelated party. Property X was eventually transferred in equal shares to the four
children. The property was held as tenants-in-common by the four children under the
name A. A leased Property X to B, a joint venture owned by Father, Child 1, Child 2 and
two unrelated parties. B constructed Property Y on Property X. The entire property,
Property XY, was leased to G.

Also prior to Year 1, Related Party, obtained financing from Lender to construct
Property Z. The loan was secured, in part, by a second trust deed and assignment of rents
on Property XY. Related Party is a corporation partially owned by Father, Child 1 and
Child 3. Father, Child 1 and Child 3 own approximately 72% of the stock of Related
Party.

In Year 1, A and B entered into an agreement with Third Party 1 for the sale of
Property XY. The parties decided to structure the transaction as a like-kind exchange
under section 1031. To facilitate the exchange, on Date 1 Taxpayer was formed as a
general partnership by Child 1, Child 2, Child 3 and Child 4 as equal partners. D, a
Subchapter §corporation, was incorporated by Child 2, Child 3 and Child 4, who
contributed their interests in Taxpayer in exchange for equal shares of stock in D. In
addition, C was formed as a limited partnership. Child 1 is the general partner and owns a
2.75% interest in C. Father and Child 2 are limited partners and together own an 88%
interest in C.

In order to effectuate the like-kind exchange, on Date 1 A contributed its interest in


Property X to Taxpayer and B contributed its interest in Property Y to C. A and B
assigned to Taxpayer and C their respective interests in the purchase agreement with
Third Party 1. In addition, Taxpayer and C entered into written exchange agreements
with Qualified Intermediary. Under the agreements, Taxpayer and C agreed to transfer
Property XY to Qualified Intermediary to complete the like-kind exchange.

Also on Date 1, Related Party entered into two purchase agreements with Qualified
Intermediary. Under the agreements, Qualified Intermediary agreed to purchase an
undivided 88% interest in Property Z plus assume some or all of the loan from Lender.
When the exchange was completed, Qualified Intermediary agreed to transfer a 51%
interest in Property Z to Taxpayer and a 37% interest to C.

On Date 2, the loan from Lender was modified to allow for the release of Property XY
from the second deed of trust. In exchange for the release of its security interest in
Property XY, Lender was paid an amount from the net proceeds from the sale of the
property to Third Party 1. The facts concerning the exact timing of the exchange are
unclear; however, it is our understanding that the exchange occurred on or about Date 2.
At this point Third Party 1 received Property XY and Taxpayer and C received 51% and
37% interests in Property Z, respectively.

On Date 3 in Year 3, Taxpayer, C and Related Party sold their interests in Property Z to
Third Party 2. At this time Taxpayer, C and Related Party were released from their
remaining obligations under the loan from Lender.
Taxpayer reported a loss on the sale of its interest in Property Z on its federal income
tax return for Year 3. In addition, Taxpayer reported cancellation of indebtedness income.

Examination has issued a Notice of Final Partnership Administrative Adjustment


(FPAA) to Taxpayer for Year 3. One of the adjustments requires Taxpayer to recognize
gain from the exchange of Property X. The adjustment, made to taxable income in Year
3, is based on the determination that the property received in the exchange with Related
Party was disposed of within 2 years from the date of the exchange. Therefore, under
1031(f)(1), there is no nonrecognition of the gain from the exchange. Year 2 was not a
subject of the examination and no adjustments were proposed for that year.

LAW AND ANALYSIS

Section 1031(a)(1) provides generally 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.

Section 1031(f)(1) provides special rules for exchanges between related persons. If, 1. a
taxpayer exchanges property with a related person; 2. there is nonrecognition of gain or
loss to the taxpayer in accordance with section 1031 with respect to the exchange; and, 3.
within 2 years of the date of the last transfer that was part of the exchange either the
taxpayer or the related person disposes of the property received in the exchange, then
there is no nonrecognition of gain or loss in the exchange. In other words, the gain or loss
that was deferred under section 1031 must be recognized. Any gain or loss the taxpayer is
required to recognize by reason of section 1031(f)(1) is taken into account as of the date
of the disposition of the property. Generally, section 1031(f) applies to transfers after July
10, 1989, in tax years ending after that date.

A related person is defined under section 1031(f)(3) as any person bearing a


relationship to the taxpayer described in section 267(b) or 707(b)(1).

Section 267(b)(10) provides that a corporation and a partnership are related persons if
the same persons own more than 50% in value of the outstanding stock of the
corporation, and more than 50% of the capital interest, or the profits interest, in the
partnership.

The ownership of stock is determined under section 267(c)(2), which provides that an
individual shall be considered as owning the stock owned, directly or indirectly, by or for
his family. Section 267(c)(4) provides that the family of an individual shall include only
his brothers and sisters, spouse, ancestors and lineal descendants.

Section 707(b)(1)(A) disallows losses from sales or exchanges of property, directly or


indirectly, between a partnership and a person owning, directly or indirectly, more than
50% of the capital interest, or the profits interest, in such partnership. Section 707(b)(3)
provides that for these purposes the ownership of a capital or profits interest in a
partnership shall be determined in accordance with the rules for constructive ownership
of stock provided in section 267(c).

Section 1031(f)(4) provides that section 1031 shall not apply to any exchange which is
part of a transaction, or series of transactions, structured to avoid the purposes of
subsection 1031(f). In other words, if a transaction is set up to avoid the restrictions on
exchanges between related persons, section 1031(f)(4) operates to prevent nonrecognition
of the gain or loss on the exchange.

Treas. Reg. §1.1031(k)-1(g) provides for various safe harbors for deferred exchanges
which result in a determination that the taxpayer is not in actual or constructive receipt of
money or other property (not of like kind) for purposes of section 1031(a). One of the
safe harbors listed in paragraph (g) is that of the qualified intermediary.

Treas. Reg. §1.1031(b)-2 also provides a safe harbor for qualified intermediaries in the
case of simultaneous transfers of like-kind properties. In such cases, the qualified
intermediary, as defined in Treas. Reg. §1.1031(k)-1(g)(4)(iii), is not considered the
agent of the taxpayer for purposes of section 1031(a). The transfer and receipt of property
by the taxpayer is treated as an exchange.

Treas. Reg. §1.1031(k)-1(g)(4)(iii) defines a qualified intermediary as a person who is


not the taxpayer or a disqualified person and who enters into a written agreement with the
taxpayer to acquire the relinquished property from the taxpayer, transfer the relinquished
property, acquire the replacement property and transfer the replacement property to the
taxpayer.

In Tech. Adv. Mem. 97-48-006 (Nov. 28, 1997), the taxpayer held a one-third interest
in real property and the taxpayer's mother held the remaining two- thirds interest. An
unrelated party wanted to purchase the entire parcel held by the taxpayer and his mother
for cash. The parties entered into a sales agreement. Subsequently, the taxpayer's mother
purchased another property (Property 2) to use as a personal residence.

After entering into the sales contract, the taxpayer decided that he wanted to arrange a
like-kind exchange. He initially attempted to acquire replacement property from a second
unrelated party, but was unsuccessful in negotiating a deal in time for the exchange to
qualify. Instead, the taxpayer entered into an agreement to purchase Property 2 from his
mother as replacement property.

The transaction was arranged using a qualified intermediary. The taxpayer transferred
his interest in the relinquished property and his rights and obligations under the sales
contract with the unrelated party to the qualified intermediary. He also transferred his
rights and obligations under the contract with his mother for the purchase of Property 2 to
the qualified intermediary. The qualified intermediary then sold the taxpayer's interest in
the relinquished property to the unrelated party and used the proceeds to pay the
taxpayer's mother for Property 2. Then, the qualified intermediary transferred title of
Property 2 to the taxpayer. In a separate, but concurrent transaction, the unrelated party
purchased the remaining two-thirds interest in the relinquished property from the
taxpayer's mother. The entire exchange took place on one day.

The technical advice did not address the issue of the treatment of nonrecognized gain
where the exchanged property is subsequently disposed of by one of the related parties.
Instead, advice was requested on the issue of whether the taxpayer was eligible for
nonrecognition treatment with respect to the exchange under section 1031(a). It was
determined that the taxpayer was not entitled to nonrecognition of gain on the above-
described transaction. The basis for this determination was section 1031(f)(4), which
prevents related parties from circumventing subsection (f)(1) by structuring their
transactions to avoid the related party rules. See H.R. Rep. No. 247, 101st Cong., 1st
Sess. 1339, 1341 (1989).

The technical advice concluded that, in substance, the result of the series of exchanges
was identical to what would have occurred in a direct exchange of property between the
taxpayer and his mother, followed by a sale of the property by the taxpayer's mother to
the unrelated party. The facts did not suggest that the qualified intermediary was needed
to prevent constructive receipt of money or other property not of a like kind. In fact, the
sole consequence of eliminating the qualified intermediary appeared to be the
disqualification of the exchange under section 1031(f). If the qualified intermediary had
been eliminated from the transaction, the taxpayer would have had to recognize gain on
the exchange under section 1031(f) when his mother sold the property to the unrelated
party within 2 years of the exchange. Because the taxpayer was unable to show that the
qualified intermediary had a substantive purpose in the transaction, the Service reasoned
that the exchange was structured to avoid application of the related party rules and,
accordingly, concluded that section 1031(f)(4) operated to preclude nonrecognition of
gain under section 1031(a).

Although they are more far more complicated, the facts of the instant case bear many
similarities to the facts outlined in the technical advice. For example, the transaction in
Year 2 is between related persons within the meaning of section 1031(f)(3).

Taxpayer is a partnership owned by Child 1 and D, a corporation owned by Child 2,


Child 3 and Child 4. Related Party is a corporation, 72.04% of which is owned by Father,
Child 1 and Child 3. Under section 267(b)(10), a corporation and a partnership are related
if the same persons own more than 50% in value of the outstanding stock of the
corporation and more than 50% of the capital interest or the profits interest in the
partnership. Child 1 may be considered as owning the stock owned by his brother and
sisters under section 267(c)(2). Accordingly, Child 1 constructively owns 100% of D and,
therefore, 100% of Taxpayer. Similarly, with respect to Related Party, Child 1 may be
considered as owning the stock of his father and sister under section 267(c)(2). Thus,
Child 1 constructively owns 72.04% of Related Party also.

Under the attribution rules, the same person owns more than 50% of Taxpayer and
Related Party. Therefore the two entities are related persons within the meaning of
section 1031(f)(3) and exchanges between the two entities are subject to the special rules
for exchanges between related persons under section 1031(f).

In the instant case, like the technical advice, a qualified intermediary was used to
complete the exchange between Taxpayer and Related Party in a transaction that included
the simultaneous sale of Taxpayer's property to an unrelated party. Further, like the
technical advice, it does not appear that a straight exchange with Related Party would
have been disqualified by the constructive receipt of money or other property not of a like
kind. Thus, like the technical advice, there is no obvious reason for interposing a
qualified intermediary in the transaction. However, if the transaction had been structured
as a straight exchange with Related Party and a subsequent sale from Related Party to
Third Party 1, the exchange would not have qualified for nonrecognition treatment under
section 1031(f)(1). Thus, as in the technical advice, it appears that the interposition of the
qualified intermediary had no purpose except to prevent the exchange from
disqualification from nonrecognition treatment under section 1031(f)(1). Accordingly, we
agree with your conclusion that the facts of this case support the argument that the
exchange in Year 2 was set up to avoid the related party rules.

Although the regulations provide for the use of a qualified intermediary to effect a like-
kind exchange, the statute makes clear that a qualified intermediary may not be used to
circumvent the related party rules. As stated in the technical advice, the mere
interposition of a qualified intermediary cannot correct a transaction otherwise flawed
under section 1031 (f)(1). Thus, in accordance with section 1031(f)(4), section 1031(a)
does not apply to the exchange between Taxpayer and Related Party in Year 2. Because
section 1031(a) does not apply to the exchange, any gain from the exchange is subject to
recognition in Year 2.

However, we believe the Service is also permitted to make an adjustment in Year 3. In


the instant case, unlike the situation in the technical advice, Taxpayer sold the
replacement property to Third Party 2 in Year 3. This sale was in contravention of the
requirements of section 1031(f)(1) because it occurred within 2 years of the initial
exchange.

Section 1031(f)(1) provides that where gain from an exchange between related persons
has not been recognized and the property is disposed of within 2 years of the exchange,
there is no nonrecognition of gain from the exchange. The statute further provides that in
such cases the recognition of gain should be taken into account as of the date of the
disposition of the property. Section 1031(f)(1)(B) specifically provides that the
determination of whether the gain or loss from the initial exchange was recognized
should be made without regard to the subsection (f) related party rules: "If...there is
nonrecognition of gain or loss to the taxpayer under this section with respect to the
exchange of such property (determined without regard to this subsection)." I.R.C.
§1031(f)(1)(B) (emphasis added).

In this case, if the related party rules of section 1031(f) are not taken into account, i.e.
the rule under section 1031(f)(4), there was nonrecognition of gain under section 1031(a)
with respect to the exchange between Taxpayer and Related Party in Year 2. Certainly
nonrecognition treatment was claimed by Taxpayer and benefits were received in Year 2.
Further, the replacement property was disposed of in Year 3, within 2 years of the
exchange in contravention of the requirements of section 1031(f)(1)(C). Thus, the facts of
the instant case fall squarely within the parameters of section 1031(f)(1). Given these
facts, section 1031(f)(1) expressly authorizes an adjustment to recognize the gain from
the exchange as of the date of the disposition of the property in Year 3. We find nothing
in the statutory language or in the legislative history to indicate that the applicability of
section 1031(f)(4) precludes or supersedes the applicability of section 1031(f)(1).
Therefore, assuming the facts support the argument, as they appear to in this case, we
believe it is proper to take the position we are permitted to make an adjustment under
section 1031(f)(1) in the year the replacement property is disposed of notwithstanding the
fact that an adjustment could have been made in a prior year under section 1031(f)(4).

CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS:

If you have any further questions, please call * * * *

PRIVATE LETTER RULING 8515016

In this Ruling, individuals who are tenants in common, each having an undivided one-
half (1/2) interest in the property, own stock of the corporation. The corporation owned
real estate. One of the individuals would exchange his property with the corporation.

The Service ruled that based on the facts given, an exchange of one parcel of property
for two parcels can nevertheless constitute a tax-deferred exchange, even including the
parties involved. The other elements of the exchange were deemed to have been met.

PRIVATE LETTER RULING 8515016

Dear ____:

This is in response to your letter dated August 28, 1984 requesting rulings under section
1031 of the Internal Revenue Code on behalf of Individual A and Corp C. The facts
represented are substantially as follows.

Individuals A and B own as tenants in common, an undivided one-half interest in real


property hereinafter referred to as Parcel ONE. It is represented that Parcel ONE is
agricultural property held for productive use in the trade or business for many years.

Individuals A and B, together with their spouses, own 100 percent of the outstanding
stock of Corp C. Corp C owns, in fee, real property hereinafter referred to as Parcel
TWO. It is represented that Parcel TWO is agricultural property held for productive use
in the trade or business for many years.
Individual A and Corp C propose to exchange their properties in an exchange that
qualifies as a like kind exchange under section 1031 of the Code. In connection with this
proposal, it is further represented that Individual A and Corp C will continue to use the
property in the trade or business and that the exchange does not involve an exchange of
liabilities.

Section 1031(a) of the Code provides, in part, that no gain or loss shall be recognized if
property held for productive use in trade or business is exchanged solely for property of a
like kind to be held for productive use in trade or business.

Section 1031(b) provides, in part, that if, on an exchange of property held for
productive use in trade or business the exchange consists not only of property permitted
to be received without the recognition of gain, but also of other property or money, then
the gain, if any, to the recipient shall be recognized, but in an amount not in excess of the
sum of such money and the fair market value of such other property.

Section 1.1031(a)-1(a) of the Income Tax Regulations provides, in part, that no gain or
loss is recognized if property held for productive use in a trade or business is exchanged
solely for property of a like kind to be held for productive use in trade or business.
However, a transfer is not within the provisions of section 1031(a) if as part of the
consideration the other party to the exchange assumes a liability of the taxpayer (or
acquires property from the taxpayer that is subject to a liability), but the transfer, if
otherwise qualified, will be within the provisions of section 1031(b). The nonrecognition
treatment provided by section 1031(a) does not apply to the property transferred which
does not meet the requirements of section 1031(a).

Section 1.1031(b)-1(c) of the regulations provides, in part, that consideration received


in the form of an assumption of liabilities (or a transfer subject to a liability) is to be
treated as "other property or money" for purposes of section 1031(b). Where, on an
exchange described in section 1031(b), each party to the exchange either assumes a
liability of the other party or acquires property subject to a liability, then, in determining
the amount of "other property or money" for purposes of section 1031(b), consideration
given in the form of an assumption of liabilities (or a receipt of property subject to a
liability) shall be offset against consideration received in the form of an assumption of
liabilities (or a transfer subject to a liability).

In Rev.Rul. 73-476, 1973-2 C.B. 300, three individual taxpayers each owned an
undivided interest as a tenant in common in three separate parcels of real estate. The
parcels were held by the taxpayers for investment purposes and none of the properties
were subject to mortgages. Each of the taxpayers exchanged his undivided interest in the
three separate parcels for a 100 percent ownership of one parcel. None of the taxpayers
assumed any liabilities of the other taxpayer or received money or other property as a
result of the exchange. Each taxpayer continued to hold the single parcel of land as an
investment.
In Rev.Rul. 73-476, the Service held that pursuant to section 1031(a) of the Code, any
gain or loss realized by the taxpayers as a result of the exchange of their property
interests is not recognized and thus, is not includible in gross income.

Both Individual A and Corp C have held, respectively, Parcel ONE and Parcel TWO
for productive use in trade or business and both intend to continue to hold the properties
for productive use in trade or business. Pursuant to Rev.Rul. 73-476, the provisions of
section 1031 apply to taxpayers who exchange an undivided interest in real estate solely
for full title in real estate to be held for the same purpose.

Therefore, based on the taxpayers' representations and the applicable law, we rule that
the exchange of Parcel ONE for Parcel TWO will constitute a like kind exchange of
property held for productive use in a trade or business for property of a like kind to be
held for productive use in a trade or business, within the meaning of section 1031.

No opinion is expressed as to the basis of the properties held by the taxpayers after the
exchange.

PRIVATE LETTER RUL. 8836006

An exchange among tenants in common can come within Code §1031(a), thereby
postponing the gain.

PRIVATE LETTER RULING 8836006

This is in reply to your letter of October 22, 1987, and subsequent correspondence,
submitted on behalf of A, B, and C, in which a ruling is requested under section 1031 of
the Internal Revenue Code.

The information submitted indicates that A, B, and C each own a one-third undivided
interest as tenants in common in three separate parcels, buildings D, E, and F, situated in
the state of * * * The three buildings have been held for productive use in a trade or
business or for investment for many years.

A, B, and C as tenants in common of buildings D, E, and F intend to exchange their


interests so that B owns the entire interest in building D and A and C each owns a one-
half undivided interest as tenants in common in buildings E and F. Because the buildings
are of unequal value, B has agreed to give A and C, in addition to his undivided interest
in buildings E and F, a note in the amount of $X, payable in six annual installments.

We have been asked to rule that (1) The proposed exchange qualifies as an exchange of
like kind property under section 103 of the Internal Revenue Code. (2) No gain or loss
will be recognized by B as a result of the proposed exchange. (3) A and C will be
required to report gain on the proposed exchange, but only to the extent required by
section 1031(b) as a result of their receipt of undivided interests in the note. (4) The gain
required to be reported by A and C under section 1031(b) will be recognized under the
installment sale method pursuant to section 453 of the Internal Revenue Code.

Section 1031(a) of the Code provides that no gain or loss shall be recognized if
property held for productive use in trade or business or for investment (excluding certain
enumerated property) is exchanged solely for property of like kind to be held either for
productive use in trade or business or for investment.

Section 1031(a)(3) of the Code provides that for purposes of this section, any property
received by the taxpayer shall be treated as property which is not like-kind property if (A)
such property is not identified as property to be received in the exchange on or before the
day which is 45 days after the date on which the taxpayer transfers the property
relinquished in the exchange, or (B) such property is received after the earlier of (i) the
day which is 180 days after the date on which the taxpayer transfers the property
relinquished in the exchange, or (ii) the due date (determined with regard to extension)
for the transferor's return of the tax imposed by this chapter for the taxable year in which
the transfer of the relinquished property occurs.

Section 1031(b) of the Code provides that when an exchange consists of like kind
property and other property, any gain from the transaction shall be recognized in an
amount not to exceed the fair market value of the other property.

In order to qualify for section 1031 nonrecognition, three elements must be present: (1)
the property transferred by the taxpayer must have been held by him either for productive
use in a trade or business or for investment, and (2) the property received by the taxpayer
must be held by him either for productive use in a trade or business or for investment, and
(2 the properties transferred and received must be of like kind.

Rev. Rul. 73-476, 1973-2 C.B. 300, holds that any gain or loss realized by three
taxpayers who each exchanged an undivided interest in three separate parcels of real
estate that were not subject to mortgages for a 100 percent ownership of one parcel not
recognized pursuant to section 1031(a) of the Code.

Rev. Rul. 79-44, 1979-1 C.B. 265, holds that the transfer interests in two parcels of
farmland held by tenants-in-common that resulted in the conversion of the parcels into
two individually owned parcels qualifies as a like kind exchange under section 1031(a) of
the Code.

Rev. Rul. 73-476 and Rev. Rul. 79-44 stand for the proposition that the severance of a
tenancy-in-common occasioned by the transfer of the co-tenant's interest in real property
for other real property qualifies for the nonrecognition treatment under section 103(a) of
the Code.

Rev. Rul. 65-155, 1965-1 C.B. 356, holds that a taxpayer who claims the benefits of
section 1031(a) and (b) of the Code in exchange of property held for productive use in a
trade or business, or for investment, for property of a like kind and a cash payment, with
additional payments to be received in installments in subsequent years, may elect to use
the installment method of reporting the payments provided the transaction otherwise
qualifies as an installment sale under section 453 of the Code.

A, B, and C have held buildings D, E, and F for productive use in trade or business or
for investment and all parties involved intend to continue to hold the properties for
productive use in trade or business or for investment. Pursuant to Rev. Rul. 73-476 and
Rev. Rul. 79-44, the provisions of section 1031 apply to taxpayers who exchange
interests in real estate held for the same purpose.

Therefore, based on the taxpayers' representations and the applicable law we rule that
the proposed exchange qualifies as exchange of like kind property under section 1031 of
the Code; that no gain or loss will be recognized by B as a result of the proposed
exchange; A and C will report gain on the proposed exchange to the extent required by
section 1031(b) of the Code; and that A and C may elect to recognize the gain under the
installment method under section 453 of the Code. These ruling are conditioned upon the
completion of the above described exchange occurring within the specified time periods
established under section 1031(a)(3) of the Code.

No opinion is expressed as to the basis of the properties held by the taxpayers after the
exchange.

This ruling letter is directed only to the taxpayer who requested it. Section 6110(j)(3) of
the Code provides that it may not be used or cited as precedent.

A copy of this letter should be attached to A, B, and C's federal income tax return for
the year in which the exchange takes place. Sincerely yours,

EXCHANGE OF UNDIVIDED INTEREST FOR 100% FEE:


PRIVATE LETTER RULING 9609016

This Private Letter Ruling addressed the use of the tax-deferred exchange involving
undivided interest for 100% fee interest. The Ruling concluded that, assuming other
requirements are met under Code §1031, the structure involving undivided interests and
the fee was qualified under Code §1031.

Internal Revenue Service (I.R.S.)


PRIVATE LETTER RULING 9609016
1996 WL 87768 (I.R.S.)
Issue: March 1, 1996
November 22, 1995

Dear ***

This responds to the ruling request, dated July 19, 1995, and supplemental
correspondence dated October 3 and November 3, 1995, that the exchange by Taxpayer
of Taxpayer's undivided one-sixth interest in various parcels of farm real estate, held by
Taxpayer in productive use in a trade or business or for investment, for 100% interests in
specific parcels of farm real estate will constitute a tax-free, like-kind exchange under the
provisions of section 1031 of the Internal Revenue Code.

Taxpayer and five other related persons (hereinafter referred to as "the Parties" when
discussed together) each own undivided one-sixth interests in 23 separate parcels of farm
land spread among seven counties in State X. The Parties have owned these properties,
either directly or indirectly (as trust and estate beneficiaries), for a period of several
years. One of the Parties, acting as agent for the others, operates these properties as farms
under customary crop share lease agreements. The Parties have directly held all 23
parcels as tenants in common since Date Y.

The Parties propose to simultaneously exchange their individual undivided interests in


the 23 parcels for 100% interests in specific parcels of the 23- parcel group. Each of the
Parties will receive a separate deed for all properties to be received by him or her in each
county. All six of the Parties will sign each deed.

Pursuant to this plan, Taxpayer will exchange Taxpayer's undivided one-sixth interest
in the 23 parcels with the other Parties for a 100% interest in Tracts A, B and C of the
same 23-parcel group. All of these properties are located in one county. Therefore,
Taxpayer will receive this conveyance by a single deed, signed by all the Parties. After
the exchange, Taxpayer will be the sole owner of Tracts A, B, and C and will either farm
these parcels outright or hold them for lease under customary crop-share lease
agreements.

There will be no other disposition of any of the 23 parcels exchanged by the Parties,
other than by reason of the death of one of the Parties, for a two- year period following
the date of the exchange. The interest in land conveyed by Taxpayer in this transaction
will be of approximately equal value to the property received. The transaction will
involve neither boot nor assumption of liabilities by any of the Parties.

Section 1031(a)(1) of the Internal Revenue 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.

Thus, for an exchange to be valid under section 1031 of the Code, the transaction must
satisfy three requirements: (1) there must be an exchange; (2) the properties exchanged
must be of like kind; and (3) The properties relinquished and received in the exchange
must be held for productive use in a trade or business or for investment.

In Rev. Rul. 57-244, 1957-1 C.B. 247, the Service validated, for section 1031 purposes,
a circular exchange between three related parties (e.g., C acquires a lot from B, B
acquires a lot from A and A acquires a lot from C). Rev. Rul. 73- 476, 1973-2 C.B. 300,
holds that where three taxpayers each owned undivided interests in three tracts of land for
investment purposes, and each of the taxpayers exchanged his undivided interest for
100% ownership of one parcel to be held for investment, pursuant to section 1031(a) of
the Code, none of the taxpayers recognized any gain or loss realized in the exchange.
Rev. Rul. 79- 44, 1979-1 C.B. 265 reached the same conclusion on similar facts. Hence,
the form of the exchange (whether structured in a circular format as in Rev. Rul. 57-244,
or as an omnibus transaction with several related parties transferring their respective
undivided interests in multiple tracts of land so that each receives whole interests in
specific parcels) will not affect the validity of the transaction under section 1031 so long
as the three requirements provided in the statute are satisfied.

In this case, Taxpayer is simultaneously trading property for property of approximately


equal value. Thus, the transaction constitutes an exchange. See section 1.1002-1(d) of the
Income Tax Regulations. Second, Taxpayer is both relinquishing and receiving only real
property. Therefore, all property involved in the transaction is of like kind. Finally, the
properties relinquished and the properties received are held (or to be held) for productive
use in the trade or business or for investment. Accordingly, as to Taxpayer in this case,
the transaction constitutes a tax-free exchange under section 1031.

However, we emphasize that for the transaction to constitute an exchange under section
1031, the values of the properties relinquished and received by Taxpayer must be
approximately equal. Therefore, this ruling is based, in part, upon Taxpayer's
representation that the values of all the relinquished properties are approximately equal to
the values of the corresponding replacement properties that each party is to receive.
[FN1]

No opinion is expressed as to the tax treatment of this transaction under the provisions
of any other sections of the Code and regulations which may be applicable thereto, or the
tax treatment of any conditions existing at the time of, or effects resulting from, the
transaction which are not specifically covered by this ruling. Specifically, we are not
ruling whether there have been any gifts between the Parties.

A copy of this letter should be attached to the federal income tax return for the year in
which the described transaction occurs.

This ruling is directed only to the taxpayer who requested it. Section 6110(j)(3) of the
Code provides that it may not be cited as precedent.

Sincerely yours,

Assistant Chief Counsel(Income Tax & Accounting)

This document may not be used or cited as precedent. Section 6110(j)(3) of the Internal
Revenue Code.
LIKE-KIND PROPERTY: UNDIVIDED INTERESTS:
PRIVATE LETTER RULING 9642029
(see P.L.R. 9642032, P.L.R. 9642033, P.L.R. 9642034 and P.L.R. 9642035)

The issue in this Ruling was whether the taxpayer could exchange an undivided 1/6th
interest in property for 100% interest in a fee position. This transaction was a
simultaneous exchange in which the taxpayer and 5 other related parties, each owning an
undivided 1/6th interest, in 23 separate parcels of real estate, were undertaking an
exchange. They were exchanging the 23 parcel interests held by these 6 people for 100%
interest in specific parcels in the 23-parcel group. Thus, each taxpayer would receive a
separate deed for all the property for a given number of parcels.

The Treasury was asked to determine whether this would qualify as a Code §1031
transaction. It held it would qualify.

This is consistent with Private Letter Ruling 9642032, P.L.R. 9642033, P.L.R. 9642034
and P.L.R. 9642035.

Internal Revenue Service (I.R.S.)


PRIVATE LETTER RULING 9642029
1996 WL 597405 (I.R.S.)

Issue: October 18, 1996


July 16, 1996

Dear ____:

This responds to the ruling request, dated March 15, 1996, and supplemental
correspondence dated June 12, 1996, that the exchange by Taxpayer of Taxpayer's
undivided one-sixth interest in various parcels of farm real estate, held by Taxpayer in
productive use in a trade or business or for investment, for 100% interests in specific
parcels of farm real estate will constitute a tax-free, like-kind exchange under the
provisions of section 1031 of the Internal Revenue Code.

Taxpayer and five other related persons (hereinafter referred to as "the Parties" when
discussed together) each own undivided one-sixth interests in 23 separate parcels of farm
land spread among seven counties in State X. The Parties have owned these properties,
either directly or indirectly (as trust and estate beneficiaries), for a period of several
years. One of the Parties, acting as agent for the others, operates these properties as farms
under customary crop-share lease agreements. The Parties have directly held all 23
parcels as tenants in common since Date Y.

The Parties propose to simultaneously exchange their individual undivided interests in


the 23 parcels for 100% interests in specific parcels of the 23- parcel group. Each of the
Parties will receive a separate deed for all properties to be received by him or her in each
county. All six of the Parties will sign each deed.
Pursuant to this plan, Taxpayer will exchange Taxpayer's undivided one-sixth interest
in the 23 parcels with the other Parties for a 100% interest in Tracts A, B, C, D, and E
(collectively, the "Tracts") of the same 23-parcel group. All of the Tracts are located in
the same county. Therefore, Taxpayer will receive this conveyance by one deed signed
by all the Parties. After the exchange, Taxpayer will be the sole owner of the Tracts and
will either farm these parcels outright or hold them for lease under customary crop-share
lease agreements.

There will be no other disposition of any of the 23 parcels exchanged by the Parties,
other than by reason of the death of one of the Parties, for a two- year period following
the date of the exchange. The interest in land conveyed by Taxpayer in this transaction
will be of approximately equal value to the property received. The transaction will
involve neither boot nor assumption of liabilities by any of the Parties.

Section 1031(a)(1) of the Internal Revenue 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.

Thus, for an exchange to be valid under section 1031 of the Code, the transaction must
satisfy three requirements: (1) there must be an exchange; (2) the properties exchanged
must be of like kind; and (3) the properties relinquished and received in the exchange
must be held for productive use in a trade or business or for investment.

In Rev. Rul. 57-244, 1957-1 C.B. 247, the Service upheld as a valid section 1031
exchange a circular exchange between three related parties (e.g., C acquires a lot from B,
B acquires a lot from A, and A acquires a lot from C).

In Rev. Rul. 73-476, 1973-2 C.B. 300, three taxpayers each owned undivided interests
in three tracts of land for investment purposes. These three taxpayers exchanged their
undivided interests for 100% ownership of one parcel to be held for investment. The
Service ruled that none of the taxpayers would recognize any gain or loss pursuant to
section 1031(a) of the Code. Accord Rev. Rul. 79-44, 1979-1 C.B. 265 (reaching same
conclusion on similar facts).

As demonstrated by the above authorities, the form of the exchange will not affect the
validity of the transaction under section 1031 provided the three requirements provided in
section 1031 of the Code are satisfied.

In this case, Taxpayer is simultaneously trading property for property of approximately


equal value. Thus, the transaction constitutes an exchange. See section 1.1002-1(d) of the
Income Tax Regulations. Second, Taxpayer is relinquishing and receiving only real
property. Therefore, all of the property involved in the transaction is of like kind. Finally,
the properties relinquished and the properties received are held (or to be held) for
productive use in the trade or business or for investment. Accordingly, as to Taxpayer in
this case, the transaction constitutes a tax-free exchange under section 1031.
However, we emphasize that for the transaction to constitute an exchange under section
1031, the values of the properties relinquished and received by Taxpayer must be
approximately equal. Therefore, this ruling is based, in part, on the Taxpayer's
representation that the values of all the relinquished properties are approximately equal to
the values of the corresponding replacement properties that each party is to receive.
[FN1]

No opinion is expressed as to the tax treatment of this transaction under the provisions
of any other sections of the Code and regulations which may be applicable thereto, or the
tax treatment of any conditions existing at the time of, or effects resulting from, the
transaction which are not specifically covered by this ruling. Specifically, we are not
ruling whether there have been any gifts between the Parties.

A copy of this letter should be attached to the federal income tax return for the year in
which the described transaction occurs.

This ruling is directed only to the taxpayer who requested it. Section 6110(j)(3) of the
Code provides that it may not be cited as precedent.

Sincerely yours,

Assistant Chief Counsel


(Income Tax & Accounting)
By:
David L. Crawford
Chief, Branch 5

LIKE-KIND PROPERTY: UNDIVIDED INTERESTS:

PRIVATE LETTER RULING 9642032


(see P.L.R. 9642029, P.L.R. 9642033,
P.L.R. 9642034, P.L.R. 9642035)

This Ruling addressed the question of exchanging undivided interests in a trade or


business for 100% interest in specific parcels. The Ruling supports the tax-deferred
treatment under Code §1031. This is consistent with Private Letter Ruling 9642029,
P.L.R. 9642033, P.L.R. 9642034 and P.L.R. 9642035.

Internal Revenue Service (I.R.S.)

PRIVATE LETTER RULING 9642032


1996 WL 597408 (I.R.S.)
Issue: October 18, 1996
July 16, 1996

Dear ***
This responds to the ruling request, dated March 15, 1996, and supplemental
correspondence dated June 12, 1996, that the exchange by Taxpayer of Taxpayer's
undivided one-sixth interest in various parcels of farm real estate, held by Taxpayer in
productive use in a trade or business or for investment, for 100% interests in specific
parcels of farm real estate will constitute a tax-free, like-kind exchange under the
provisions of section 1031 of the Internal Revenue Code.

Taxpayer and five other related persons (hereinafter referred to as "the Parties" when
discussed together) each own undivided one-sixth interests in 23 separate parcels of farm
land spread among seven counties in State X. The Parties have owned these properties,
either directly or indirectly (as trust and estate beneficiaries), for a period of several
years. One of the Parties, acting as agent for the others, operates these properties as farms
under customary crop-share lease agreements. The Parties have directly held all 23
parcels as tenants in common since Date Y.

The Parties propose to simultaneously exchange their individual undivided interests in


the 23 parcels for 100% interests in specific parcels of the 23- parcel group. Each of the
Parties will receive a separate deed for all properties to be received by him or her in each
county. All six of the Parties will sign each deed.

Pursuant to this plan, Taxpayer will exchange Taxpayer's undivided one-sixth interest
in the 23 parcels with the other Parties for a 100% interest in Tracts A, B, C, D, and E
(collectively, the "Tracts") of the same 23-parcel group. Tracts A, B, C, and D are located
in the same county, and Tract E is located in a different county. Therefore, Taxpayer will
receive this conveyance by two deeds, signed by all the Parties. After the exchange,
Taxpayer will be the sole owner of the Tracts and will either farm these parcels outright
or hold them for lease under customary crop-share lease agreements.

There will be no other disposition of any of the 23 parcels exchanged by the Parties,
other than by reason of the death of one of the Parties, for a two- year period following
the date of the exchange. The interest in land conveyed by Taxpayer in this transaction
will be of approximately equal value to the property received. The transaction will
involve neither boot nor assumption of liabilities by any of the Parties.

Section 1031(a)(1) of the Internal Revenue 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.

Thus, for an exchange to be valid under section 1031 of the Code, the transaction must
satisfy three requirements: (1) there must be an exchange; (2) the properties exchanged
must be of like kind; and (3) the properties relinquished and received in the exchange
must be held for productive use in a trade or business or for investment.
In Rev. Rul. 57-244, 1957-1 C.B. 247, the Service upheld as a valid section 1031
exchange a circular exchange between three related parties (e.q., C acquires a lot from B,
B acquires a lot from A, and A acquires a lot from C).

In Rev. Rul. 73-476, 1973-2 C.B. 300, three taxpayers each owned undivided interests
in three tracts of land for investment purposes. These three taxpayers exchanged their
undivided interests for 100% ownership of one parcel to be held for investment. The
Service ruled that none of the taxpayers would recognize any gain or loss pursuant to
section 1031(a) of the Code. Accord Rev. Rul. 79-44, 1979-1 C.B. 265 (reaching same
conclusion on similar facts).

As demonstrated by the above authorities, the form of the exchange will not affect the
validity of the transaction under section 1031 provided the three requirements provided in
section 1031 of the Code are satisfied.

In this case, Taxpayer is simultaneously trading property for property of approximately


equal value. Thus, the transaction constitutes an exchange. See section 1.1002-1(d) of the
Income Tax Regulations. Second, Taxpayer is relinquishing and receiving only real
property. Therefore, all of the property involved in the transaction is of like kind. Finally,
the properties relinquished and the properties received are held (or to be held) for
productive use in the trade or business or for investment. Accordingly, as to Taxpayer in
this case, the transaction constitutes a tax-free exchange under section 1031.

However, we emphasize that for the transaction to constitute an exchange under section
1031, the values of the properties relinquished and received by Taxpayer must be
approximately equal. Therefore, this ruling is based, in part, on the Taxpayer's
representation that the values of all the relinquished properties are approximately equal to
the values of the corresponding replacement properties that each party is to receive.
[FN1]

No opinion is expressed as to the tax treatment of this transaction under the provisions
of any other sections of the Code and regulations which may be applicable thereto, or the
tax treatment of any conditions existing at the time of, or effects resulting from, the
transaction which are not specifically covered by this ruling. Specifically, we are not
ruling whether there have been any gifts between the Parties.

A copy of this letter should be attached to the federal income tax return for the year in
which the described transaction occurs.

This ruling is directed only to the taxpayer who requested it. Section 6110(j)(3) of the
Code provides that it may not be cited as precedent.

Sincerely yours,

Assistant Chief Counsel


(Income Tax & Accounting)
By:
David L. Crawford
Chief, Branch 5

FN1 Moreover, because the Parties are "related persons" within the meaning of section
1031(f), Taxpayer is also cautioned as to the possible application of section 1031(f) to
this case. Section 1031(f)(1) of the Code provides that if:

(A) a taxpayer exchanges property with a related person,


(B) there is nonrecognition of gain or loss to the taxpayer under
this section with respect to the exchange of such property
(determined without regard to this subsection), and
(C) before the date two years after the date of the last transfer
which was part of such exchange (i) the related person
disposes of such property or (ii) the taxpayer disposes of the
property received in the exchange from the related person
which was of like kind to the property transferred by the
taxpayer, there shall be no nonrecognition of gain or loss to
the taxpayer with respect to such exchange unless one of the
exceptions stated in section 1031(f)(2) applies.

This document may not be used or cited as precedent. Section 6110(j)(3) of the Internal
Revenue Code.

REVENUE RULING 66-209

This Ruling addressed the issue as to whether receipt of property by a corporation


would generate taxable income or whether it would be tax-deferred under Code §1031(a).

The corporation received a lot in exchange for the execution of a lease for more than 30
years on other property and the lot in question.

Inasmuch as the exchange was not a fee interest for a long-term lease, per se, but rather
was for rental, it was included in income; therefore, it was not within Code §1031(a).

REVENUE RULING 66-209


1966-2 C.B. 299

Advice has been requested whether the receipt of property by a corporation under the
circumstances described below gives rise to taxable income or whether the transaction is
an exchange with respect to which section 1031(a) of the Internal Revenue Code of 1954
applies.

Y corporation owns two pieces of property, lots A and C, which are separated by lot B.
Y entered into an agreement with X, an unrelated corporation, under which X agreed to
purchase lot B and convey in to Y solely in exchange for a lease on lots A, B, and C. The
term of the lease is for 30 years and 1 month with three successive renewal options for 25
years, 25 years, and 19 years, 11 months, respectively. The rent for the three lots is 25x
dollars for the first year, 80x dollars for each of the next 5 years, 90x dollars for the
balance of the initial term, and 90x dollars plus certain increases for the option period.
Improvements on the lots will become the property of Y upon construction, but X will
have the right to use the improvements during the initial term of the lease and any
renewal periods.

The question presented is whether the conveyance of lot B solely in exchange for the
execution of a lease of more than 30 years on lots A, B, and C is an exchange of property
under section 1031(a) of the Code, or whether Y has taxable income resulting from the
conveyance to it of lot B.

Section 1.1031(a)--1(c) of the Income Tax Regulations provides, in part, that no gain or
loss is recognized if a taxpayer who is not a dealer in real estate exchanges a leasehold of
a fee with 30 years or more to run for real estate.

Section 1.61--8(b) of the Regulations provides, in part, that gross income includes
advance rentals, which must be included in income for the year of receipt regardless of
the period covered or the method of accounting employed by the taxpayer.

In Pembroke v. Commissioner, 23 B.T.A. 1176 (1931), affirmed, 70 F.2d 850 (D.C.


Cir. 1934), the taxpayer executed a lease on a parcel of land for a term of 99 years, in
consideration of annual rents, and a fee interest in other property. It was held that the
value of the fee interest in the other property constituted income to the taxpayer as an
advance rental, and that section 203 of the Revenue Act of 1926, a predecessor of section
1031 of the 1954 Code, did not apply to the transaction.

In Central Electric Company v. Commissioner, 192 F.2d 155 (8th Cir. 1951), however,
the taxpayer had conveyed certain property to a college for cash and a 95-year lease on
the same property. The taxpayer sought to deduct a loss equal to the excess of its basis in
the property over the amount of cash received. The court held, in part, that this was an
exchange of like kind with boot under section 112(e) of the Internal Revenue Code of
1939 (the predecessor of sec. 1031(c) of the 1954 Code), and that no loss may be
recognized.

Under the circumstances existing in the present case, while the transfer of real property
in consideration of the execution of a leasehold interest in the same or other property may
be an exchange of properties of like kind for purposes of section 1031 of the Code to the
transferor-lessee, it is not an exchange of properties of like kind by the transferee-lessor.
The real property is received by the lessor as an advance rental, in consideration of the
execution of the lease. See Burnet v. Harmel, 287 U.S. 103 (1932), and Voloudakis v.
Commissioner, 274 F.2d 209 (9th Cir. 1960). Cf., Commissioner v. P. G. Lake, Inc., 356
U.S. 260 (1958). Compare, Hort v. Commissioner, 313 U.S. 28 (1941), with
Commissioner v. Golonsky, 200 F.2d 72 (3d Cir. 1952), and Metropolitan Building
Company v. Commissioner, 282 F.2d 592 (9th Cir. 1960).
Accordingly, the fair market value of lot B received by Y corporation is advance rental
includible in gross income in the taxable year of receipt under section 1.61--8(b) of the
regulations.

PRIVATE LETTER RULING 8434015

This Ruling examines numerous questions, including the use of Code §1031 between or
among related parties, basis adjustments, segregation of some transactions from other
transactions, installment sale issues, mortgage in excess of basis as boot, and additional
questions under Code §1031 as for compliance.

PRIVATE LETTER RULING 8434015

This is in reply to a letter of August 23, 1983 and subsequent correspondences from
your authorized representative, requesting rulings under section 1031 of the Internal
Revenue Code.

The information submitted indicates that X owns and rents real property, Property a, to
Y. A solely owns X and 45 of the outstanding 65 shares of Y. The remaining shares of Y
are owned proportionately by A's four adult children. B, C & D are family members who
jointly own Property b for the production of rental income. Property b consists primarily
of real property but includes incidental personal property, Property bb. B, C & D are not
directly or indirectly related to the shareholders of X or Y.

The proposed transaction involves the exchange of Property a for Properties b & bb and
the subsequent sale by Y of its operating assets to D. We have determined that the latter
sale is independent of the exchange of properties and is outside the parameters of this
ruling letter. The transaction is to be executed in accordance with a Basic Memorandum
Agreement (Agreement) executed by the parties on July 8, 1982. All of the transfers and
exchanges will be made contemporaneously at a closing date. Properties a and b are both
encumbered by recourse liabilities. Property a is encumbered by a mortgage in the
amount of 5x ($416,076 principal balance as of December 31, 1983). Property b is
encumbered by mortgages in the amounts of 20x and 25x ($629,385 aggregate principal
balance as of December 31, 1983). It is assumed that these liability amounts will not
change substantially between December 31, 1983 and the closing date. The Agreement
intends that the properties will be transferred with their respective mortgages and all
liabilities shall be personally assumed by the transferees on the exchange.

It is represented that at the time of the exchange Property a will have a greater equity
value than Property b. Under covenant six of the Agreement, X will use its best efforts to
refinance property a and/or obtain a second mortgage from an institutional lender in such
an amount that the equity values to be exchanged are equal. Pursuant to this provision, on
July 1, 1983 in exchange for $250,000 in proceeds from an institutional lender, X
executed a mortgage in the amount of 10x on Property a. In addition it is planned that B,
C & D will execute a promissory note in the amount of 15x to X, representing the
remaining difference in equity values between the two properties. The note will be
secured by a collateral recourse mortgage on Property a and installment payments will be
made to X. Both parties expect to realize gain on the exchange of real property.

You have requested we rule that:

1. No gain or loss will be recognized on the exchange of the


properties between X and B, C & D, except that X will
recognize gain to the extent that the mortgage indebtedness
on Property a (including the mortgage to be given by B, C &
D to X) exceeds the mortgage indebtedness on Property b at
the time of closing.
2. X's basis in Property b will be equal to its basis in Property a
increased by the amount of gain recognized on the exchange
and by the amount of the mortgage on Property b at the time
of the exchange, and decreased by the amount of the
mortgage indebtedness on Property a (including the mortgage
to be given by B, C & D to X) at the time of exchange.
3. B, C & D's basis in Property a will be equal to their basis in
Property b, increased by the amount of the mortgage on
Property a at the time of the exchange (including the
mortgage to be given by B, C & D to X) and decreased by the
amount of the mortgage on Property b at the time of the
exchange.
4. The holding period for Property b in X's hands will include
the period for which it held Property a.
5. The holding period for Property a in B, C & D's hands will
include the period for which they held Property b.
6. Income received by X on the mortgage to be received from B,
C & D may be taken into account under the installment
method.

Section 1031(a) of the Code provides that no gain or loss shall be recognized if
property held for productive use in a trade or business or for investment (not including
stock in trade or other property held primarily for sale, nor stocks, bonds, notes, choses in
action, certificates of trust or beneficial interest, or other security or evidences of
indebtedness or interest) is exchanged solely for property of a like kind to be held either
for productive use in trade or business or for investment. Section 1.1031(a)-1(b) of the
Income Tax Regulations provides, in part, that the words "like kind" have reference to the
nature or character of the property and not to its grade or quality. One kind or class of
property may not, under section 1031(a) of the Code, be exchanged for property of a
different kind or class. 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. Unproductive real estate held by one other than a dealer for future use or
future realization of the increment in value is held for investment and not primarily for
sale.
Section 1.1031(a)-1(c) of the regulations provides, in part, that no gain or loss is
recognized if a taxpayer who is not a dealer in real estate exchanges city real estate for a
ranch or farm or exchanges improved real estate for unimproved real estate.

Section 1031(b) of the Code provides, in part, that if an exchange would be within the
provisions of Section 1031(a) of the Code, if it were not for the fact that the property
received in exchange consists not only of property permitted by such provisions to be
received without the recognition of gain, but also of other property or money (boot), then
the gain, if any, to the recipient shall be recognized, but in an amount not in excess of the
sum of such money and the fair market value of such other property.

Rev.Rul. 72-151, 1972-1 C.B. 225, held that when an exchange under Section 1031 of
the Code involves multiple assets, the fact that the assets in the aggregate comprise a
business or an integrated economic investment does not result in treating the exchange as
a disposition of a single piece of property. Rather, an analysis is required of the
underlying property involved in the exchange. The effect of the ruling is that a transfer of
"multiple assets" must be fragmented in applying section 1031(a) even if the assets
constitute a going business or an integrated economic investment. So analyzed, the
transaction described in Rev.Rul. 72-151 (an exchange of rental property consisting of
land and a house for farmland and associated farm machinery) was treated as tax-free so
far as the exchange of realty was concerned, but the taxpayer's realized gain was held
taxable to the extent of the value of the farm machinery received.

Section 1031(c) of the Code provides, in part, that if an exchange would be within the
provisions of Section 1031(a), if it were not for the fact that the property received in
exchange consists not only of property permitted by such provisions to be received
without the recognition of gain or loss, but also of other property or money, then no loss
from the exchange shall be recognized.

Section 267 of the Code provides, in pertinent part, that no deduction shall be allowed
in respect of losses from sales or exchanges of property (other than losses in cases of
distributions in corporate liquidations), directly or indirectly, between persons specified
within any one of the paragraphs of section 267(b). Section 267(b) provides at paragraph
(2) that an individual and a corporation more than 50% in value of the outstanding stock
of which is owned, directly or indirectly, by or for such individual represents a
relationship referred to in section 267(a).

Section 1031(d) of the Code provides, in part, this if property was acquired on an
exchange described in that section, then the basis shall be the same as that of the property
exchanged, decreased in the amount of any money received by the taxpayer and increased
in the amount of gain or decreased in the amount of loss to the taxpayer that was
recognized on such exchange. If property so acquired consisted in part of the type of
property permitted by that section of the Code, to be received without the recognition of
gain or loss, and in part of other property, the basis provided in that subsection shall be
allocated between the properties (other than money) received, and for the purpose of the
allocation there will be assigned to such other property an amount equivalent to its fair
market value at the date of the exchange. For purposes of this section, where as part of
the consideration to the taxpayer another party to the exchange assumed a liability of the
taxpayer or acquired from the taxpayer property subject to a liability, such assumption or
acquisition (in the amount of the liability) shall be considered as money received by the
taxpayer on the exchange.

Section 453(f)(6) of the Code provides that in the case of any installment obligations
received pursuant to an exchange described in section 1031(b), (1) The total contract
price shall be reduced to take into account the amount of any property permitted to be
received in such exchange without recognition of gain; (2) The gross profit from such
exchange shall be reduced to take into account any amount not recognized by reason of
section 1031(b); and (3) The term "payment", when used in any provision of section 453
other than subsection (b)(1), shall not include any property permitted to be received in
such exchange without recognition of gain.

Section 1223(1) of the Code, in part, provides that in determining the period for which
the taxpayer has held property received in an exchange, there shall be included the period
for which he held the property exchanged if, the property has, for the purpose of
determining gain or loss from sale or exchange, the same basis in whole or in part in his
hands as the property exchanged.

The following rulings are based solely on the information and documents submitted
with your request:

1. It is held that the proposed exchange of Property a for Property b is an exchange


of property of "like kind" within the meaning of section 1031(a) of the Code.

Property bb (personal property) is not of the same class of property as Properties a and
b (real property). Thus, Property bb will not be exchanged solely for property of "like
kind" and the nonrecognition treatment provided by Section 1031(a) of the Code will not
be applicable to such property. See, generally, section 1031(b) and Rev.Rul. 72-151.

Accordingly, any gain or loss realized by B, C or D on the exchange of Property bb will


be recognized to the extent of the difference between the basis and fair market value of
Property bb. As the parties to the exchange are unrelated, section 267 of the Code will not
disallow any loss realized but the basis of Property a received will be decreased by such
amount. If a gain is realized, the basis of Property a will be increased by such gain.

In regards to X, the receipt of Property bb will constitute nonqualified property ("boot")


under section 1031(b) of the Code, and any gain realized will be recognized in an amount
at least equal to the fair market value of Property bb. For purposes of allocating the basis
to the properties received, an amount equivalent to the fair market value of Property bb
on the date of the exchange must be assigned as its basis.

2. Treatment of X: Transferee of Property b


We hold that X will receive boot in the exchange equal to 10x plus 15x. The basis of
Property b after the proposed exchange will include the adjusted basis of Property a
transferred plus the liabilities 20x and 25x to which Property b will be subject, less the
amount of money received in the amounts of 5x, 10x and 15x.

In this case, we disagree with taxpayer's proposed treatment of liabilities 10x and 15x.
In general, when liabilities are received and assumed on both sides of an exchange, they
are netted against each other in determining the extent, if any, to which taxable boot has
been received. Consideration given in the form of an assumption of liabilities (or a
receipt of property subject to a liability) is offset against consideration received in the
form of an assumption of liabilities (or a transfer subject to a liability). These "liability
netting rules" normally provide that the party to the exchange who has the higher amount
of liabilities to transfer recognizes gain in the amount of the difference between the two
sets of liabilities. See sections 1.1031(b)-1(c) and 1.1031(d)-2 of the regulations. It is
undisputed that Property b will be encumbered throughout the transaction with 20x and
25x and that the transfer to X will result in the assumption of liabilities by X
(consideration given). However, the proper figure to be used to offset 20x and 25x is in
dispute. Under taxpayer's analysis, the offset includes the sum 5x, 10x and 15x resulting
in taxable gain since the consideration received is greater than that given. We do not
agree with this computation of gain and rule that 10x and 15x cannot be used as offsetting
amounts under the liability netting rules and must in their entirety be recognized as
money received under section 1031(b) of the Code. In other words, of the gain realized,
X must recognize gain to the extent of 10x and 15x, which represents the consideration
given to equalize the exchange.

We regard 15x as money received by X. X is the party to which payments will be made
under the promissory note and the collateral mortgage on Property a will be executed
contemporaneously with the proposed exchange merely as a security device. This is not a
situation in which the other party to the exchange assumes a liability of X, and thus this
amount is not reduced under the liability netting rules. See Max Feldman, 18 BTA
1222(1930), where as part of the consideration of the exchange, it was held that taxpayer
received boot in the form of a mortgage against the property that was transferred.
However, payments under the note must be taken into income in accordance with the
installment sales provisions of section 453(f) (6) of the code. Under covenant 6 of the
Basic Memorandum Agreement dated July 8, 1982, X agreed that it would use its best
effort to refinance the mortgage representing indebtedness 5x and/or obtain a second
mortgage from an institutional lender. Taxpayer asserts that the 10x liability is a bonafide
mortgage which should be offset against assumed liabilities 20x and 25x through a
general application of the liability netting rules. The tax effect of taxpayer's position is
that X receives $250,000 in a transaction related to the exchange, but because of the
offsetting liabilities does not recognize gain for most of this amount in the year of the
exchange. In essence, taxpayer would effectively "cash-out" his investment in like kind
property without the corresponding gain imposed for money received under section
1031(b) of the Code. We feel that X should not be allowed to take advantage of this
literal reading of the liability netting rules as the substance of the transaction is
tantamount to money received. In Long v. Commissioner, 77 T.C. 1045 (1981), the Tax
Court reminded the parties that it would closely examine the underlying assets in section
1031 cases to make sure the substance of a transaction complies with its form. In
considering the validity of any adjustment agreed to by the parties so close in time to the
date of the exchange, the documents and the transaction as a whole should be carefully
scrutinized to make sure that the form accurately reflects the substance. The form will not
be permitted to control over the substance where the form was chosen merely to alter the
tax liabilities of the parties ... (77 T.C. at 1077). Form cannot control if it alters the tax
liabilities of the parties without changing the economic substance. Commissioner v.
Court Holding Co., 334 U.S. 331 (1945); Gregory v. Helvering, 293 U.S. 465 (1935).

In Garcia v. Commissioner, 80 T.C. 491, the court rejected a substance over form
approach involving the liability netting rules similar to that advocated in this letter. That
case involved numerous escrows and the court held that the apparently tax-motivated
refinancing of property immediately prior to the exchange was proper because there was
an assumption of a debt which had independent economic significance. We feel that 10x
under the proposed transaction does not have the same independent significance.

3. Treatment of B, C and D: Transferees of Property a

We hold that B, C and D will recognize gain to the extent the liabilities given up (20x
and 25x) are greater than the liabilities assumed (5x, 10x) and the other consideration
tendered (15x). The basis of Property a after the proposed exchange will include the
adjusted basis of Property b transferred plus the mortgage indebtedness 5x and 10x to
which Property a will be transferred, plus the other 15x consideration tendered; less the
amount of money received in the amounts of 20x and 25x.

4. We rule that the holding period for property b will include the period for which
X held property a.

This ruling does not apply to property bb, which will begin a new holding period at the
time of the exchange. Likewise, we rule that the holding period for property a will
include the period for which B, C and D held property b. See section 1223(1) of the
Code.

INTENT TO HOLD FOR INVESTMENT:


PRIVATE LETTER RULING 8429039

The Service ruled on the question as to whether Code §1031 was met when there was
an exchange by a trust of a beach house for a residence. This qualified as a non-taxable
exchange, given the unique facts.

PRIVATE LETTER RULING 8429039

This is in reply to a letter dated February 14, 1984, submitted on your behalf by your
authorized representative, requesting a ruling with respect to the applicability of section
1031 of the Internal Revenue Code to an exchange of rental property held by the Trust for
a personal residence that the Trust intends to rent for a period not less than two years
after the exchange.

The pertinent facts are understood to be as set forth below:

The Trust owns a beach house that it has been renting since January 1982. T is an
individual who owns a personal residence. T wants to exchange the residence for the
beach house held by the Trust. T vacated the residence on November 1, 1981. Since early
1983 the residence has been rented to an unrelated third party. On December 1, 1982, this
office issued an adverse private letter ruling to the Trust under section 1031 of the Code
because the Trust intended to sell the residence soon after its acquisition. The Trust now
represents that it will hold the residence for productive use in a trade or business or for
investment for a period not less than two years from and after the exchange.

Section 1031(a) of the Code provides that no gain or loss shall be recognized if
property held for productive use in trade or business or for investment (excluding certain
enumerated property) is exchanged solely for property of like kind to be held either for
productive use in trade or business or for investment.

In order to qualify for section 1031 nonrecognition, three elements must be present:

(1) the property transferred by the taxpayer must have been held
by him either for productive use in a trade or business or for
investment,
(2) the property received by the taxpayer must be held by him
either for productive use in a trade or business or for
investment, and
(3) the properties transferred and received must be of like kind.

In this case the Trust will exchange rental real property for other real property which it
will hold as rental property for a minimum of two years. This is a sufficient period to
ensure that the residence to be acquired will meet the holding period test prescribed by
section 1031 of the Code, which requires that the property received by a taxpayer be held
either for productive use in a trade or business or for investment.

Accordingly, based on the information submitted, we conclude that the exchange by the
Trust of the beach house for the residence will qualify as a nontaxable exchange under
section 1031 of the Code.

PRIVATE LETTER RULING 9413006

This Ruling is an excellent recent example of the application of the nonsimultaneous


Regulations, the use of an intermediary, construction issues in compliance with Code
§1031 as well as proper reinvestment.
In an intricate set of facts that were examined in the Ruling, the Ruling held that the
conveyance of the X property and the receipt by X of City property and a building on the
same met the requirements of Code §1031.

PRIVATE LETTER RULING 9413006


December 20, 1993
Publication Date: April 1, 1994

Dear ____:

This letter is in response to the ruling request dated January 15, 1993, that was
submitted by X. Specifically, X requests a ruling under section 1031 of the Internal
Revenue Code with regard to the following transaction.

X is a general partnership owning a tract, T, of real property which it uses as rental


property. Y is a general partner of X and holds a license as a general contractor. City
owns a tract of real property which is part of an industrial park. Z is a title company.

X wants to trade its property to City. However, X will require that City construct a
building upon R the property City owns. The building must be constructed according to
X's plans and specifications prior to the completion of the exchange.

X will enter into an agreement with a purchaser wherein the purchaser will agree to
purchase T. X will enter into an exchange agreement with Z and assign all of the right,
title and interest in T to Z. Under the exchange agreement X will have no right to receive
the proceeds received from the purchaser prior to the expiration of the periods specified
in the agreement between X and Z. On or before the date of the transfer of T, X will
notify Z and City of the assignment of X's rights.

Z will sell T to the purchaser and the proceeds of the transaction will be held by Z
pursuant to the exchange agreement. Under the exchange agreement X will convey T to
the purchaser.

X will enter into an agreement to acquire City's property on the condition that at the
time of the conveyance a building will be constructed by City on the property in
accordance with plans and specifications contained in an agreement between X and City.
A construction agreement between Y and City will specify Y as the general contractor to
construct the building. The construction agreement will provide that Y will be entitled to
receive construction draws from Z as the work progresses on the building.

X will assign all of its right, title, and interest in the agreement between it and City to
acquire City's property to Z. The signed agreement will be hand delivered, mailed,
telecopied, or otherwise sent to Z before the end of the identification period specified in
the exchange agreement and will identify the replacement property. Also, X will notify
City of its assignment of rights to Z.
Following completion of the building on RZ will pay all of the remaining funds to City
and City will convey the property R to X. The property will then be leased to B on a
long-term lease.

If no replacement property has been identified prior to the, end of the identification
period, or if the sale and purchase of the replacement property has not been consummated
prior to the end of the exchange period specified in the exchange agreement then the
proceeds from the sale of X's property will be paid to X by Z after the exchange period.

X has made the following representations:

1. It has held the property for productive use in a trade or


business.
2. It will hold the property obtained from City for productive use
in a trade or business for an indefinite period of time.
3. The properties are like-kind property within the meaning of
section 1.1031(A)-1(B) of the Income Tax Regulations.
4. X intends to structure this transaction as a deferred exchange as
defined in section 1031(A)(3) of the Code and section
1.1031(K)-1 of the regulations in which identification of City's
property has already been made in a timely manner and in
which City's property is to be received within the exchange
period (i.e. prior to the earlier of (a) 180 days after the date on
which X transfers its property or (b) the due date (determined
without regard to extension) for X's return of the income tax
imposed under the Internal Revenue Code for the taxable year
in which the transfer of X's property occurs).
5. Z is a qualified intermediary within the meaning of section
1.1031(K)-1(g)(4)(iii) of the regulations.
6. All construction funds drawn by Y arise from Y's performance
under the construction contract and none represent receipts
from the transfer of T, the relinquished property.

EXCHANGE OF INDIVIDUAL INTERESTS ARE: MARITAL TRUSTS:


PRIVATE LETTER RULING 9550021
(see also Private Letter Ruling 9550022)

The issue in this Private Letter Ruling involved marital trusts. The proposed exchange
involved entities controlled by the taxpayer, including a marital trust and a corporation.
The Ruling determined that Code §1031 requirements were met.

PRIVATE LETTER RULING 9550021


Internal Revenue Service (I.R.S.)
1995 WL 743700 (I.R.S.)
Issue: December 15, 1995
September 15, 1995

Dear ____:

This responds to the letter dated January 24, 1995 (and previous correspondence dated
April 15, 1994, August 30, 1994, December 21, 1994, January 12, 1995 and January 18,
1995) concerning the application of the like- kind exchange rules to proposed
transactions. Taxpayer is B Corp. The following facts are represented:

M and G were married in 1929 and had three sons, X, Y and Z. M accumulated
substantial holdings in real estate. In 1937, M established a trust (the 1937 Trust) for the
benefit of G for life with the remainder to be distributed to the sons, per stirpes, 21 years
after the death of G. The 1937 Trust holds various interests in real property. In 1948, M
established the Foundation, an entity exempt from income tax under section 501(c)(3) of
the Internal Revenue Code and a private foundation within the meaning of section 509(a)
of the Code. [FN1] M died in 1964. M's will bequeathed one-half of his residuary estate
to the Foundation, one-quarter to the Marital Trust (established under the will of M) and
the balance to the sons in equal shares.

M's will also granted G a general power of appointment over the corpus of the Marital
Trust exercisable by will. In default of the exercise of such power, the corpus was to pass
in equal one-third shares to the sons. In 1967, G released her power of appointment as to
one-quarter of the Marital Trust corpus, in partial consideration of the settlement of a
dispute with the sons concerning the termination distribution of a certain inter vivos trust.
[FN2] The one-quarter share of the Marital Trust vested in the sons in 1967 and each
son's one-third share of the vested one-quarter interest in the Marital Trust is referred to
as (that son's) "Vested Share." In 1990, one of the sons, X, assigned his Vested Share to
W, who in 1991 further assigned a portion of the Vested Share to the Federal Deposit
Insurance Corporation (FDIC). The remaining three-quarters of the Marital Trust (the
"Non-Vested Share") remained subject to G's general power of appointment.

A Corp is a holding company, created by M, which owns directly or indirectly full or


partial interests in real property. One-third of the stock of A Corp is owned by the Marital
Trust and the other two-thirds is owned by the Foundation. A Corp owns all of the stock
of B Corp which, in turn, owns certain real property assets. In addition, the Marital Trust,
the Foundation, the 1937 Trust, A Corp, B Corp and the sons own, as tenants-in-
common, several other properties in various combinations and proportions.

G died in 1988. By will, she gave the bulk of her estate and appointed the Non-Vested
Share of the Marital Trust to the Foundation.

In June 1989, X and Y initiated a will contest in probate court, alleging that G lacked
testamentary capacity and had been unduly influenced by the appointed personal
representatives of her estate. However, this action was stayed pending the outcome of a
second lawsuit filed by X and Y in probate court in August 1989. This second suit alleges
that, by appointing the Foundation, G had not validly exercised her power of appointment
over the Non- Vested Share. X and Y claimed that the power was not exercisable in favor
of a corporation, such as the Foundation. This latter contest is referred to as the
"construction proceeding." In April 1991, the probate court granted X's and Y's motion
for summary judgment, ordering immediate distribution of the Non-Vested Share of the
Marital Trust to the sons pursuant to the default provisions of the power of appointment.
The Foundation appealed this decision and enforcement of the order was stayed. In
December 1993, the parties to both civil suits entered a Settlement Agreement which, by
its terms, would terminate the litigation between them and substantially eliminate the
common ownership of properties by the parties. To achieve this result as to B Corp, the
following exchange is proposed:

In exchange for B Corp's transfer to the Marital Trust of c% of T-9 and d% of T-10, the
Marital Trust will transfer to B Corp:

a% of T-1,
1/x of T-2,

Taxpayer makes the following additional representations regarding the general


qualifications of the described transactions for tax-free treatment under section 1031 of
the Code:

1. All relinquished properties are held by Taxpayer either for


investment or for productive use in a trade or business and all
replacement property will be held for one of the same purposes.
2. The fair market values of the properties subject to this ruling
were determined by independent appraisal to which all parties
agreed to be bound. The parties utilized such appraisals to
determine that the fair market values of the properties to be
exchanged were approximately equal, taking into account the
amounts of any mortgages to which such properties are subject.
3. All property to be exchanged is real property. [FN3]
4. Section 1031(a)(1) of the Internal Revenue 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.

Section 1031(b) of the Code provides, in part, that if an exchange would be within the
provisions of subsection (a) if it were not for the fact that some property received in the
exchange consists not only of property permitted by such provisions to be received
without the recognition of gain, but also of other property or money, then the gain, if any,
to the recipient shall be recognized, but not in excess of the sum of such money and the
fair market value of such other property.

Section 1031(d) of the code provides, in part, that if property was acquired on an
exchange described in this section, then the basis shall be the same as that of the property
exchanged, decreased in the amount of any money received by the taxpayer and increased
in the amount of gain or decreased in the amount of loss to the taxpayer that was
recognized on such exchange. It further provides that where as part of the consideration
to the taxpayer another party to the exchange assumed a liability of the taxpayer or
acquired from the taxpayer property subject to a liability, such assumption or acquisition
(in the amount of the liability) shall be considered as money received by the Taxpayer on
the exchange.

Section 1.1031(b)-1(c) of the Income Tax Regulations provides, in part, that


consideration received in the form of an assumption of liabilities (or a transfer subject to
a liability) is to be treated as "other property or money," for purposes of section 1031(b).
Where on an exchange described in section 1031(b), each party to the exchange either
assumes a liability of the other party or acquires property subject to a liability, then, in
determining the amount of "other property or money" for purposes of section 1031(b),
consideration given in the form of an assumption of liabilities (or a receipt of property
subject to a liability) shall be offset against consideration received in the form of an
assumption of liabilities (or a transfer subject to a liability). See §1.1031(d)-2, example
(2).

The simultaneous transfers of like-kind properties, of approximately equal value, is


treated as an exchange. In this case, Taxpayer is simultaneously exchanging real property
held for investment solely for other real property to be held for investment. All of the
properties to be exchanged in the proposed transactions are held by two or more of the
parties as tenants in common. The legislative history of section 1031(f) of the Code
suggests that a fractional interest in a fee, i.e., a tenancy in common, is of like kind to a
fee interest in real property. [FN4] Hence, this transaction involves like-kind property
within the meaning of section 1031(a) of the Code.

In the proposed exchange between the Marital Trust and B Corp the parties will be
transferring and receiving real property subject to shares of an existing mortgages. Under
section 1031(d) of the Code and the related regulations cited above, the relief of liability
on a mortgage, whether by its assumption by another party or by transfer of property
subject to a mortgage, equates to the receipt of cash or other property for which gain must
be recognized. Furthermore, the relief of liability as to the Marital Trust is offset by the
amount of any liability to which the property it receives is subject.

Therefore, the Taxpayer will recognize no gain or loss in its exchange with the Marital
Trust in connection with the Settlement Agreement except to the extent required by
application of section 1031(b) of the Code relating to the receipt of money or other
property, including relief from mortgage debt, in connection with the exchange. As to the
mortgage debt, no gain will be recognized with respect to such transfers except to the
extent of the excess, if any, of liabilities transferred over liabilities assumed by Taxpayer.
The scope of this ruling is limited to the land, buildings and fixtures constituting real
property under local law and has no application to the transfer of tangible personal
property, if any, located in or on the real properties to be transferred, where such tangible
personal property does not constitute a fixture under local law.

No opinion is expressed as to the tax treatment of this item(s) (or transaction(s)) under
the provisions of any other section of the Code or regulations which may be applicable
thereto, or the tax treatment of any conditions existing at the time of, or effects resulting
from, the item(s) (or transaction(s)) described which are not specifically covered in the
above ruling. Moreover, the amount of mortgage liability to which T-9 may be subject is
not clear as of the date of this letter. Therefore, we express no opinion as to what extent,
if any, Taxpayer may experience net gain as a result of its transfer and receipt of
mortgage encumbered property or of how Taxpayer's basis in its remaining property may
be affected by its transfer of c% of T-9 subject to the mortgage.

If it is later determined that the values of the properties exchanged are not
approximately equal, there may be a basis for holding that part of the consideration for
the exchange was the receipt of non-like-kind property or may have involved an
exchange of a chose in action, a relinquishment of a chose in action or be taxable as some
other form of income. We express no opinion on the factual question of the relative
values of the exchange properties. In this connection, we note that section 1031(a)(2)(F)
of the Code states that section 1031 shall not apply to any exchange of a chose in action.

EXCHANGE RE: MARITAL TRUSTS:


PRIVATE LETTER RULING 9550022
(see also Private Letter Ruling 9550021)

This Private Letter Ruling is similar to Private Letter Ruling 9550021, with the same
result.

PRIVATE LETTER RULING 9550022


Internal Revenue Service (I.R.S.)
1995 WL 743701 (I.R.S.)
Issue: December 15, 1995
September 15, 1995

Dear ***

This responds to the letter dated January 24, 1995 requesting a private letter ruling (and
other correspondence dated April 15, 1994, August 30, 1994, December 21, 1994,
January 12, 1995, January 18, 1995 and February 6, 1995) concerning the application of
the like-kind exchange rules to proposed transaction. Taxpayer is A Corp. The following
facts are represented:
M and G were married in 1929 and had three sons, X, Y and Z. M accumulated
substantial holdings in real estate. In 1937, M established a trust (the 1937 Trust) for the
benefit of G for life with the remainder to be distributed to the sons, per stirpes, 21 years
after the death of G. The 1937 Trust holds various interests in real property. In 1948, M
established the Foundation, an entity exempt from income tax under section 501(c)(3) of
the Internal Revenue Code and a private foundation within the meaning of section 509(a)
of the Code. [FN1] M died in 1964. M's will bequeathed one-half of his residuary estate
to the Foundation, one-quarter to the Marital Trust (established under the will of M) and
the balance to the sons in equal shares.

M's will also granted G a general power of appointment over the corpus of the Marital
Trust exercisable by will. In default of the exercise of such power, the corpus was to pass
in equal one-third shares to the sons. In 1967, G released her power of appointment as to
one-quarter of the Marital Trust corpus, in partial consideration of the settlement of a
dispute with the sons concerning the termination distribution of a certain inter vivos trust.
[FN2] The one-quarter share of the Marital Trust vested in the sons in 1967 and each
son's one-third share of the vested one-quarter interest in the Marital Trust is referred to
as (that son's) "Vested Share." In 1990, one of the sons, X, assigned his Vested Share to
W, who in 1991 further assigned a portion of the Vested Share to the Federal Deposit
Insurance Corporation (FDIC). The remaining three-quarters of the Marital Trust (the
"Non-Vested Share") remained subject to G's general power of appointment.

A Corp is a holding company, created by M, which owns directly or indirectly full or


partial interests in real property. One-third of the stock of A Corp is owned by the Marital
Trust and the other two-thirds is owned by the Foundation. A Corp owns all of the stock
of B Corp which, in turn, owns certain real property assets. In addition, the Marital Trust,
the Foundation, the 1937 Trust, A Corp, B Corp and the sons own, as tenants-in-
common, several other properties in various combinations and proportions.

G died in 1988. By will, she gave the bulk of her estate and appointed the Non-Vested
Share of the Marital Trust to the Foundation.

In June 1989, X and Y initiated a will contest in probate court, alleging that G lacked
testamentary capacity and had been unduly influenced by the appointed personal
representatives of her estate. However, this action was stayed pending the outcome of a
second lawsuit filed by X and Y in probate court in August 1989. This second suit alleges
that, by appointing the Foundation, G had not validly exercised her power of appointment
over the Non- Vested Share. X and Y claimed that the power was not exercisable in favor
of a corporation, such as the Foundation. This latter contest is referred to as the
"construction proceeding." In April 1991, the probate court granted X's and Y's motion
for summary judgment, ordering immediate distribution of the Non-Vested Share of the
Marital Trust to the sons pursuant to the default provisions of the power of appointment.
The Foundation appealed this decision and enforcement of the order was stayed.

In December 1993, the parties to both civil suits entered a Settlement Agreement
which, by its terms, would terminate the litigation between them and substantially
eliminate the common ownership of properties by the parties. To achieve this result as to
the Taxpayer, the following exchange is proposed:

In exchange for A Corp's transfer to the Marital Trust of b% of T-10, the Marital Trust
will transfer to A Corp c% of T-1, 1/x of T-2, 1/x of T-3, 1/x of T-4, 1/x of T-5, 1/x of T-
6, 1/x of T-7, a% of T-8 and 1/x of T-9.

Taxpayer makes the following additional representations regarding the general


qualifications of the described transactions for tax-free treatment under section 1031 of
the Code:

1. All relinquished properties are held by Taxpayer either for


investment or for productive use in a trade or business and all
replacement property will be held for one of the same purposes.
2. All property to be exchanged is real property.
3. The fair market values of the properties subject to this ruling
were determined by independent appraisal to which all parties
agreed to be bound. The parties utilized such appraisals to
determine that the fair market values of the properties to be
exchanged were approximately equal, taking into account the
amounts of any mortgages to which such properties are subject.

Section 1031(a)(1) of the Internal Revenue 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.

Section 1031(b) of the Code provides, in part, that if an exchange would be within the
provisions of subsection (a) if it were not for the fact that some property received in the
exchange consists not only of property permitted by such provisions to be received
without the recognition of gain, but also of other property or money, then the gain, if any,
to the recipient shall be recognized, but not in excess of the sum of such money and the
fair market value of such other property.

Section 1031(d) of the code provides, in part, that if property was acquired on an
exchange described in this section, then the basis shall be the same as that of the property
exchanged, decreased in the amount of any money received by the taxpayer and increased
in the amount of gain or decreased in the amount of loss to the taxpayer that was
recognized on such exchange. It further provides that where as part of the consideration
to the taxpayer another party to the exchange assumed a liability of the taxpayer or
acquired from the taxpayer property subject to a liability, such assumption or acquisition
(in the amount of the liability) shall be considered as money received by the Taxpayer on
the exchange.

Section 1.1031(b)-1(c) of the Income Tax Regulations provides, in part, that


consideration received in the form of an assumption of liabilities (or a transfer subject to
a liability) is to be treated as "other property or money," for purposes of section 1031(b).
Where on an exchange described in section 1031(b), each party to the exchange either
assumes a liability of the other party or acquires property subject to a liability, then, in
determining the amount of "other property or money" for purposes of section 1031(b),
consideration given in the form of an assumption of liabilities (or a receipt of property
subject to a liability) shall be offset against consideration received in the form of an
assumption of liabilities (or a transfer subject to a liability). See §1.1031(d)-2, example
(2).

In this case, Taxpayer is simultaneously exchanging real property held for investment
solely for other real property to be held for investment. Hence, this transaction involves
like-kind property within the meaning of section 1031(a) of the Code. The simultaneous
transfers of like-kind properties, of approximately equal value, is treated as an exchange.

In the proposed exchange the parties will be transferring real property subject to a share
of an existing mortgage and receiving real property subject to a share of an existing
mortgage. Under section 1031(d) of the Code and the related regulations cited above, the
relief of liability on a mortgage, whether by its assumption by another party or by transfer
of property subject to a mortgage, equates to the receipt of cash or other property for
which gain must be recognized. Furthermore, the relief of liability as to Taxpayer, A
Corp, is offset by the amount of any liability to which the property it receives is subject.

Therefore, Taxpayer will recognize no gain or loss in its exchange with the Marital
Trust in connection with the Settlement Agreement except to the extent required by
application of section 1031(b) of the Code relating to the receipt of money or other
property, including relief from mortgage debt, in connection with the exchange. As to the
mortgage debt, no gain will be recognized with respect to such transfers except to the
extent of the excess, if any, of liabilities transferred over liabilities assumed by Taxpayer.
The scope of this ruling is limited to the land, buildings and fixtures constituting real
property under local law and has no application to the transfer of tangible personal
property, if any, located in or on the real properties to be transferred, where such tangible
personal property does not constitute a fixture under local law.

No opinion is expressed as to the tax treatment of this item(s) (or transaction(s)) under
the provisions of any other section of the Code or regulations which may be applicable
thereto, or the tax treatment of any conditions existing at the time of, or effects resulting
from, the item(s) (or transaction(s)) described which are not specifically covered in the
above ruling. Moreover, the amount of mortgage liability to which T-10 may be subject is
not clear as of the date of this letter. Therefore, we express no opinion as to what extent,
if any, Taxpayer may experience net gain as a result of its transfer and receipt of
mortgage encumbered property or of how Taxpayer's basis in its remaining property may
be affected by its transfer of b% of T-10 subject to the mortgage.

If it is later determined that the values of the properties exchanged are not
approximately equal, there may be a basis for holding that part of the consideration for
the exchange was the receipt of non-like-kind property or may have involved an
exchange of a chose in action, a relinquishment of a chose in action or be taxable as some
other form of income. We express no opinion on the factual question of the relative
values of the exchange properties. In this connection, we note that section 1031(a)(2)(F)
of the Code states that section 1031 shall not apply to any exchange of a chose in action.

MULTIPLE ENTITIES: CORPORATIONS AND LLCS:


PRIVATE LETTER RULING 9751012

In this Ruling, the taxpayer was a U.S. holding company, owned in part by a foreign
corporation. However, the taxpayer, the U.S. holding company, owned all of the stock of
two (2) subsidiaries. The subsidiaries were transferring their old to properties to a
qualified intermediary under Code §1031 and the Regulations under §1.1031(k).

On or before the 45 days after the transfer of the properties by the subsidiaries, the
subsidiaries would identify the property desired for replacement property, and then would
be liquidated.

After this event, the taxpayer would form separate Limited Liability Companies (LLC),
and each replacement property would be received by an LLC.

The taxpayer requested the Ruling that it would be treated as both the transferor of the
relinquished property, and the transferee of the properties that were involved. The
taxpayer also requested that the transactions would qualify under Code §1031.

The Ruling held that such transactions would qualify under Code §1031. Thus, this is
another example of the use of multiple entities, and to have the replacement property
flow into a new entity formed at the time of the exchange but controlled by the taxpayer-
relinquishing entity.

ENTITIES: USE OF LLCs, LIQUIDATION, ETC.:


PRIVATE LETTER RULING 9850001
1998 WL 855386

This Ruling involved a complicated set of facts in which there were multiple transfers
with the desire to obtain a tax-deferred position under Code §1031. Although the Ruling
involved a foreign corporation, U.S. holding company, LLCs, liquidations, etc., the focus
for purposes of the exchange issue was whether a liquidation of one of the entities into
another entity would constitute a violation of the replacement requirement under Code
§1031.

There were also questions as to transfers of interests between controlled LLCs.

Without an attempt to rule on other issues involving tax questions on some of the
settings, and with regard to the exchange issue the Ruling, held that the liquidations and
the transfers noted would not violate Code §1031.
PRIVATE LETTER RULING 9850001
Internal Revenue Service (I.R.S.)
1998 WL 855386 (I.R.S.)
Issue: December 11, 1998
August 31, 1998

Dear ___:

This responds to Taxpayer's request for a private letter ruling dated April 8, 1998, as
amended by correspondence dated May 20, 1998, June 15, 1998, and August 26, 1998.
Taxpayer represents the following facts:

P, a foreign corporation, owns, directly or indirectly, 95% of H, a U.S. holding


company, which owns all the outstanding stock of Taxpayer, a U.S. operating company.
H and Taxpayer file a U.S. consolidated return on the basis of a calendar year. P also
owns, directly or indirectly 95% of the stock of S, a U.S. operating company. §is the sole
owner of LLC1, a limited liability company that has not elected pursuant to §301.7701 of
the Regulations on Procedure and Administration to be classified as an association. LLC1
holds an interest in hotel property.

Taxpayer held hotel property for productive use in a trade or business (the relinquished
property). On Date 1, Taxpayer transferred the hotel property to a qualified intermediary,
pursuant to §1.1031(k)-1(g)(4) of the Income Tax Regulations. [FN1] The qualified
intermediary then transferred the property to W. On Date 2 (within 45 days after the
transfer by Taxpayer of the relinquished property), Taxpayer identified like kind
replacement property in accordance with §1031(a)(3)(A) of the Internal Revenue Code.

After the transfer of the relinquished property, but prior to receipt of the replacement
property, Taxpayer formed LLC2, a wholly-owned limited liability company that did not
elect to be treated as an association pursuant to §301.7701 of the regulations. Taxpayer
directed that the replacement property be transferred to LLC2. On Date 3 (within 180
days after the transfer by Taxpayer of the relinquished property and before the due date
of Taxpayer's return for the year of transfer), LLC2 received the replacement property for
use in its trade or business.

At some time after receipt of the replacement property by LLC2, Taxpayer will
liquidate into H. The liquidation will qualify for nonrecognition of gain or loss under
§332 of the Code. H will then merge with S. The merger of H with §will qualify as a
corporate reorganization under §368(a)(1)(A) of the Code.

As a result of the merger of H with S, §will be the sole owner of LLC1 and LLC2. §will
then transfer its interest in LLC2 to LLC1 and both entities will continue in existence.

Under these facts, Taxpayer requests a ruling that the liquidation of Taxpayer into H,
and the merger of H into §will not affect the requirement under §1031(a)(1) that the
replacement property be held by Taxpayer either for the productive use in a trade or
business or for investment. Taxpayer also requests a ruling that the transfer by §of S's
interest in LLC2 to LLC1 will not adversely affect the §1031 exchange involving the
relinquished property and the replacement property.

Section 1031(a)(1) of the Code provides that no gain or loss will be recognized on the
exchange of property held for productive use in a trade or business or for investment if
the property is exchanged solely for property of a like kind which is to be held either for
productive use in a trade or business or for investment. Under §1.1031(a)-1(b) of the
regulations relating to the meaning of the term "like kind," real property is generally
considered to be of like kind to all other real property, whether or not any of the real
property involved is improved. However, under §1031(a)(3), any property received by
the taxpayer (the "replacement property") will be treated as if it is not of a like kind to the
property transferred (the "relinquished property") if the replacement property (a) is not
identified within 45 days of the taxpayer's transfer of the relinquished property, or (b) is
received after the earlier of (i) 180 days after the taxpayer's transfer, or (ii) the due date of
the taxpayer's return for the year in which the taxpayer's transfer occurred.

Section 381(a) of the Code provides that, in the case of the acquisition of assets of a
corporation by another corporation--(1) in a distribution to such corporation to which
§332 (relating to liquidations of subsidiaries) applies; or (2) in a transfer in which §361
applies (relating to nonrecognition of gain or loss to corporations) applies, but only if the
transfer is in connection with a reorganization described in subparagraph (A), (C), (D),
(F) or (G) of §368(a)(1), the acquiring corporation shall succeed to and take into account
as of the close of the day of distribution or transfer, the items of the distributor or
transferor corporation described in 381(c) subject to certain conditions and limitations.

Section 332(a) of the Code generally provides that no gain or loss shall be recognized
on receipt by a corporation of property distributed in complete liquidation of another
corporation.

Section 368(a)(1)(A) of the Code provides that the term "reorganization" includes a
statutory merger or consolidation.

Section 1.381(a)-1(b)(3)(i) of the regulations provides, in part, that §381 does not apply
to the carryover of an item or tax attribute not specified in §381(c) of the Code. Section
381(c) does not refer to like kind exchanges under §1031 of the Code. However, the
legislative history of §381 explains that "[T]he section is not intended to affect the
carryover treatment of an item or tax attribute not specified in the section or the carryover
treatment of items or tax attributes in corporate transactions not described in subsection
(a). No inference is to be drawn from the enactment of this section whether any item or
tax attribute may be utilized by a successor or predecessor corporation under existing
law." H.R.Rep. No. 1337, 83rd Cong., 2d Sess. A135 (1954). See also §1.381(a)-
1(b)(3)(i) of the regulations (to the same effect). In other words, Congress did not intend
the tax attributes listed in §381(c) of the Code to be the exclusive list of attributes
available for carryover. The legislative history further reveals that the purpose of §381 is
to put into practice the policy that "economic realities rather than ... such artificialities as
the legal form of the reorganization" ought to control in the question of whether a tax
attribute from an acquired corporation is to be carried over to the acquiring one. Section
381 was enacted "to enable the successor corporation to step into the 'tax shoes' of its
predecessor corporation without necessarily conforming to artificial legal requirements
which [then existed at the time of its enactment] under court-made law." See S.Rep. No.
1622, 83rd Cong., 2d Sess. 52 (1954).

The special treatment of like kind exchanges under §1031 of the Code has been
explained primarily on two grounds. First, a taxpayer making a like kind exchange has
received property similar to the property relinquished and therefore has not "cashed out"
of the investment in the relinquished property. In addition, administrative problems may
arise with respect to valuing property which is exchanged solely or primarily for similar
property. See, e.g., Staff of the Joint Committee of Taxation, General Explanation of the
Revenue Provisions of the Deficit Reduction Act of 1984, 98th Cong., 2d Sess. 244-5
(1984); Starker v. United States, 602 F.2d 1341, 1352 (9th Cir.1979). These concerns are
equally applicable when, as a result of a liquidation under §332 or a reorganization under
§368(a)(1)(A), a successor corporation obtains ownership of like kind property
previously received by a liquidated or an acquired corporation in a transaction to which
§1031 applies. Accordingly, we conclude that for purposes of §1031(a)(1) there is a
carryover of tax attributes following both a §332 liquidation and a §368(a)(1)(A)
reorganization. Thus, the intervening liquidation and reorganization, under the facts of
this case, will not affect whether the replacement property is held for productive use in a
trade or business or for investment.

Section 301.7701-2(c)(2) of the regulations provides that, in general, a business entity


that has a single owner and is not a corporation (as defined in §301.7701-2(b)) is
disregarded as an entity separate from its owner for federal tax purposes unless the entity
elects to treat itself as an association for federal tax purposes. Because LLC1 and LLC2
each will be disregarded as an entity separate from its owner for federal tax purposes, the
assets of each wholly-owned LLC will be treated as assets of its owner.

Based on the facts presented above, we rule that:

(1) The liquidation of Taxpayer into H, and the merger of H into


S, will have no affect on the requirement under §1031(a)(1)
that the replacement property be held [by Taxpayer] either for
the productive use in a trade or business or for investment.
(2) The transfer by §of its interest in LLC2 to LLC1 will have no
affect on the §1031 exchange of the relinquished property and
the replacement property.

No opinion is expressed as to the application of any other provision of the Code or the
regulations to the transaction at issue or as to the tax treatment of any conditions existing
at the time of, or effects resulting from, the transaction described which are not
specifically covered in the above ruling. In particular, we express no opinion on whether
the liquidation of Taxpayer into H will qualify under §332 of the Code or whether the
merger of H into §qualifies as a reorganization described under §368(a)(1)(A).

EXCHANGE INVOLVING NUMEROUS REPLACEMENT PROPERTIES:


SEPARATE ENTITIES:
PRIVATE LETTER RULING 9807013

In Private Letter Ruling 9807013, the taxpayer requested a favorable ruling where the
taxpayer, a limited partnership, was relinquishing property to an intermediary. In turn, the
taxpayer would form a separate entity for each replacement property that would be
acquired, since a series of replacement properties was involved. Each replacement entity
would receive a separate replacement property from the intermediary in the overall
exchange.

The taxpayer, the partnership, would be the sole owner of the ownership interest in
each replacement entity. Assuming the property was otherwise qualified, the ruling
supported the Code §1031 to qualify treatment of this exchange. Thus, this illustrates the
use of separate entities to hold the replacement properties.

However, note that the relinquishing entity continues to be the sole owner of all of the
other multiple entities that were formed to acquire the replacement property.

PRIVATE LETTER RULING 9807013


Internal Revenue Service (I.R.S.)
Issue: February 13, 1998
November 13, 1997

Dear ____:

This letter responds to your request for a private letter ruling, dated May 16, 1997,
submitted on behalf of Taxpayer. Taxpayer, a State A limited partnership, requests a
ruling that the receipt of several parcels of real property (each parcel is a "Replacement
Property", collectively, the parcels are the "Replacement Properties") by an entity owned
by Taxpayer will be treated as the receipt of real property directly by the Taxpayer for
purposes of qualifying the receipt of such Replacement Property for nonrecognition of
gain under §1031 of the Code.

FACTS

Taxpayer, a State A limited partnership, uses the accrual method for maintaining its
accounting books and for preparing its federal income tax returns. The Taxpayer's taxable
year ends on December 31. The Taxpayer's partners are LLC, a State A limited liability
company, and GP, a general partnership organized in State B.

Taxpayer's business operations consist of the ownership and leasing of a single parcel
of improved land. The improvements to the land consist of a commercial office building
and related structures. The land and improvements are leased to a single lessee under a
long-term lease. Collectively, the land and building are referred to as the "Relinquished
Property".

The Relinquished Property serves as security for the Taxpayer's indebtedness. Under
the terms of the indebtedness, Taxpayer is required to hold only the Relinquished
Property.

Taxpayer has determined that it is in its partners' best interests to dispose of the
Relinquished Property. Taxpayer has identified a party interested in acquiring the
Relinquished Property. Each Replacement Property will be subject to indebtedness
("Replacement Indebtedness") secured by that Replacement Property. Taxpayer wishes to
acquire each Replacement Property subject to its Replacement Indebtedness. The terms
of each Replacement Indebtedness require that, for such indebtedness to be taken subject
to as part of an exchange, the Replacement Property securing such Replacement
Indebtedness must be acquired by a single asset entity.

Taxpayer proposes to achieve its business objectives by engaging in the following


actions:

(1) Taxpayer will transfer title to the Relinquished Property


directly to a qualified intermediary (within the meaning of
§1.1031(k)-1(g)(4) of the Income Tax Regulations).
(2) Taxpayer will form a separate entity (a "Replacement Entity")
to take title to each Replacement Property to be received in the
exchange. Accordingly, Taxpayer will form one such entity for
each of the Replacement Properties.
(3) Each Replacement Entity will receive title to its designated
Replacement Property directly from the qualified intermediary
as part of the overall exchange.
(4) Each Replacement Entity will be a "business entity" that is a
"domestic eligible entity" within the meaning of §301.7701-2
and 3 of the regulations.
(5) Taxpayer will be the sole owner of the ownership interests in
each Replacement Entity.
(6) Each Replacement Entity will either: (i) file a timely and
proper election to be disregarded as an entity separate from its
owner pursuant to §301.7701-3 of the regulations, or (ii) will
not file any election pursuant to §301.7701-3(c) regarding its
classification and will instead rely on the default classification
rule for single owner entities pursuant to §301.7701-
3(b)(1)(ii).
(7) Each Replacement Entity will hold its Replacement Property
either for productive use in a trade or business or for
investment, in each case, within the meaning of §1031 of the
Code.
(8) Neither Taxpayer nor any Replacement Entity will be a bank
as defined in §581 of the Code.
(9) Taxpayer has represented that the exchange of the
Relinquished Property for the Replacement Properties will
comply with the requirements of §1.1031(k)-1 of the
regulations relating to the qualification of such exchange for
nonrecognition of gain or loss under §1031(a) of the Code.
LAW AND ANALYSIS

Section 1031(a)(2) 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. Section 1031(a)(2) excludes from
eligibility for nonrecognition treatment any exchange of interests in a partnership, stock,
or certificates of trust or beneficial interest.

Section 301.7701-2(c)(2) of the regulations provides that, in general, a business entity


that has a single owner and is not a corporation (as defined in §301.7701-2(b)) is
disregarded as an entity separate from its owner for federal tax purposes unless the entity
elects to treat itself as an association for federal tax purposes. Because each Replacement
Entity will be disregarded as an entity separate from its owner for federal tax purposes,
the assets of each Replacement Entity will be treated as assets of the Taxpayer.

CONCLUSION

Taxpayer's receipt of the Replacement Properties by the Replacement Entities will be


treated as the receipt of real property directly by the Taxpayer for purposes of qualifying
the receipt of such Replacement Property for nonrecognition of gain under §1031 of the
Code.

Except as specifically ruled above, no opinion is expressed as to the federal tax


treatment of the above transactions under other provisions of the Code and regulations
that may be applicable. No opinion is expressed as to the tax treatment of any conditions
existing at the time of or effects resulting from the transaction that are not specifically
covered by the above ruling. A copy of this letter ruling should be attached to the
appropriate federal income tax returns for the taxable years in which the transactions
described herein are consummated.

This letter ruling is directed only to the taxpayer who requested it. Section 6110(j)(3) of
the Code provides that it may not be used or cited as precedent.

Assistant Chief Counsel


(Income Tax & Accounting)

This document may not be used or cited as precedent. Section 6110(j)(3) of the Internal
Revenue Code.
ENTITY ISSUE: LLC (SOLE) TREATED AS NON-ENTITY:
PRIVATE LETTER RULING MEMORANDUM 9911033
1999 WL 148569

This Ruling captured the question of entities and whether entities involved in a Code
§1031 exchange can meet the requirements of this Section, in particular if the entity is an
LLC. Since the LLC involved a sole owner, and the Ruling stipulated that the LLC would
not file an election to be treated as a corporation, the LLC would be disregarded as an
entity separate from the trust in question, and, therefore, that part of the requirement for
the exchange was met.

The reacquisition of replacement property by the LLC was treated as a direct


acquisition by the trust within the meaning of Code §1031(a)(3).

PRIVATE LETTER RULING 9911033

Internal Revenue Service (I.R.S.)


1999 WL 148569 (I.R.S.)
Issue: March 19, 1999
December 18, 1998

This responds to a letter dated November 10, 1998, and prior correspondence submitted
on behalf of Trust and requesting rulings under ss 1031 and 7701 of the Internal Revenue
Code.

FACTS

You have represented the facts as follows. A is the grantor of Trust. Under §671, all of
the income, deductions, and credits against tax of the trust are treated as those of A for
purposes of computing A's taxable income. On Date1, the trustees of Trust assigned all of
their rights in a contract to sell a parcel of real estate (the Relinquished Property) to
Intermediary pursuant to an exchange agreement dated Date1. Intermediary is a
"qualified intermediary" as defined in §1.1031-1(g)(4) of the Income Tax Regulations.
As required by those regulations, notice of the assignment was given to the buyer on
Date2.

As contemplated by the exchange agreement, Intermediary will acquire like- kind


property (the Replacement Property), and transfer it to Trust. The intent of the parties is
that the transfer of the Relinquished Property and the receipt of the Replacement Property
will constitute a nontaxable deferred exchange under §1031(a)(3). Consistent with the
requirements of that section, Trust identified the Replacement Property that it will
acquire by Date3.

The Replacement Property will be financed by Lender. Lender insists that legal title to
the Replacement Property be held by a bankruptcy remote entity. To satisfy this
requirement, Trust will form a State limited liability company (LLC) pursuant to a
limited liability company agreement (the Agreement) between the Trustees and
Member2, a corporation wholly owned by Trust. To protect the Lender's interest, one of
the members of the Board of Directors of Member2 will be a representative of Lender.
The Replacement Property will be transferred directly to LLC.

Except as otherwise provided in section 7.1 of the Agreement, all decisions of the LLC
will be made solely by Trust. Under section 7.1, for so long as the loan from Lender is,
outstanding without the approval of Member2 (whose Board of Directors vote must be
unanimous) the LLC may not:

(1) file or consent to the filing of a bankruptcy or insolvency


petition or otherwise institute insolvency proceedings;
(2) dissolve, liquidate, merge, consolidate, or sell substantially
all of its assets;
(3) engage in any business activity other than those specified in
its Certificate of Formation;
(4) borrow money or incur indebtedness other than the normal
trade accounts payable and any other indebtedness expressly
permitted by the documents evidencing and securing the
loan from Lender;
(5) take or permit any action that would violate any provision of
any of the documents evidencing or securing the loan from
Lender;
(6) amend the Certificate of Formation concerning any of the
aforesaid items; or
(7) amend any provision of the Agreement concerning any of
the aforesaid items.

With respect to items 2 and 7, the LLC must have the prior written consent of the
Lender.

With the exception of the rights contained in section 7.1, Member2 has no other rights
relating to the management of the LLC. Section 5 of the Agreement provides that all
profits, losses, and credits of the LLC will be allocated to Trust. In addition, all
distributions of net cash flow and capital proceeds will be made entirely to Trust.
Furthermore, upon the dissolution of LLC, Trust will wind up the affairs of LLC in any
manner permitted or required by law, provided that the payment of any outstanding
obligations owed to Lender will have priority over all other expenses or liabilities.

RULINGS REQUESTED

Based on these facts and representations, you have requested that we rule as follows:

(1) The LLC will be treated as having a single owner for purposes
of ss 301.7701-2(c)(2) and 301.7701-3 and, in the absence of
any election to the contrary, will be disregarded as an entity
separate from its owner; and
(2) The acquisition of Replacement Property by the LLC will be
treated as a direct acquisition by Trust for purposes of
§1031(a)(3).
LAW AND ANALYSIS

Section 301.7701-2(a) of the Procedure and Administration Regulations provides that


business entities are entities recognized for federal tax purposes but not properly
classified as trusts under §301.7701-4 or otherwise subject to special treatment under the
Code. A business entity with two or more members is classified for federal tax purposes
as either a partnership or a corporation. Under §301.7701-3(b)(1)(i), a domestic eligible
entity (as defined in §301.7701-3(a)) will be treated as a partnership unless it elects to be
treated as a corporation. A business entity with only one owner is classified as a
corporation or is disregarded as an entity separate from its owner. Under §301.7701-
3(b)(1)(ii), a domestic eligible entity with a single owner is disregarded as an entity
separate from its owner unless it elects to be treated as a corporation under §301.7701-
3(c).

Since LLC is a domestic eligible entity and you have represented that it will not file an
election to be treated as a corporation, its federal tax classification depends upon the
number of members of LLC. The cases of Commissioner v. Tower, 327 U.S. 280 (1946)
and Commissioner v. Culbertson, 337 U.S. 733 (1949), provide general principles
regarding the determination of whether individuals have joined together as partners in a
partnership. The primary inquiry is whether the parties had the intent to join together to
operate a business and share in its profits and losses. The inquiry is essentially factual and
all relevant facts and circumstances must be examined. Furthermore, it is federal, not
state, law that controls for income tax purposes, regardless of how the parties are treated
under state law.

In Herbert M. Luna, 42 T.C. 1067, 1077 (1964), the court stated that the following
factors should be considered in determining whether the parties intended to be a
partnership: (1) the agreement of the parties and their conduct in executing its terms; (2)
whether business was conducted in the joint names of the parties; (3) whether the parties
filed Federal partnership returns or otherwise represented to the Service or to persons
with whom they dealt that they were joint venturers; (4) whether separate books of
account were maintained for the venture; (5) the contributions, if any, which each party
has made to the venture; (6) whether each party was a principal and co-proprietor,
sharing a mutual proprietary interest in the net profits and having an obligation to share
losses, or whether one party was the agent or employee of the other, receiving for his
services contingent compensation in the form of a percentage of income; (7) the parties'
control over income and capital and the right of each to make withdrawals; and (8)
whether the parties exercised mutual control over and assumed mutual responsibility for
the enterprise.
In this case, the members of LLC have not come together to form a partnership for
federal tax purposes because, as evidenced by the LLC agreement, Trust and Member2
did not enter into the Agreement to operate a business and share profits and losses.
Member2 is a member of LLC for the sole limited purpose of preventing Trust from
placing LLC into bankruptcy on its own volition. Member2 has no interest in LLC's
profits or losses and neither manages the enterprise nor has any management rights other
than those limited rights described above. Thus, for federal tax purposes LLC will not be
treated as a partnership between Trust and Member2 but rather as being owned solely by
Trust. Because Trust is the sole owner of LLC and LLC will not elect to be treated as a
corporation for federal tax purposes, LLC will be disregarded as an entity separate from
Trust. Accordingly, the transfer of Replacement Property to LLC will be treated as a
transfer of the Replacement Property to Trust for purposes of §1031(a)(3).

CONCLUSION

Based on the facts submitted and the representations made, we rule as follows:

(1) Provided that LLC does not file an election to be treated as a


corporation for federal tax purposes under §301.7701-3(c),
LLC will be disregarded as an entity separate from Trust; and
(2) The acquisition of Replacement Property by LLC will be
treated as a direct acquisition by Trust for purposes of
§1031(a)(3).

Except as specifically ruled on above, no opinion is expressed or implied concerning


the federal tax consequences of the facts described above under any other provisions of
the Code. In particular, no opinion is expressed concerning whether the transaction
described above otherwise meets the requirements for nonrecognition of gain treatment
under §1031.

This ruling is directed only to the taxpayer requesting it. Section 6110(j)(3) provides
that it may not be used or cited as precedent.

Sincerely yours

****

This document may not be used or cited as precedent. Section 6110(j)(3) of the Internal
Revenue Code.

PRIVATE LETTER RULING 9929009

FSA 9929009
Internal Revenue Service (I.R.S.)
Field Service Advisory
Issue: July 23, 1999
April 15, 1999
1999 WL 525830 (I.R.S.)

INTERNAL REVENUE SERVICE NATIONAL OFFICE


FIELD SERVICE ADVICE MEMORANDUM FOR
FROM DEBORAH A. BUTLER ASSISTANT CHIEF COUNSEL
(FIELD SERVICE) CC:DOM:FS

SUBJECT:

Like Kind Exchange between Parent and Subsidiary

This Field Service Advice responds to your request dated January 13, 1999, wherein
you asked that we reconsider aspects of our earlier advice of November 25, 1996,
regarding the subject taxpayer. This Field Service Advice is not binding on Examination
or Appeals and is not a final case determination. This document may not be cited as
precedent.

ISSUE:

Whether the Service can take the position that an exchange of certain equipment among
corporations within Taxpayer's consolidated group does not qualify as a tax-free
exchange under I.R.C. §1031.

CONCLUSION:

The Service could correctly, as a matter of law and policy, challenge nonrecognition
treatment here and assert that the transactions involved do not qualify under section 1031.

FACTS:

Taxpayer owns, operates, leases and sells Equipment and Equipment parts. In Year 1,
Taxpayer and Corp. A entered into an agreement for the sale of Y used Equipment. The
transfer of X of that used Equipment is in issue here.

Taxpayer's basis in the Equipment had been substantially reduced by depreciation over
the years by the time it had agreed to sell the used Equipment to Corp. A. Thus,
purportedly, in order to avoid a large gain on the sale of this Equipment, Taxpayer
entered into "tax-free" exchange agreements with two of its subsidiaries whereby the
used Equipment of Taxpayer was swapped for certain new Equipment recently purchased
directly by the subsidiaries from an individual shareholder.

The new Equipment had a relatively high basis compared to the long- depreciated basis
of the old Equipment. The subsidiaries then transferred the Equipment to Corp. A to
satisfy Taxpayer's obligation under the sales agreement with Corp A. The subsidiaries
apparently recognized and reported the minimal gain made on the transfer to Corp. A of
the old Equipment (which now carried a much higher basis in the hands of the
subsidiaries). If allowed, therefore, the transaction enabled Taxpayer to avoid the large
gain inherent in a direct sale of its used Equipment as well as to escape any required
recapture of depreciation taken on that Equipment.

LAW AND ANALYSIS:

Section 1031(a) 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 a like kind which is also to be held for productive use
in a trade or business or for investment. The "touchstone" of section 1031 is the
requirement that "there be an exchange of like-kind properties rather than a cash sale"
and reinvestment of proceeds. Young v. Commissioner, T.C. Memo. 1985-221.

An exchange is not limited to reciprocal transfers between two parties. Multiple-party


and "accommodating" party exchanges are certainly allowed. [FN1] Where a party acts as
a mere conduit or agent for the taxpayer, however, the exchange is not cognizable under
section 1031. Coupe v. Commissioner, 52 T.C. 394, at 406 (1969). Similarly, passing the
property to a "sham" or "strawman" also fails the test. See Garcia v. Commissioner, 80
T.C. 491, at 500-01 (1983).

As we discussed in our earlier memorandum, Congress has recognized the inherent tax-
avoidance motivations of exactly the type of transaction presented here. It passed section
1031(f) to end those possibilities by requiring a longer holding period for the related
party swap to be allowed nonrecognition. Section 1031(f), however, was not in effect for
the year in issue; consequently, it is unavailable to challenge this deal. We note also that
even under new section 1031(f), related party exchanges are not universally barred. Such
swaps merely carry a longer holding requirement.

Where a wholly-owned subsidiary purchased new trucks from a manufacturer, while its
parent sold its used trucks to the same manufacturer, the transaction was treated as
merely a tax-free exchange between the related corporations and not as a separate sale
and purchase. Redwing Carriers, Inc. v. Tomlinson, 399 F.2d 652 (5 superth Cir. 1968).
In Redwing Carriers, it was the Government successfully seeking to invoke section 1031
treatment. The swapping parties' interrelationship, however, was never made an issue.

There are numerous other instances where related parties attempting to effect a section
1031 transaction went unchallenged on that particular ground. See, e.g., Coastal
Terminals, Inc. v. United States, 320 F.2d 333 (4 superth Cir 1963); Rev. Rul. 72-151,
1972-1 C.B. 225 (sole shareholder and corporation); Rev. Rul. 72-601, 1972-2 C.B. 467
(father and son). Moreover, in Boise Cascade Corp. v. Commissioner, T.C. Memo. 1974-
315, the Service argued, and the court's opinion acknowledged, that the parent/subsidiary
relationship of the swapping parties in and of itself had no effect on the availability of
section 1031 treatment to the transaction involved.
CASE DEVELOPMENT, HAZARDS, AND OTHER CONSIDERATIONS:

FN1. In the accommodating buyer cases, the buyer, under taxpayer's specific direction,
buys the property that the taxpayer wishes to acquire before the exchange takes place. In
those circumstances, the exchange qualifies under section 1031 for the taxpayer but not
with respect to the accommodating buyer. That is because the buyer did not acquire the
property it eventually passed on to the taxpayer with the requisite holding intent. Rev.
Rul. 77-297, 1977-2 C.B. 304.

This document may not be used or cited as precedent. Section 6110(j)(3) of the Internal
Revenue Code.

RELATED PARTIES:
PRIVATE LETTER RULING 9931002
(FSA-FIELD SERVICE MEMORANDUM 9931002),
1999 WL 589318

The issue in this Field Service Advice was whether the taxpayer could undertake a tax-
deferred transaction or whether it violated Code §1031(f) as to related parties. The
government held that the related party rule applied. However, part of the issue was
whether the adjustment, because of an early disposition, would take place in the year of
disposition, or a different year.

The government held that the adjustment should take place ". . . in the year the
replacement property is disposed of notwithstanding the fact that an adjustment could
have been made in a prior year under Section 1031(f)(4)." Thus, the government
contended that the taxable income would come into play in the year the replacement
property was disposed; this was controlled under Code §1031(f)(1).

FOR EDUCATIONAL USE ONLY


Copr. © West 1999 No Claim to Orig. U.S. Govt. Works

PRIVATE LETTER RULING 9931002


FSA 9931002

Field Service Advisory


Issue: August 6, 1999
April 12, 1999
1999 WL 589318 (I.R.S.)

This Field Service Advice responds to your memorandum dated January 13, 1999.
Field Service Advice is not binding on Examination or Appeals and is not a final case
determination. This document is not to be cited as precedent.

ISSUE(S):
1. Whether Taxpayer was entitled to nonrecognition of gain
treatment under I.R.C. §1031(a) in Year 2 on the exchange of
Property X for an interest in Property Z.
2. Whether there are grounds either under section 1031(f)(1), or
under another theory for including the gain on the exchange of
Property X in Year 3.
CONCLUSION(S):
1. Taxpayer was not entitled to nonrecognition of gain on the
exchange of Property X for an interest in Property Z in Year 2
under section 1031(a) because the transaction was structured to
avoid the purposes of section 1031(f). Therefore, Taxpayer is
subject to an adjustment in Year 2.
2. Although under section 1031(f)(4) it is proper to recognize the
gain from the exchange of Property X in Year 2, we believe that,
under the circumstances presented in this case, section 1031(f)(1)
also supports an argument that the gain may be included in Year
3.
FACTS:

We rely on the facts set forth in your memorandum of January 13, 1999.

Father is a real estate developer. Father and his four children have interests in several
related entities involved in developing real estate.

Prior to Year 1, E, a corporation owned by Father, purchased Property X from an


unrelated party. Property X was eventually transferred in equal shares to the four
children. The property was held as tenants-in-common by the four children under the
name A. A leased Property X to B, a joint venture owned by Father, Child 1, Child 2 and
two unrelated parties. B constructed Property Y on Property X. The entire property,
Property XY, was leased to G.

Also prior to Year 1, Related Party, obtained financing from Lender to construct
Property Z. The loan was secured, in part, by a second trust deed and assignment of rents
on Property XY. Related Party is a corporation partially owned by Father, Child 1 and
Child 3. Father, Child 1 and Child 3 own approximately 72% of the stock of Related
Party.

In Year 1, A and B entered into an agreement with Third Party 1 for the sale of
Property XY. The parties decided to structure the transaction as a like-kind exchange
under section 1031. To facilitate the exchange, on Date 1 Taxpayer was formed as a
general partnership by Child 1, Child 2, Child 3 and Child 4 as equal partners. D, a
Subchapter §corporation, was incorporated by Child 2, Child 3 and Child 4, who
contributed their interests in Taxpayer in exchange for equal shares of stock in D. In
addition, C was formed as a limited partnership. Child 1 is the general partner and owns a
2.75% interest in C. Father and Child 2 are limited partners and together own an 88%
interest in C.
In order to effectuate the like-kind exchange, on Date 1 A contributed its interest in
Property X to Taxpayer and B contributed its interest in Property Y to C. A and B
assigned to Taxpayer and C their respective interests in the purchase agreement with
Third Party 1. In addition, Taxpayer and C entered into written exchange agreements
with Qualified Intermediary. Under the agreements, Taxpayer and C agreed to transfer
Property XY to Qualified Intermediary to complete the like-kind exchange.

Also on Date 1, Related Party entered into two purchase agreements with Qualified
Intermediary. Under the agreements, Qualified Intermediary agreed to purchase an
undivided 88% interest in Property Z plus assume some or all of the loan from Lender.
When the exchange was completed, Qualified Intermediary agreed to transfer a 51%
interest in Property Z to Taxpayer and a 37% interest to C.

On Date 2, the loan from Lender was modified to allow for the release of Property XY
from the second deed of trust. In exchange for the release of its security interest in
Property XY, Lender was paid an amount from the net proceeds from the sale of the
property to Third Party 1. The facts concerning the exact timing of the exchange are
unclear; however, it is our understanding that the exchange occurred on or about Date 2.
At this point Third Party 1 received Property XY and Taxpayer and C received 51% and
37% interests in Property Z, respectively.

On Date 3 in Year 3, Taxpayer, C and Related Party sold their interests in Property Z to
Third Party 2. At this time Taxpayer, C and Related Party were released from their
remaining obligations under the loan from Lender.

Taxpayer reported a loss on the sale of its interest in Property Z on its federal income
tax return for Year 3. In addition, Taxpayer reported cancellation of indebtedness income.

Examination has issued a Notice of Final Partnership Administrative Adjustment


(FPAA) to Taxpayer for Year 3. One of the adjustments requires Taxpayer to recognize
gain from the exchange of Property X. The adjustment, made to taxable income in Year
3, is based on the determination that the property received in the exchange with Related
Party was disposed of within 2 years from the date of the exchange. Therefore, under
1031(f)(1), there is no nonrecognition of the gain from the exchange. Year 2 was not a
subject of the examination and no adjustments were proposed for that year.

CHAPTER 8
LEASEHOLDS AND EXCHANGES: MARSH

Under Treas. Regs. §1.1031(a)-1(c), there is an interpretive problem as to whether a


lease constitutes a fee interest for purpose of an exchange. The question is whether A has
a tax-deferred exchange under Section 1031 where he transfers a leasehold interest in
exchange for a fee, or transfers a fee in exchange for a lease. The Regulations provide
that, if otherwise qualified, it will qualify for tax-deferred exchange treatment under
Section 1031 so long as the lease has 30 years or more to run. (See above-noted
Regulation.)
However, there can be unusual twists to the given case. In Jordan Marsh Co., the
department store conveyed the real estate where the store was located. Subsequently,
within the same transaction, there was a leaseback for 30 years, plus a few days. The
argument by the taxpayer was that there was a recognizable loss since there was a sale for
the value of property, and it did not constitute an exchange.

The government argued that the leasehold interest was substantial enough to constitute
a fee; therefore, it was an exchange under Section 1031 and any loss would not be
recognized. The court held that it was not an exchange; therefore, the loss was
recognizable.

The government issued its nonacquiescence to the position of Jordan Marsh; Rev. Rul.
60-43, 1960-1 C.B. 687 (see also Levine, West text, Section 387).

JORDAN MARSH COMPANY, Petitioner,


v.
COMMISSIONER OF INTERNAL REVENUE, Respondent.

59-2 U.S.T.C. Para. 9641,


269 F.2d 453 (2nd Cir. 1959)

HINCKS, Circuit Judge.

This is a petition to review an order of the Tax Court, which upheld the Commissioner's
deficiency assessment of $2,101,823.39 in income and excess profits tax against the
petitioner, Jordan Marsh Company. There is no dispute as to the facts, which were
stipulated before the Tax Court and which are set forth in substance below.

The transactions giving rise to the dispute were conveyances by the petitioner in 1944
of the fee of two parcels of property in the city of Boston where the petitioner, then as
now, operated a department store. In return for its conveyances the petitioner received
$2,300,000 in cash which, concededly, represented the fair market value of the
properties. The conveyances were unconditional, without provision of any option to
repurchase. At the same time, the petitioner received back from the vendees leases of the
same properties for terms of 30 years and 3 days, with options to renew for another 30
years if the petitioner-lessee should erect new buildings thereon. The vendees were in no
way connected with the petitioner. The rentals to be paid under the leases concededly
were full and normal rentals so that the leasehold interests which devolved upon the
petitioner were of no capital value.

In its return for 1944, the petitioner, claiming the transaction was a sale under 112(a),
Internal Revenue Code of 1939,[FN1] sought to deduct from income the difference
between the adjusted basis of the property and the cash received. The Commissioner
disallowed the deduction, taking the position that the transaction represented an exchange
of property for other property of like kind. Under Section 112(b)(1) such exchanges are
not occasions for the recognition of gain or loss; and even the receipt of cash or other
property in the exchange of the properties of like kind is not enough to permit the
taxpayer to recognize loss. Section 112(e).[FN2] Thus the Commissioner viewed the
transaction, in substance, as an exchange of a fee interest for a long term lease, justifying
his position by Treasury Regulation 111, 29.112(b)(1)-1, which provides that a leasehold
of more than 30 years is the equivalent of a fee interest.[FN3] Accordingly the
Commissioner made the deficiency assessment stated above. The Tax Court upheld the
Commissioner's determination. Since the return was filed in New York, the case comes
here for review. 26 U.S.C.A. 7482.

Upon this appeal, we must decide whether the transaction in question here was a sale or
an exchange of property for other property of like kind within the meaning of 112(b) and
112(e) of the Internal Revenue Code cited above. If we should find that it is an exchange,
we would then have to decide whether the Commissioner's regulation, declaring that a
leasehold of property of 30 years or more is property 'of like kind' to the fee in the same
property, is a reasonable gloss to put upon the words of the statute. The judge in the Tax
Court felt that Century Electric Co. v. Commissioner of Internal Rev., 8 Cir., 192 F.2d
155, certiorari denied 342 U.S. 954, 72 S.Ct. 625, 96 L.Ed. 708, affirming 15 T.C. 581,
was dispositive of both questions. In the view which we take of the first question, we do
not have to pass upon the second question. For we hold that the transaction here was a
sale and not an exchange.

The controversy centers around the purposes of Congress in enacting 112(b), dealing
with non-taxable exchanges. The section represents an exception to the general rule,
stated in 112(e), that upon the sale or exchange of property the entire amount of gain or
loss is to be recognized by the taxpayer. The first Congressional attempt to make certain
exchanges of this kind non-taxable occurred in Section 202(c), Revenue Act of 1921, c.
135, 42 Stat. 227. Under this section, no gain or loss was recognized from an exchange of
property unless the property received in exchange had a 'readily realizable market value.'
In 1924, this section was amended to the form in which it is applicable here. Discussing
the old section the House Committee observed:

'The provision is so indefinite that it cannot be applied with accuracy or with


consistency. It appears best to provide generally that gain or loss is recognized from all
exchanges, and then except specifically and in definite terms those cases of exchanges in
which it is not desired to tax the gain or allow the loss. This results in definiteness and
accuracy and enables a taxpayer to determine prior to the consummation of a given
transaction the tax liability that will result.' (Committee Reports on Rev.Act of 1924,
reprinted in Int.Rev.Cum.Bull.1939-1 (Part 2), p. 250.)

Thus the 'readily realizable market value' test disappeared from the statute. A later
report, reviewing the section, expressed its purpose as follows:

'The law has provided for 12 years that gain or loss is recognized on exchanges of
property having a fair market value, such as stocks, bonds, and negotiable instruments; on
exchanges of property held primarily for sale; or on exchanges of one kind of property
for another kind of property; but not on other exchanges of property solely for property of
like kind. In other words, profit or loss is recognized in the case of exchanges of notes or
securities, which are essentially like money; or in the case of stock in trade; or in case the
taxpayer exchanges the property comprising his original investment for a different kind
of property; but if the taxpayer's money is still tied up in the same kind of property as that
in which it was originally invested, he is not allowed to compute and deduct his
theoretical loss on the exchange, nor is he charged with a tax upon his theoretical profit.
The calculation of the profit or loss is deferred until it is realized in cash, marketable
securities, or other property not of the same kind having a fair market value.' (House
Ways and Means Committee Report, reprinted in Int.Rev.Cum.Bull.1939-1 (Part 2), p.
564.)[FN4]

These passages lead us to accept as correct the petitioner's position with respect to the
purposes of the section. Congress was primarily concerned with the inequity, in the case
of an exchange, of forcing a taxpayer to recognize a paper gain which was still tied up in
a continuing investment of the same sort. If such gains were not to be recognized,
however, upon the ground that they were theoretical, neither should equally theoretical
losses. And as to both gains and losses the taxpayer should not have it within his power to
avoid the operation of the section by stipulating for the addition of cash, or boot, to the
property received in exchange. These considerations, rather than concern for the
difficulty of the administrative task of making the valuations necessary to compute gains
and losses,[FN5] were at the root of the Congressional purpose in enacting 112(b)(1) and
(e). Indeed, if these sections had been intended to obviate the necessity of making
difficult valuations, one would have expected them to provide for nonrecognition of gains
and losses in all exchanges, whether the property received in exchanges were 'of a like
kind' or not of a like kind. And if such had been the legislative objective, 112(c), [FN6]
providing for the recognition of gain from exchanges not wholly in kind, would never
have been enacted.

That such indeed was the legislative objective is supported by Portland Oil Co. v.
Commissioner of Internal Revenue, 1 Cir., 109 F.2d 479. There Judge Magruder, in
speaking of a cognate provision contained in 112(b), said at page 488:

'It is the purpose of Section 112(b)(5) to save the taxpayer from an immediate
recognition of a gain, or to intermit the claim of a loss, in certain transactions where gain
or loss may have accrued in a constitutional sense, but where in a popular and economic
sense there has been a mere change in the form of ownership and the taxpayer has not
really 'cashed in' on the theoretical gain, or closed out a losing venture.'

In conformity with this reading of the statute, we think the petitioner here, by its
unconditional conveyances to a stranger, had done more than make a change in the form
of ownership: it was a change as to the quantum of ownership whereby, in the words just
quoted, it had 'closed out a losing venture.' By the transaction its capital invested in the
real estate involved had been completely liquidated for cash to an amount fully equal to
the value of the fee. This, we hold, was a sale-- not an exchange within the purview of
112(b).
The Tax Court apparently though it of controlling importance that the transaction in
question involved no change in the petitioner's possession of the premises: it felt that the
decision in Century Electric Co. v. Commissioner of Internal Rev., supra, controlled the
situation here. We think, however, that that case was distinguishable on the facts. For
notwithstanding the lengthy findings made with meticulous care by the Tax Court in that
case, 15 T.C. 581, there was no finding that the cash received by the taxpayer was the full
equivalent of the value of the fee which the taxpayer had conveyed to the vendeelessor,
and no finding that the lease back called for a rent which was fully equal to the rental
value of the premises. Indeed, in its opinion the Court of Appeals pointed to evidence that
the fee which the taxpayer had 'exchanged' may have had a value substantially in excess
of the cash received. [FN7] And in the Century Electric case, the findings showed, at
page 585, that the taxpayer-lessee, unlike the taxpayer here, was not required to pay
'general state, city and school taxes' because its lessor was an educational institution
which under its charter was exempt from such taxes. Thus the leasehold interest in
Century Electric on this account may well have had a premium value. [FN8] In the
absence of findings as to the values of the properties allegedly 'exchanged,' necessarily
there could be no finding of a loss. And without proof of a loss, of course, the taxpayer
could not prevail. Indeed, in the Tax Court six of the judges expressly based their
concurrences on that limited ground. 15 T.C. 596.

In the Century Electric opinion it was said, 192 F.2d at page 159:

'* * * Subsections 112(b)(1) and 112(e) indicate the controlling policy and purpose of
the section, that is, the nonrecognition of gain or loss in transactions where neither is
readily measured in terms of money, where in theory the taxpayer may have realized gain
or loss but where in fact his economic situation is the same after as it was before. * * * *

Here plainly the petitioner by the transfer finally closed out a losing venture. And it
cannot justly be said that the economic situation of the petitioner was unchanged by a
transaction which substituted $2,300,000 in cash for its investment in real estate and left
it under a liability to make annual payments of rent for upwards of thirty years. Many
bona fide business purposes may be served by such a transaction. * * * *

In ordinary usage, an 'exchange' means the giving of one piece of property in return for
another[FN10] -- not, as the Commissioner urges here, the return of a lesser interest in a
property received from another. It seems unlikely that Congress intended that an
'exchange' should have the strained meaning for which the Commissioner contends. For
the legislative history[FN11] states expressly an intent to correct the indefiniteness of
prior versions of the Act by excepting from the general rule 'specifically and in definite
terms those cases of exchanges in which it is not desired to tax the gain or allow the loss.'

But even if under certain circumstances the return of a part of the property conveyed
may constitute an exchange for purposes of 112, we think that in this case, in which cash
was received for the full value of the property conveyed, the transaction must be
classified as a sale. * * * *
Reversed.

FN1. '112. Recognition of gain or loss--'(a) General rule. Upon the sale or exchange of
property the entire amount except as hereinafter provided in this section.' 26 U.S.C.A.
112.

FN2. '112. Recognition of gain or loss--'(b) Exchanges solely in kind-- (1) Property
held for productive use in trade or business or for investment * * * * '(e) Loss from
exchanges not solely in kind. If an exchange would be within the provisions of subsection
(b)(1) to (5), inclusive, or (10), or within the provisions of subsection (1), of this section
if it were not for the fact that the property received in exchange consists not only of
property permitted by such paragraph to be received without the recognition of gain or
loss, but also of other property or money, then no loss from the exchange shall be
recognized.'

FN3. 'Reg. 111, Sec. 29.112(b)(1)-1. Property Held for Productive Use in Trade or
Business or for Investment.-- As used in section 112(b)(1), the words 'like kind' have
reference to the nature or character of the property and not to its grade or quality. One
kind or class of property may not, under such section, be exchanged for property of a
different kind or class. The fact that any real estate involved is improved or unimproved
is not material, for such fact relates only to the grade or quality of the property and not to
its kind or class. Unproductive real estate held by one other than a dealer for future use or
future realization of the increment in value is held for investment and not primarily for
sale. 'No gain or loss is recognized if (1) a taxpayer exchanges property held for
productive use in his trade or business, together with cash, for other property of like kind
for the same use, such as a truck for a new truck or a passenger automobile for a new
passenger automobile to be used for a like purpose, or (2) a taxpayer who is not a dealer
in real estate exchanges city real estate for a ranch or farm, or a leasehold of a fee with 30
years or more to run for real estate, or improved real estate, or (3) a taxpayer exchanges
investment property and cash for investment property of a like kind.'

FN4. Emphasis supplied.

FN5. In Century Electric Co. v. Commissioner of Internal Rev., supra, 192 F.2d at page
159, the court thought that in the enactment of 112 Congress 'was concerned with the
administrative problem involved in the computation of gain or loss in transactions of the
character with which the section deals.' But so far as appears from the opinion the
attention of the court had not been called to the legislative history of the section set forth
earlier in this opinion.

FN6. '112. '(c) Gain from exchanges not solely in kind. (1) If an exchange would be
within the provisions of subsection (b)(1), (2), (3), or (5), or within the provisions of
subsection (1), of this section if it were not for the fact that the property received in
exchange consists not only of property permitted by such paragraph or by subsection (1)
to be received without the recognition of gain, but also of other property or money, then
the gain, if any, to the recipient shall be recognized, but in an amount not in excess of the
sum of such money and the fair market value of such other property.'

FN10. Trenton Cotton Oil Co. v. Commissioner, supra (109 F.2d 489).

REVENUE RULING 76-301

This Ruling looked to the issue as to the potential of tax-deferred treatment under Code
Section 1031 when exchanging a lease and leasehold improvements in a building in
exchange for the leaseback of a portion of the building and certain payments.

REVENUE RULING 76-301


1976-2 C.B. 241

Advice has been requested concerning the treatment for Federal income tax purposes of
the transfer of a lease and leasehold improvements in a building in return for the
leaseback of a portion of the building and money under the circumstances described
below.

X corporation is engaged in the retail clothing business. Its main store is located in the
first five stories and basement of a 20-story building. The entire building was leased by X
in 1940 under a lease agreement that ends on June 30, 2000.

At all times since 1940 X has used the first five floors and basement for its retail
operations. The balance of the building (15 floors) was made into office space and sublet
to others. Prior to January 2, 1973, X made various leasehold improvements most of
which benefitted the entire building (elevators, air conditioning, boilers, and similar
improvements).

On January 2, 1973, X consummated a transaction with Z, an unrelated corporation,


whereby Z acquired X's entire leasehold interest including all of X's leasehold
improvements, except those that only benefitted the retail store. The agreement between
X and Z called for a sublease to X for the full term of the underlying lease with respect to
the first five floors and basement of the building. The agreement also provided for a
payment of 1,000x dollars purchase price by Z determined by the valve of the leasehold
interest and improvements of floors 6 through 20 of the building. X's adjusted basis of the
nonretail store leasehold interest and improvements (except those improvements
attributable to the retail store) was 1,200x dollars.

The specific question in the instant case is whether an exception to the application of
section 1031(a) and (c) of the Internal Revenue Code of 1954, which precludes
recognition of loss may be justified because the transaction results in the disposition of
the portion of the property used in connection with one of X's two businesses. If an
exception is applicable, X will recognize a 200x dollar loss.
Section 1031(a) of the Code provides, in part, that no gain or loss shall be recognized if
property held for productive use in trade or business or for investment is exchanged
solely for property of a like kind to be held either for productive use in a trade or business
or for investment.

An exchange is considered to occur for the purposes of section 1031 of the Code if the
transfers of the like kind property are reciprocal. Rev. Rul. 61-119, 1961--1 C.B. 395.
Moreover, the reciprocal transfer of interests in like kind property is an exchange for the
purposes of section 1031 even though the interests are in the same property. See Century
Electric Co. v. Commissioner, 192 F.2d 155 (8th Cir. 1951), cert. denied, 342 U.S. 954
(1952), where a loss sustained on the sale of business property by a taxpayer was
disallowed were it immediately leased back the same property under a long-term lease.

Section 1.1031(a)--1(a) of the Income Tax Regulations provides that property held for
productive use in trade or business may be exchanged for property held for investment.
Similarly, property held for investment may be exchanged for property held for
productive use in a trade or business.

Section 1.1031(a)--1(b) of the regulations provides that the words 'like kind' in section
1031 of the Code have reference to the nature and character of the property and not its
grade or quality. Furthermore, no gain or loss is recognized as a result of the exchange by
a taxpayer, who is not a dealer in real estate, of city real estate for a ranch or farm, or a
leasehold of a fee with 30 years or more to run for real estate, or improved real estate for
unimproved real estate. Section 1.1031(a)--1(c) of the regulations. Thus, the exchange of
a long term leasehold interest in a building in return for an identical leasehold interest in
another building or a portion of a building would qualify as a like kind exchange subject
to section 1031.

Section 1031(c) of the Code provides, in part, that if an exchange would be within the
provisions of section 1031(a) if it were not for the fact that the property received in
exchange consists not only of property permitted by such provisions to be received
without the recognition of gain or loss, but also of other property or money, then no loss
from the exchange shall be recognized.

Consequently, the assignment of the leasehold interest in the building in the instant case
in return for an identical leasehold interest in a portion of the building qualifies as an
exchange of property for like kind property and money subject to section 1031(c) of the
Code.

The fact that the transaction results in the disposition of the portion of the property used
in one of the taxpayer's two businesses is not significant for the purposes of section 1031
of the Code. Section 1.1031(a)--1(a) of the regulations. Rather, the significant factor for
the purposes of section 1031 is that the taxpayer's investment is still tied up in the same
kind of property. See H.R .Rep. No. 704, 73d Cong., 2d Sess. 13 (1934), 1939--1 (Part 2)
C.B. 554, 564.
Accordingly, the loss of 200x dollars realized by X in the exchange of X's leasehold
interest and improvements in the building in return for an identical leasehold interest in a
portion of the building and money may not be recognized under the provisions of section
1031(a) and (c) of the Code.

LESLIE CO.

The Leslie Co. is an important decision relative to exchanges. The petitioner purchased
land intending to construct new facilities on it. He was unable to obtain the financing
needed, and therefore he entered into a sale and leaseback agreement with Prudential.
Upon completion of the construction of the new facility as approved by Prudential, the
taxpayer was to sell the property to Prudential and lease it back under a leasehold with an
initial term of 30 years.

The question was whether the transaction constituted a bona fide sale and not an
exchange of property for a leasehold with cash as boot. Section 1031 was held not to
apply: this was a bona fide sale and leaseback arrangement.

LESLIE CO.
v.
COMMISSIONER OF INTERNAL REVENUE, Appellant.

76-2 U.S.T.C. Para. 9553,


539 F.2d 943 (3rd Cir. 1976),
aff'g 64 T.C. 247

OPINION OF THE COURT

GARTH, Circuit Judge.

This appeal involves the tax consequences of a sale and leaseback arrangement. The
question presented is whether the sale and leaseback arrangement constitutes an exchange
of like-kind properties, on which no loss is recognized, or whether that transaction is
governed by the general recognition provision of Int.Rev.Code §1002.[FN1] The Tax
Court, on taxpayer's petition for a redetermination of deficiencies assessed against it by
the Commissioner, held that the fee conveyance aspect of the transaction was a sale
entitled to recognition, and that the leaseback was merely a condition precedent to that
sale. The Tax Court thereby allowed the loss claimed by the taxpayer. For the reasons
given below, we affirm.

FN1. All references are to the Internal Revenue Code of 1954.

I.

Leslie Company, the taxpayer, is a New Jersey corporation engaged in the manufacture
and distribution of pressure and temperature regulators and instantaneous water heaters.
Leslie, finding its Lyndhurst, New Jersey plant inadequate for its needs, decided to move
to a new facility. To this end, in March 1967 Leslie purchased land in Parsippany, on
which to construct a new manufacturing plant.

Leslie, however, was unable to acquire the necessary financing for the construction of
its proposed $2,400,000 plant. Accordingly, on October 30, 1967, it entered into an
agreement with the Prudential Life Insurance Company of America, whereby Leslie
would erect a plant to specifications approved by Prudential and Prudential would then
purchase the Parsippany property and building from Leslie. At the time of purchase
Prudential would lease back the facility to Leslie. The property and improvements were
to be conveyed to Prudential for $2,400,000 or the actual cost to Leslie, whichever
amount was less.

The lease term was established at 30 years,[FN2] at an annual net rental of $190,560,
which was 7.94% of the purchase price. The lease agreement gave Leslie two 10-year
options to renew. The annual net rental during each option period was $72,000, or 3% of
the purchase price. The lease also provided that Leslie could offer to repurchase the
property [FN3] at five-year intervals, beginning with the 15th year of the lease, at
specified prices as follows:

FN2. The parties stipulated, and the Tax Court found accordingly, that the useful life of
the building Leslie constructed was 30 years.

Under the lease Prudential was entitled to all condemnation proceeds, net of any
damages suffered by Leslie with respect to its trade fixtures and certain structural
improvements, without any deduction for Leslie's leasehold interest.

Construction was completed in December, 1968, at a total cost to Leslie (including the
purchase price of the land) of $3,187,414. On December 16, 1968 Leslie unconditionally
conveyed the property to Prudential, as its contract required, for $2,400,000. At the same
time, Leslie and Prudential executed a 30-year lease.

Leslie, on its 1968 corporate income tax return, reported and deducted a loss of
$787,414 from the sale of the property.[FN4] The Commissioner of Internal Revenue
disallowed the claimed loss on the ground that the sale and leaseback transaction
constituted an exchange of like-kind properties within the scope of Int.Rev.Code s 1031.
That section of the Code, if applicable, provides for nonrecognition (and hence
nondeductibility) of such losses.[FN5] Rather than permitting Leslie to take the entire
deduction of $787,414 in 1968, the Commissioner treated the $787,414 as Leslie's cost in
obtaining the lease, and amortized that sum over the lease's 30-year term. Accordingly,
Leslie was assessed deficiencies of $383,023.52 in its corporate income taxes for the
years 1965, 1966 and 1968.

Leslie petitioned the Tax Court for a redetermination of the deficiencies assessed
against it, contending that the conveyance of the Parsippany property constituted a sale,
on which loss is recognized.[FN6] The Tax Court agreed. [FN7]
Although the Tax Court found as a fact that Leslie would not have entered into the sale
transaction without a leaseback guarantee, 64 T.C. at 250, it concluded that this finding
was not dispositive of the character of the transaction. Rather, it held that to constitute an
exchange under Int.Rev.Code §1031 there must be a reciprocal transfer of properties, as
distinguished from a transfer of property for a money consideration only. 64 T.C. at 252,
citing Treas.Reg. §1.1002-1(d). Based on its findings that the fair market value of the
Parsippany property at the time of sale was "in the neighborhood of" the $2,400,000
which Prudential paid, and that the annual net rental of $190,560 to be paid by Leslie was
comparable to the fair rental value of similar types of property in the Northern New
Jersey area,[FN8] the Tax Court majority reasoned that Leslie's leasehold had no separate
capital value which could be properly viewed as part of the consideration paid.
Accordingly, Leslie having received $2,400,000 from Prudential as the sole consideration
for the property conveyed, the Tax Court held that the transaction was not an exchange of
like-kind properties within the purview of Int.Rev.Code §1031, but was rather a sale, and
so governed by the general recognition provision of Int.Rev.Code §1002. [FN9]

Six judges of the Tax Court dissented from this holding. Judge Tannenwald, in an
opinion in which Judges Raum, Drennen, Quealy and Hall joined, agreed with the Tax
Court majority that the conveyance was a sale, but would have disallowed a loss
deduction, reasoning that the leasehold had a premium value to Leslie equal to the
$787,414 difference between cost and sales price.[FN10] This dissent reasoned that since
Leslie would not have willingly incurred the loss but for the guaranteed lease, this
amount should be treated as a bonus paid for the leasehold, and should be amortized over
the leasehold's 30-year term.

FN10. 64 T.C. at 255. Judge Quealy also filed a separate dissent, 64 T.C. at 257, in
which he pointed to Leslie's reservation of a favorable option to repurchase the property
as further support for the position that the petitioner incurred no loss upon sale. We are
hard pressed to agree with this characterization of Leslie's very limited rights of
repurchase under the lease as "favorable." The repurchase right is set forth in Article
XXIV of the lease, entitled "Option to Purchase." Leslie is given the right to terminate
the lease after the 15th, 20th, 25th and 30th years. To do so, however, it must make an
offer to repurchase the property back from Prudential, at specified prices. See page 3,
supra. Prudential need not accept the offer, although nonacceptance does not prejudice
Leslie's rights of termination. Thus Leslie's option to offer to repurchase may be
exercised only at the risk of losing the right to use the property for the remainder of the
lease term.

The Commissioner's appeal from the decision of the Tax Court followed.

PRIVATE LETTER RULING 9110007

This Ruling supports the position that there is great flexibility in undertaking an
exchange under Code §1031, even when there is a leasehold and other building that will
take place.
Taxpayer X, Corporation, owned property in fee simple. Y was a tax-exempt
Corporation that owned property in fee simple. Z was a nonprofit Corporation that was
formed for the purpose of exchanging the properties with X.

X and Z executed an exchange agreement to pass property to Z and to also provide for a
lease arrangement.

Taxpayer X requested a Ruling indicating that the transfer by X of property to Z in


exchange for a leasehold to another property W: qualify under Code §1031.

The Service ruled in favor of this position. That is, the transfer by X of its property to Z
in exchange for a leasehold, including office building, would qualify as an exchange.

PRIVATE LETTER RULING 9110007


Section 1031 -- Like-Kind Exchanges

Publication Date: March 8, 1991

Dear
This is in reply to your letter dated July 5, 1990, submitted on your behalf by your
authorized representatives, requesting certain rulings under sections 1031 and 1223 of the
Internal Revenue Code.

X is a corporation located in State N and has owned property a in fee simple since
1955. Property a is land and an office building. The building is rented to a partnership,
W, which is business e. There is and will be a bond trust indenture securing a mortgage
note on property a of approximately 3x dollars as of the date of the exchange.

Y is a tax-exempt, nonprofit corporation in State N and owns property b in fee simple.


Z is also a nonprofit corporation, incorporated by Y in State N for the purpose of
exchanging properties with X. Y leased a portion of property b (property c) to Z for a
period of 51 years for x dollars per year. Z will construct building d, a four story office
building according to the specifications satisfactory to W, X, Y and Z by date f. The
construction of building d will cost approximately 2x dollars plus interest. The building
will be encumbered with a mortgage note of approximately 4x dollars as of the date of
the exchange. Pursuant to the terms of the lease from Y to Z (leasehold to property c),
building d will revert back to Y at the termination of the lease. Y also holds an option to
buy back the leasehold and building d if specified events occur.

X and Z executed an Exchange Agreement whereby record title to property a will pass
to Z at the same time as record title to leasehold to property c and the office building will
pass to X. X and Z also executed an Escrow Agreement and deposited the Exchange
Agreement with the escrow agent. Pursuant to the terms of the Escrow Agreement, the
Exchange Agreement becomes effective upon the completion of the office building.

In the request, X makes the following representations:


1) Property a is held for use in X's trade or business;
2) The leasehold to property c and the office building to be
constructed thereon will be held and used by X in its trade or
business in replacement and substantially to the same extent as
property a;
3) Z is a separate and independent entity from X and X has no
ownership interest in Z, nor any control as to Z, and no partner
in W has any position with Z and, among such persons, only
one, A, holds any position with Y. A is on Y's nine member
governing board;
4) Z has entered into the lease of property c solely on its own
behalf and is not acting as agent for X in securing this lease,
the fee simple title to which is owned by Y, nor is it acting as
agent for X in constructing the office building thereon. X
understands that the decision to convey the leasehold to
property c from Y to Z, and to have Z effectuate the exchange
with X, was made by Y for business reasons of Y. Z is,
however, entering into the lease of property c and constructing
the office building in anticipation of the exchange, but will be
fully at risk with respect thereto in the event the exchange
does not become effective;
5) X will have no interest in the leasehold to property c or the
office building prior to the Exchange date, except in
accordance with the Escrow Documents. Furthermore, X will
bear no burdens of ownership or risk of economic loss for the
leasehold to property c and the office building until the
Exchange Date including, but not limited to, liability for real
estate taxes or for obligations under construction agreements
and loans, and C will not be entitled to any income, insurance
proceeds or condemnation proceeds prior to the Exchange
Date;
6) Z's obligation to transfer property the leasehold to property c
and the office building thereon is expressly conditioned upon
X's obligation to convey property a to Z in accordance with
the Escrow Documents;
7) X's obligation to transfer property a is expressly conditioned
on Z's obligation to complete construction of the office
building within the time specified and convey the leasehold c
and the office building thereon to X, as provided in the Escrow
Documents;
8) The mortgage note on the office building will exceed in
amount the mortgage on property a when the ownership
thereof is transferred to Z upon the Exchange Date. Except for
the transfer of property a subject to a mortgage note, X will
not receive any money or property (except the leasehold to
property c, including the office building thereon) as
consideration for its transfer of property a to Z;
9) X will not lend any amounts to Z or guarantee any obligations
of Z; and
10) Under the laws of State N, the Exchange of Real Properties
will not be effective to convey title, and will not shift the
rights and burdens of ownership of the leasehold to property c
from Z to X, or property a from X to Z, until the Exchange
Date (i.e., when the Exchange of Real Properties is dated and
recorded by the escrow agent), but upon the dating and
recording of the Exchange of Real Properties on the Exchange
Date, title to, and the rights and burdens of ownership of those
properties will, simultaneously, pass between Z and X.

X requests the following rulings:

1) The transfer by X of property a to Z in exchange for the


leasehold to property c and the office building thereon will
qualify as an exchange of property used in a trade or business
for property of a like kind to be held for the same purpose
within the meaning of section 1031.
2) X will not recognize any gain upon such transfer.
3) The adjusted basis to X of the leasehold to property c and
building d, as a unit, acquired in the section 1031 exchange
shall be the same as that of property a transferred to Z,
increased by the excess of the mortgage note on the building d
over the mortgage note on property a, and said adjusted basis
shall be allocated between the leasehold to property c and
building d based on relative fair market values as of the date of
the Section 1031 exchange.
4) Because X's transfer of its property and its receipt of Z's
property will be a simultaneous exchange, section 1031(a)(3) is
not applicable. 5) X's holding period for the leasehold to
property c and the office building thereon will include the
period for which X held property a.

Section 1031(a)(1) of the Code provides, generally, 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.

Section 1031(a)(3) of the Code provides, generally, that for the purposes of section
1031, any property received by the taxpayer shall be treated as property which is not like-
kind property if (A) such property is not identified as property to be received in the
exchange on or before the day which is 45 days after the date on which the taxpayer
transfers the property relinquished in the exchange, or (B) such property is received after
the earlier of (i) the day which is 180 days after the date on which the taxpayer transfers
the property relinquished in the exchange, or (ii) the due date (determined with regard to
extension) for the transferor's return of the tax imposed by this chapter for the taxable
year in which the transfer of the relinquished property occurs.

Section 1031(b) of the Code provides, generally, that if an exchange would be within
the provisions of section 1031(a) if it were not for the fact that the property received in
exchange consists not only of property permitted by such provisions to be received
without the recognition of gain, but also of other property or money, then the gain, if any,
to the recipient shall be recognized, but in an amount not in excess of the sum of such
money and the fair market value of such other property.

Section 1031(d) of the Code provides, in part, that if property was acquired in an
exchange described in section 1031, then the basis shall be the same as that of the
property exchanged, decreased in the amount of any money received by the taxpayer and
increased in the amount of gain or decreased in the amount of loss to the taxpayer that
was recognized on such exchange. For purposes of section 1031, where as part of the
consideration to the taxpayer another party to the exchange assumed a liability of the
taxpayer or acquired from the taxpayer property subject to a liability, such assumption or
acquisition (in the amount of the liability) shall be considered as money received by the
taxpayer on the exchange.

Section 1245(a)(1) of the Code provides, in part, that except as otherwise provided in
this section, if section 1245 property is disposed of the amount by which the lower of --

(A) the recomputed basis of the property, or


(B) (i) in the case of a sale, exchange, or involuntary conversion,
the amount realized, exceeds the adjusted basis of such
property shall be treated as ordinary income. Such gain shall
be recognized notwithstanding any other provision of Subtitle
A.

Section 1245(b)(4) of the Code provides, generally, that if property is disposed of and
gain (determined without regard to this section) is not recognized in whole or in part
under section 1031 or 1033, then the amount of gain taken into account by the transferor
under section 1245(a)(1) shall not exceed the sum of

(A) the amount of gain recognized on such disposition


(determined without regard to this section), plus
(B) the fair market value of property acquired which is not section
1245 property and which is not taken into account under
section 1245(b)(4)(A).

Section 1.1031(a)-1(a) of the Income Tax Regulations provides, in part, that a transfer
is not within the provisions of section 1031(a) if as part of the consideration the taxpayer
receives money or property which does not meet the requirements of section 1031(a) but
the transfer, if otherwise qualifies, will be within the provisions of section 1031(b).
Similarly, a transfer is not within the provisions of section 1031(a) if as part of the
consideration the other party to the exchange assumes a liability of the taxpayer (or
acquires property from the taxpayer that is subject to a liability), but the transfer, if
otherwise qualified, will be within the provisions of section 1031(b).

Section 1.1031(a)-1(b) of the regulations provides, in part, that as used in section


1031(a), the words "like kind" have reference to the nature or character of the property
and not to its grade or quality.

Section 1.1031(a)-1(c) of the regulations provides, in part, that no gain or loss is


recognized if a taxpayer who is not a dealer in real estate exchanges city real estate for a
ranch or farm, or exchanges a leasehold of a fee with 30 years or more to run for real
estate.

Section 1.1031(d)-2(b) of the regulations provides, generally, that for the purposes of
determining the basis of the acquired property, the basis is the same as the basis of the
relinquished property increased by liabilities to which the acquired property is subject,
decreased by the amount of money received (including liabilities assumed to which the
acquired property is subject), increased by any gain recognized on the exchange and
decreased by any loss recognized on the exchange.

Section 1223 of the Code provides, generally, that in determining the period for which
the taxpayer has held property received in an exchange, there shall be included the period
for which he held the property exchanged if, under this chapter, the property has, for the
purpose of determining gain or loss from a sale or exchange, the same basis in whole or
in part in his hands as the property exchanged, and, in the case of such exchanges after
March 1, 1954, the property exchanged at the time of such exchange was a capital asset
as defined in section 1221 or property described in section 1231.

Section 1231(b) of the Code defines the term "property used in the trade or business" as
property used in the trade or business, of a character which is subject to the allowance for
depreciation provided in section 167, held for more than 1 year, and real property used in
the trade or business, held for more than 1 year, which is not (A) property of a kind which
would properly be includible in the inventory of the taxpayer if on hand at the close of
the taxable year, (B) property held by the taxpayer primarily for sale to customers in the
ordinary course of his trade or business, (C) a copyright, a literary, musical, or artistic
composition, a letter or memorandum, or similar property, held by a taxpayer described
in section 1221(3) or (D) a publication of the United States Government which is
received from the United Stated Government, or any agency thereof, other than by
purchase at the price at which it is offered for sale to the public, and which is held by a
taxpayer described in section 1221(5).

In the present case, X has represented that property a was held for use in its trade or
business, that the leasehold to property c and building d will be held for use in its trade or
business, that the exchange will be simultaneous and that X and Z will assume the
mortgages on building d and property a respectively. Although the leasehold to property c
is taken by X subject to an option, the characterization of this lease as like kind to real
estate under section 1.1031(a)-1(c) of the regulations is not affected because X continues
to have a right to possess, occupy and use property c for 51 years.

Based on the above authorities and the information and representations submitted by X,
we rule that: 1) The transfer by X of property a to Z in exchange for the leasehold to
property c, including the office building thereon will qualify as an exchange of property
used in a trade or business for property of a like kind to be held for the same purpose
within the meaning of section 1031. 2) X will not recognize any gain upon such transfer,
except as otherwise provided in section 1245. 3) The adjusted basis to X of the leasehold
to property c and building d, as a unit, acquired in the section 1031 exchange shall be the
same as that of property a transferred to Z, increased by the excess of the mortgage note
on the building d over the mortgage note on property a, and said adjusted basis shall be
allocated between the leasehold to property c and building d based on relative fair market
values as of the date of the Section 1031 exchange. 4) Because X's transfer of its property
and its receipt of Z's property will be a simultaneous exchange, section 1031(a)(3) is not
applicable. 5) X's holding period for the leasehold to property c and building d thereon
will include the period for which X held property a.

Except as is specifically ruled above, no opinion is expressed as to the federal tax


treatment of the transaction under the provisions of any other section of the Internal
Revenue Code and regulations that may be applicable. No opinion is expressed as to the
tax treatment of any conditions existing at the time of or effects resulting from the
transaction that is not specifically covered by the above ruling.

A copy of this letter should be attached to the federal income tax return for the taxable
year in which the transaction described herein is consummated.

This letter is directed only to the taxpayer who requested it. Section 6110(j)(3) of the
Code provides that it may not be used or cited as precedent. Sincerely yours,

CROWLEY, MILNER

In this case, the Court was faced with the question as to whether a transaction would be
denied a loss deduction because of a sale leaseback, thus coming within Code §1031 in
concept.

The Court cited the Leslie Co. case, a 1976 decision out of the 3rd Circuit, supporting
the proposition that where the intent was very clear to have a sale as opposed to an
exchange, and the lease terms involved on the sale and leaseback were arms' length
bargaining, such transaction would be treated as a sale and a leaseback, and not a tax-
deferred exchange. Thus, the taxpayers were successful in receiving the loss deduction
inasmuch as they were trying to avoid the position of a tax-deferred exchange.
A change in the status of the investment and the rights involved was sufficient to take
this out of the Code §1031, said the Court. Often it is difficult to distinguish a situation
where there is a sale and a leaseback which might be considered the equivalent of a fee
for purposes of an exchange under Code §1031 and the Regulations thereunder, and a
sale and a leaseback not within Code §1031.

CROWLEY, MILNER
v.
COMMISSIONER of INTERNAL REVENUE, RESPONDENT
76 T.C. 1030 (1981)

FEATHERSTON , Judge:

Respondent determined a deficiency in the amount of $159,724.57 and an addition to


tax under section 6651(a) [FN1] in the amount of $919.61 for the tax year ended January
31, 1976. The issues for decision are:

(1) Whether section 1031 applies to a sale-leaseback entered into by petitioner and
Prudential Insurance Co. of America;

FINDINGS OF FACT

At the time it filed its petition, petitioner's principal place of business was located in
Detroit, Mich. Petitioner filed its return for the taxable year ended January 31, 1976, with
the Internal Revenue Service Center, Cincinnati, Ohio, on September 24, 1976. Petitioner
reports its income on the accrual method of accounting.

During the period in issue, petitioner operated department stores emphasizing national
brand ready-to-wear merchandise. Petitioner's main store was located in Detroit. It also
operated eight suburban and satellite outlets.

In the early 1970's, due to the continued deterioration of downtown Detroit's retail
environment and the continued unprofitability of petitioner's downtown store, petitioner
began to consider closing that store. To maintain revenue and increase profitability,
petitioner also began searching for a location for a new store.

At the same time, the Taubman Co., a nationwide developer of major regional shopping
centers, proposed to develop three new regional shopping centers for the Detroit area.
The Taubman shopping centers typically were large, enclosed malls with one or more
anchor stores and a number of smaller specialty shops intended to serve a large
geographical area. The Taubman Co. had devised a "package" plan for developing large
regional shopping centers. The Taubman Co. would establish a partnership or a
corporation which would purchase land for the shopping center site. This partnership or
corporation would, in turn, sell parcels of land to the various so-called anchor or large
department store participants in the shopping center project and enter into an operating
agreement with these anchor participants whereby the anchor stores would build their
stores and the partnership or corporation established by Taubman would build the
remainder of the shopping center complex. These major parties to the arrangement would
contribute pro rata to the development of the shopping center's common elements, e.g.,
roadways, parking, lighting, sidewalks, etc.

After investigating the malls planned by Taubman, petitioner decided that the proposed
Lakeside Mall (sometimes hereinafter the mall) would meet petitioner's requirements as
to timing, demographics, size, complementary anchor department stores, growth
potential, and the prestige of being part of a large regional shopping center. In September
1973, petitioner began negotiating with Lakeside Center Associates (Lakeside
Associates), the partnership formed to develop and operate the mall, to include one of
petitioner's stores as an anchor store in the proposed mall. At the same time, petitioner
entered into negotiations with H. F. Campbell Co. (Campbell), a major Detroit area
construction firm, for the design and construction of the contemplated store at the mall.

The "package" developed by Taubman required each anchor participant to purchase the
land and build its own store in accordance with the unified shopping center plan.
Petitioner, however, was not interested in holding or owning real estate. Instead,
petitioner preferred using its limited capital for retail merchandising. With the exception
of the original downtown store, all of petitioner's stores were leased rather than owned.
Consequently, to comply with Taubman's requirements and to meet its own financial
needs, petitioner investigated various forms of financing its Lakeside venture. Petitioner
eventually concluded that a sale-leaseback with the Prudential Insurance Co. of America
(Prudential) was the most attractive arrangement.

After oral agreements were reached with Lakeside Associates, Campbell, and
Prudential, petitioner's board of directors, on March 26, 1974, authorized petitioner to
enter into firm written agreements with these parties. The authorization was given in the
belief that the negotiation with all three parties would successfully be completed.

After having reached an agreement in principle with Lakeside Associates and with
Prudential, petitioner executed the Campbell contract on April 27, 1974. The contract
provided that the design of the facility would be developed simultaneously with its
construction, and a maximum price of $2,985,072 was set for the landscaping, building
exterior, and walls.

On May 2, 1974, petitioner entered into an operating agreement and a supplemental


agreement with Lakeside Associates. The agreements provided, among other things, that
petitioner would pay Lakeside Associates $28,000 for the land on which the store would
be built, and that petitioner would contribute $879,411 towards common area
improvements. The agreement further granted mutual easements to the parties for the
common areas.

Petitioner continued to negotiate with Prudential during 1974. On November 18, 1974,
petitioner entered into an "Agreement of Purchase and Leaseback" with Prudential for the
land and improvements to petitioner's property. The sales price was set at $4 million.
Although petitioner originally expected to be able to exclude certain fixtures and
improvements from the sale, Prudential insisted that they be included. After
unsuccessfully trying to negotiate a higher sales price to cover the costs of the additional
inclusions, petitioner eventually acceded to Prudential's demands.

Petitioner and Prudential entered into a 30-year lease with four successive 5- year
options to renew. The lease provided for an annual rent of $360,000 plus 1 percent of
gross sales exceeding $10 million at the Lakeside Mall store. During the renewal periods,
rent was increased by 1 percent of annual gross sales exceeding the average gross sales of
the last 2 years of the preceding period.

Petitioner and Prudential closed the sale and leaseback on September 4, 1975.

OPINION

Section 165(a) provides that a corporation may deduct any "loss sustained during the
taxable year and not compensated for by insurance or otherwise." Section 1002 [FN2]
sets forth the general rule that the entire amount of the gain or loss realized upon the sale
or exchange of property, except as otherwise provided, shall be recognized.

An exception to the general rule is established by section 1031. [FN3] That section
provides for the nonrecognition of gain or loss when property held for use in a trade or
business or investment is exchanged for like-kind property which is to be held for use in
the trade or business or investment. If cash or other property which does not qualify as
like-kind property is included in the exchange, gain (but not loss) is recognized to the
extent of the cash or other property received.

Respondent contends that petitioner transferred the land and building to Prudential in a
like-kind exchange for a 30-year renewable lease and cash. [FN4] Consequently,
respondent reasons, under section 1031 petitioner is not entitled to currently deduct the
loss realized upon the sale. Rather, respondent contends that the loss should be amortized
over the term of the lease as a cost incurred to obtain the lease. Petitioner, to the contrary,
maintains that the property was transferred to Prudential in a sale rather than a like-kind
exchange. Petitioner concludes, therefore, that the loss is deductible in the year of the
transfer.

The threshold issue to be decided is whether the transaction constituted a sale or an


exchange. If a sale occurred, then the provisions of section 1031 do not apply. If, on the
other hand, an exchange took place, then we would have to decide whether the exchange
was made for like-kind property as required by section 1031.

The applicable income tax regulations define an exchange as "a reciprocal transfer of
property, as distinguished from a transfer of property for a money consideration only."
Sec. 1.1002-1(d), Income Tax Regs. The regulations further state that nonrecognition will
be accorded only if the exchange meets both the definition and "the underlying purpose
for which such exchange is excepted from the general rule." Sec. 1.1002-1(b), Income
Tax Regs. Thus, in order to determine whether the transfer was a sale or an exchange, we
must determine whether the transfer was for cash only or whether the lease had capital
value so that it was part of the consideration for the transfer of the property. * * * * The
lease had capital value if the $4 million sales price was less than the property's fair
market value, or if the rent to be paid was less than the fair rental rate.

In Leslie Co. v. Commissioner, supra, this Court faced a set of facts involving
construction financed by Prudential on terms virtually identical to the facts presently
before us. In that case, we found, in the light of all the evidence, that the lease entered
into by the taxpayer had no capital value and that the sale-leaseback, therefore,
constituted a transfer for cash only rather than a like-kind exchange accompanied by
"boot." Accordingly, we allowed petitioner to deduct the loss realized upon the sale in the
year of the sale. We reach the same conclusion here.

Respondent attempts to distinguish Leslie on the grounds that, in the case before us, the
lease entered into by petitioner had capital value. Respondent contends that the $4 million
price received by petitioner was less than the fair market value of the property, and that
therefore the capital value of the leaseback equaled the amount by which the property's
fair market value exceeded the sales price. As evidence to support his argument that the
leasehold had a capital value, respondent points to petitioner's great interest in the
property's unique features.

Considerable testimony has been introduced with regard to the fair market value and
fair rental of the transferred property. We think it clear that the sale and lease were
negotiated in an arm's-length dealing. We are convinced by the expert testimony
introduced by petitioner that the actual sales price of the building and the agreed rent
were at fair market values.

The lease for the 115,300-square-foot building calls for rental at an annual rate of
$360,000 or about $3.12 per square foot, plus 1 percent of annual sales over $10 million.
Petitioner's expert compared this rate with the average net rental of $2.48 per square foot
paid for K-Mart stores in southeastern Michigan during 1974 and 1975. Because of the
superior quality of the Lakeside Mall store, he used the K-Mart rent to set a lower limit
on the fair market rental of the Lakeside store. He also consulted an authoritative
publication on shopping center rents of 550 centers throughout the United States for
comparison purposes. In the light of this information, he concluded that the lease called
for a fair rent, not a bargain rate.

Petitioner's expert used an income approach to derive the building's value. He


determined that a fair rate of return for the property would be between 9 and 91;2
percent. Capitalizing the rent paid by petitioner at that percentage, petitioner's expert
concluded that the building had a value of $4 million. [FN5] We agree with petitioner
that actual construction costs do not necessarily measure fair market value, and that, here,
the fair market value of the store was $4 million notwithstanding construction costs
exceeding that figure by approximately $340,000.
We recognize that the lease was desirable to petitioner due to the mall's unique features
detailed in our findings of fact. Nevertheless, this does not mean, as respondent
apparently contends, that the lease had greater value than the rent to be paid and thus had
capital value. The factors that appealed to petitioner were considered in determining
whether the negotiated rent provided by the lease was at fair market value. Thus, the fact
that petitioner was interested in the lease was reflected by the fair market rental paid by
petitioner. We note that the lease provided that Prudential was to receive the entire
proceeds in the event of condemnation. Furthermore, the lease did not grant petitioner
any greater control over the property than that generally held by a tenant. Therefore, the
leasehold itself had no capital value. See Leslie Co. v. Commissioner, 539 F.2d at 949.

The transaction also fails to meet the underlying purpose for which section 1031
excepts exchanges from the general rules. Sec. 1.1002-1(b), Income Tax Regs. One of the
primary purposes for allowing the deferral of gain in a like-kind exchange is to avoid
imposing a tax upon a taxpayer who, while changing his form of ownership, is continuing
the nature of his investment.

We do not think that an exchange of like-kind property occurred here. Petitioner's


money did not continue to be "tied up" in like-kind property. Rather, consistent with its
longstanding policy, petitioner cashed in its investment in the property because it
preferred to use its limited working capital in its merchandising endeavors rather than to
buy "bricks and mortar."

It is true that petitioner would not have sold the property to Prudential without
obtaining the leaseback. Nevertheless, the parties bargained at arm's length to arrive at a
fair market sales price and rent.

To reflect the foregoing,

Decision will be entered for the petitioner.

CROOKS

To have an "exchange," there must be an "exchange," not a lease.

RICHARD WAYNE CROOKS and MAXINE L. CROOKS, Petitioners


v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

92 T.C. 816
92 T.C. No. 49

Petitioners owned a farm under which oil was discovered in 1981. In 1982, petitioners
conveyed all of their interest in the minerals underlying the farm to Henry Energy
Corporation in consideration for four other farms, new farm equipment, and a one-fourth
royalty interest in all oil and gas produced from the conveyed mineral interest. HELD:
Petitioners retained an economic interest in the minerals underlying the farm by retaining
a right to receive a specified percentage of all the oil and gas produced. Petitioners looked
solely to the extraction of the minerals underlying the farm for a return of their capital
(sec. 1.611-1(b), Income Tax Regs.) and, as such, the four farms and the farm equipment
received by petitioners are considered a lease bonus for Federal income tax purposes and
will be taxable to petitioners as ordinary income. HELD FURTHER: There was no 'sale
or exchange' and no 'gain or loss' within the meaning of sec. 1031, I.R.C. 1954, to permit
nonrecognition of the value of the four farms received by petitioners.

GOFFE, JUDGE:

The Commissioner determined deficiencies in petitioners' Federal income taxes for the
following taxable years:

Taxable Year Deficiency


1982 $733,357.81
1983 3,128.85

Petitioners have conceded the Commissioner's adjustments in disallowing, in 1983,


utility expenses in the amount of $1,515.60, gasoline expenses in the amount of $520,
and depreciation expense in the amount of $3,222, and have conceded an increase in the
investment tax credit for 1983 in the amount of $500.30. There are no issues remaining
for our decision for the taxable year 1983. After concessions, the issues remaining for
decision are: (1) whether petitioners retained an economic interest in the minerals
underlying the Brown County farm; and, (2) whether the conveyance of the minerals
underlying the Brown County farm in consideration for four parcels of real property is a
like- kind exchange under section 1031. [FN1]

FINDINGS OF FACT

This case was submitted fully stipulated under Rule 122. The stipulation of facts and
accompanying exhibits are incorporated by this reference.

Petitioners resided in La Prairie, Illinois, at the time of the filing of the petition in this
case.

In 1981 oil was discovered in Brown County, Illinois. Petitioners owned, and continue
to own, a 160-acre farm located in Brown County. As a result of the discovery of oil,
petitioners entered into an Agreement on October 15, 1982, with Henry Energy
Corporation whereby petitioners agreed to convey all of their mineral rights in the 160-
acre farm to Henry Energy Corporation in consideration for four farms located in Adams
County, Illinois, and new farm equipment. Upon consummation of this transaction and
pursuant to the Agreement, Henry Energy Corporation also agreed to convey to
petitioners one-fourth of any oil or gas, on and under, and to be produced and saved from
the mineral interest underlying the Brown County farm. The four Adams County farms
and the new farm equipment described in the Agreement had a value, as of October 15,
1982, of $1,676,800 and $235,804.34, respectively.

The conveyance of the minerals was completed by way of a Mineral Deed dated
December 13, 1982. In addition, on December 13, 1982, Henry Energy Corporation
conveyed to petitioners by quit-claim deed the four Adams County farms and the new
farm equipment. On that same date, pursuant to the Agreement, Henry Energy
Corporation executed a Conveyance of the one-fourth royalty interest to petitioners.

On their 1982 joint Federal income tax return, Schedule D, petitioners reported a long-
term capital gain (as 'mineral ownership in 160 acres') in the amount of $235,804.34, with
a taxable gain of $94,322. The former amount represented the value of the items of farm
machinery received by petitioners from Henry Energy Corporation pursuant to the
October 15, 1982, Agreement. Petitioners did not report the receipt of the four Adams
County farms nor the royalty from Henry Energy Corporation on their 1982 joint Federal
income tax return on the theory that petitioners' receipt of the four Adams County farms
was a like-kind exchange for the mineral interest in the 160-acre Brown County farm.

The Commissioner determined that the October 15, 1982, Agreement between
petitioners and Henry Energy Corporation was a lease, and that the value of the property
received by petitioners from Henry Energy Corporation (the four Adams County farms
and the new farm equipment) was a lease bonus, taxable to petitioners as ordinary
income. The Commissioner increased petitioners' 1982 taxable income in the amount of
$1,818,282 (i.e., $1,676,800 + ($235,804 - $94,322)).

OPINION

The first issue for our decision is the characterization, as ordinary income or capital
gain, of the value of the property received by petitioners. This characterization depends
upon whether the Agreement is a sale or a lease for Federal income tax purposes, which
is ultimately determined by whether petitioners retained an economic interest in the
minerals underlying the Brown County farm.

Having decided that petitioners granted an oil and gas lease to Henry Energy
Corporation, we must decide whether granting of the lease in consideration for four
parcels of real property is a like- kind exchange under section 1031. Central to this issue
is whether the granting of the lease in consideration for the real property received is a
'sale or exchange of property' for purposes of section 1031.

Petitioners contend that the receipt of property by them in consideration for their
conveyance of a mineral interest to Henry Energy Corporation is an exchange of property
of like kind. Petitioners concede that the fair market value of the farm equipment is
taxable to them as ordinary income.

For petitioners to prevail, they must show that, within the meaning of section 1031,
there was a sale or exchange. Section 1031 applies only when the taxpayer has sustained
a gain or loss from a sale or exchange. Having held that the total transaction constituted a
lease, it follows that there has not been a sale or exchange. Petitioners realized no gain or
loss. In Pembroke v. Helvering, 23 B.T.A. 1176 (1931), affd. 70 F.2d 850 (D.C. Cir.
1934), the taxpayer was the owner of real property located in Ohio. In 1925, the taxpayer
leased the property for a term of 99 years in consideration of an annual rental and a
conveyance of a fee interest in other real estate. The taxpayer contended that the property
received by him was a like-kind exchange for the granting of the lease. The Board of Tax
Appeals decided that the transaction in question was not an 'exchange of properties' and
that section 203 of the Revenue Act of 1926, a predecessor of section 1031 of the 1954
Internal Revenue Code, did not apply to the transaction. The Board decided, instead, that
the transaction was a lease for which the taxpayer received annual rent plus a lease bonus
represented by the real property received by him. Pembroke v. Helvering, 23 B.T.A. at
1178.

The facts in Pembroke are indistinguishable from the facts in the instant case. In the
instant case, having decided that the transaction constituted a lease, it follows that the
farms received from the lessee, Henry Energy Corporation, are a lease bonus and there
has been no sale or exchange within the meaning of section 1031.

We reaffirmed this portion of the Pembroke holding in Koch v. Commissioner, 71 T.C.


54, 70 (1978). [FN2] In Koch, the taxpayer exchanged fee simple interests in real estate
for real estate encumbered by 99-year leases. Section 1.1031(a)- 1(c), Income Tax Regs.,
provides that the exchange of a leasehold with 30 or more years to run for a fee simple
interest in land is an exchange of property of like kind. The government contended that if
the lessee's interest is equal to a fee interest then, by negative inference, the lessor's
interest is less than a fee interest. The Court rejected the government's argument, holding
that section 1031 does not require that the exchanged property interests be equal.
Although the lessor's interest was not equal to that of the fee simple owner of property
not subject to a lease, the Court held that the lessor nevertheless held fee simple title to
the real estate. Relying upon Pembroke, the Court stated, 'The reason for the rule is that
owner-lessor does not part with his real property but merely transfers the right to use it
for a period of years. The execution of a long-term lease is not the conveyance of a fee.'
Koch v. Commissioner, supra at 70.

The same rule applies in the instant case. When petitioners granted the lease to Henry
Energy Corporation they did not part with an interest in real property for Federal income
tax purposes, but merely transferred the right to use such property. This holding is
consistent with the prior decision of the Board of Tax Appeals in Butler v.
Commissioner, 19 B.T.A. 718, 728 (1930), when, in explaining the tax results of creating
a lease, the Board stated 'that a lessee under a 99-year lease, renewable forever, does not,
by virtue of the execution of the lease, acquire any ownership of the property which is the
subject of the lease, despite the fact that such leases are treated locally as in many
respects like conveyances of the fee.'

Petitioners rely upon Crichton v. Commissioner, 42 B.T.A. 490 (1940), affd. 122 F.2d
181 (5th Cir. 1941). In Crichton, the taxpayer conveyed an undivided three-twelfths
interest in the 'oil, gas, and other minerals in, on and under and that may be produced
from' certain lands in consideration for an undivided three-sixths interest in real property.
The Board of Tax Appeals decided that the exchange of a ROYALTY INTEREST in
minerals for a fee qualified as a like-kind exchange.

In the instant case, however, we do not have a situation in which a taxpayer-lessor


exchanged a royalty interest for real property. Petitioners, as lessors, granted a lease of a
mineral interest while RESERVING a royalty in such interest in consideration for real
property. As we previously decided, the reservation of the royalty interest characterizes
the transaction as a lease rather than a sale of the mineral interest. There is no gain or loss
to which section 1031 could apply. The execution of a lease does not give rise to a gain
or loss. Had petitioners, subsequent to the transaction with Henry Energy Corporation,
conveyed all or a portion of the one-fourth royalty interest in exchange for an interest in
real property, the exchange would then fall within the ambit of Crichton and section
1031.

This analysis is consistent with section 1.1031(a)-1(c), Income Tax Regs., which
provides: "No gain or loss is recognized if * * * a taxpayer who is not a dealer in real
estate exchanges * * a leasehold of a fee with 30 years or more to run for real estate * *
*.' The regulation contemplates the transfer of an existing leasehold by the lessee, not the
creation of leasehold. Only a lessee can transfer a leasehold interest, as contemplated by
the regulations, because the lessee owns the leasehold and the lessor's property is subject
to the leasehold. Petitioners, as lessors, created a leasehold interest in favor of the lessee,
Henry Energy Corporation. If Henry Energy Corporation, subsequent to the transaction
involved here, exchanged the leasehold interest it acquired for a fee interest in real estate,
the Commissioner has held that such exchange would be nontaxable under section 1031.
Rev. Rul. 68-331, 1968-1 C.B. 352.

In accordance with this analysis, when a mineral interest is assigned for real property
and the assignor retains a right to receive a specified percentage of all oil and gas
produced for the economic life of the mineral deposit, the transaction is a lease for
Federal income tax purposes. The granting of an oil and gas lease does not give rise to a
gain or loss. The real property received from the lessee as part consideration for the lease
is not an 'exchange of property' under section 1031 and will, therefore, be taxable as a
lease bonus as ordinary income.

Because our decision for the taxable year 1982 affects the amount of the deficiency for
the taxable year 1983 which was not taken into account in the statutory notice of
deficiency for such year,

Decision will be entered under Rule 155.

CHAPTER 9: DEBT RELIEF


ASSUMPTION OF LIABILITIES OR TRANSFERS SUBJECT TO A
LIABILITY
It is the position of Treas. Regs. Section 1.1031(b)-1(c) that liabilities which are
transferred to another party constitute boot to the party relieved of debt, to the extent of
the net debt relief.

As an example, if A were transfer property to B with the property otherwise being


qualified under Section 1031(a), except for the fact that there was a mortgage on the
property of $20,000, and B "assumed" that mortgage or took "subject to" (meaning that
he is not personally liable to pay it, but he has the obligation to pay it or he may lose the
property transferred to him), the $20,000 is boot to A. This is no different, at least for
most purposes, than B handing A the sum of $20,000 dollars in cash. This assumes there
is no net position, that is, B, when transferring his like-kind property to A, does not
transfer the property with any debt on it. Putting the example into numbers, A might
transfer his property to B, where A has a fair market value in the property of $120,000
and a mortgage on it for $20,000. B in turn transfers his property to A, with no mortgage
or debt on the property and a fair market value on the property of $100,000. The equities
of the two properties, assuming the values given, constitute $l00,000. Assuming that A's
basis in his property transferred was only $40,000, his realized gain is obviously greater
than the boot, thus $100,000 fair market value, less $40,000 basis, results in a $60,000
realized gain to A (Section 1001). Since $60,000 is greater than the boot amount,
$20,000, A would recognize a gain of $20,000, due to the debt relief. Tax is on the lesser
of realized gain or boot.

One should not confuse "debt relief" in the tax sense with "debt relief" in the technical
or legal sense. Thus, some taxpayers have argued that there should be no boot in the
situation described, because A remains liable on the obligation. This is not relevant so far
as the federal tax law is concerned. The issue in question is not whether A is or is not
formally relieved of the debt. The issue is whether B is to undertake payments on the
obligation in question and whether the debt is associated with the realty involved.

The Regulations under §1.1031(b)-1(c) further support this conclusion by stating that
where consideration is received in the form of an assumption of liabilities (or a transfer
subject to a liability), it is to be treated as "other property or money" for purposes of
Section 1031(b). In other words, it is boot.

The Regulations also state that where, on an exchange described in Section 1031(b),
each party to the exchange either assumes a liability of the other party or acquires
property subject to a liability, when determining the amount of boot, consideration is
given in the form of an assumption of liabilities or receipt of property subject to a
liability, shall be offset against consideration received in the form of an assumption of
liabilities (or a transfer subject to a liability). Thus, there is a netting.

As an example if we take the exchange between A and B, and this time assume that B
also had a debt on his property of $20,000, and assume further that both of the properties
have a fair market value of $120,000, an exchange of those properties would result in A
assuming B's debt of $20,000; A would receive the same equity that B received; and B
would assume A's debt of $20,000. There is no boot.
We could further modify the example by assuming the fair market value of A's property
is $120,000, with a debt of $20,000, or a net equity value of $100,000, with a debt on B's
property of $10,000 (assume B's value is now $110,000). Exchanging the property results
in equity of $100,000 transfer to each; there is debt relief to A of $10,000, that is, the net
difference between the $20,000 on A's property, which A is relieved, and the $10,000 on
B's, which A assumes. As such, the boot or non-like-kind property which causes
recognition of gain to A would be a net of $10,000. (See Treas. Regs. Section 1.1031(d)-
2, Examples 1 and 2).

MORTGAGES AND DEBT: TREATMENT OF ASSUMPTION OF LIABILITIES,


SUBJECT TO: WRAPS, CONTRACT FOR DEED,
OTHER DEBT INSTRUMENTS

The treatment of liabilities in exchange, and whether the liabilities are assumed or taken
subject to, can be important in determining basis, and a number of other important points.
This issue has been raised, litigated and discussed in great depth in the installment sales
area, where there has been a great deal of controversy, including case law and rulings,
interpreting the question of whether a contract for deed or a wraparound mortgage or
deed of trust, or a land contract constitutes an assumption or taking subject to the debt.
(See Levine, West text, Chapter 25.)

We must interpret whether loans which involve purchase money mortgages, contracts
for deeds, wraparound mortgages or other circumstances fall within the category of
"assuming or taking subject to."

A number of cases have said that if one taxpayer, A, transfers his property with a loan
on it to B, and B transfers his property to A, with a loan on it, the net debt relief, if any,
and thus boot to one party or the other, would be the net difference. Thus, if A transferred
his property with a debt on it of $50,000, which was assumed by B, and B transferred his
property to A with a debt on it of $75,000, and A assumed that debt or took subject to it,
there would be net debt relief for B of $25,000. There would be no net debt relief to A,
since A transferred and "got out of," (not necessarily legally, but practically), a debt of
$50,000, but took subject to paying the debt of $75,000; he has no net debt relief.

Would this be the case if in place of the $75,000 loan, on the B property, the B property
was free and clear, but, by agreement of the parties, A loaned B $75,000, and B executed
a purchase money mortgage in favor of A? There is also the question as to whether there
might be a different treatment if there is a wraparound note and deed of trust, a contract
for deed or other arrangements which do not literally fit the labels of "assuming or
subject to," but for practical purposes of paying the debt, they may have the same net
effect. Do these items fit within the netting concept to allow the rule to take place and
thus in many instances avoid debt relief and thereby avoid boot? There is some authority
for the position that they would be treated in a similar fashion. Some of the Regulations
under Section 1031 seem to imply this result; there are some rulings which reach this
type of conclusion in some settings. However, the area is certainly not clear. See the
cases and rulings that follow.
Exactly which types of mortgages, deeds of trust and other obligations will constitute
an "assumption" or "taking subject to a debt," as used under Section 1031, relative to the
question of debt relief and netting of debt, is not altogether clear.

There are questions as to whether a taxpayer, B, can exchange, tax-free, his property,
with a debt on it of $100,000, for property from C, with a debt on it of $50,000, where B
also executes a purchase money mortgage or other obligation in favor of C for an
additional $50,000. That is, if we can include the executed note and deed of trust by B to
C as part of the debt which C "assumes or takes subject to," there would be no net debt
relief. Some of the rulings follow, which cover this point.

ACQUISITION, IMPROVEMENTS AND EXCHANGES:


COASTAL TERMINALS, INC.

In the lower court decision of Coastal Terminals, Inc., Judge Wyche was dealing with
the treatment of an assumption of liabilities and the issue of an exchange.

The issue was whether the transfer by the plaintiff of properties to Delhi-Taylor Oil
Corp. for certain properties transferred by it, to the plaintiff, was a sale, thereby resulting
in a taxable gain or whether the transaction was a nontaxable exchange under Section
1031.

The plaintiff was a corporation which was formed to serve a group of independent oil
jobbers. The plaintiff owned a deep water terminal which Delhi-Taylor wanted. They
could not agree upon a sale, and plaintiff knew of property which it would be willing to
accept in exchange for its terminal, provided Delhi-Taylor would acquire and improve
the property on its own behalf so it would be in a position to make the exchange.

Concluding in favor of the plaintiff taxpayer, the court held that it was eligible for
Section 1031 tax-deferred treatment. However, the government, not ready to concede that
position, appealed. The appellate court affirmed the same decision in 1963.

The Court on appeal found ample evidence to support the conclusion of the District
Court that the transaction was an exchange and not a sale. The factual conclusion was
that before any binding legal obligation had been incurred by Coastal, Delhi undertook to
have the terminals constructed to make its position feasible for the exchange. Therefore,
Delhi Corp. paid its own legally incurred obligations and not those of Coastal. Therefore,
the transaction qualified under Section 1031.

COASTAL TERMINALS, INC., Plaintiff,


v.
UNITED STATES of America, Defendant.

63-2 U.S.T.C. Para. 9623


207 F.Supp. 560 (1963)
WYCHE, Chief Judge.

This suit was instituted by the plaintiff taxpayer to recover refund of taxes which it
alleges the District Director of Internal Revenue erroneously assessed against it in
holding that certain of its properties were sold on June 30, 1957, for $1,200,000.00 to
Delhi-Taylor Oil Corporation.

The issue is whether the transfer by plaintiff of certain of its properties to Delhi-Taylor
Oil Corporation for certain properties transferred by it to plaintiff was a sale resulting in a
taxable gain, a non-taxable exchange within the meaning of Section 1031(a) of the
Internal Revenue Code of 1954, 26 U.S.C.A. 1031(a), or a partial taxable exchange
within the meaning of Section 1031(b) of the Internal Revenue Code of 1954.

Plaintiff is a corporation which was formed by and designed to serve a group of


independent oil jobbers. It performed its function by owning and providing facilities for
the storage of petroleum products. In this connection it owned and operated a deep water
terminal in North Charleston, South Carolina. This terminal was ultimately transferred to
Delhi-Taylor Oil Corporation and it is this transfer which constitutes the subject matter of
this action.

In compliance with Rule 52(a), Rules of Civil Procedure, 28 U.S.C.A., I find the facts
specially and state my conclusions of law thereon, in the above cause, as follows:

FINDINGS OF FACT
1. Years prior to the transfer there became available to plaintiff's
stockholders and jobbers in the interior an inland source of oil
supply on what was called the plantation pipe line. Plaintiff,
taking into consideration the cost of transporting oil from
Charleston, to the interior, commenced investigating the
possibility of acquiring terminal sites along this pipe line and as a
result acquired options at Doraville, Georgia; Belton, South
Carolina, and Salisbury, North Carolina. While investigating the
feasibility of developing these sites plaintiff found that steel with
which storage tanks could be built was in short supply and was
able to obtain commitments from a steel concern so that the same
would be available in the event plaintiff found actual need for the
same. There existed at this time an operating terminal at
Wilmington, North Carolina, which was owned by Coastal
Terminals of North Carolina, a separate and distinct corporation
of which plaintiff owned sixty (60%) per cent. of the stock, but
which plaintiff hoped in the future to acquire and own outright.
Plaintiff lacked the capital to purchase and develop these sites,
and the obtaining of options and the other things done in
connection therewith, at this time constituted no more than
investigation and future corporate planning.
2. With this background, and years later, Delhi-Taylor Oil
Corporation contacted plaintiff and expressed an interest in
acquiring plaintiff's deep water terminal at North Charleston.
After a few days of negotiations, the parties concluded that they
could not agree upon a sale. Instead, on May 11, 1957, they
entered into an alternative agreement under which they agreed
Delhi- Taylor Oil Corporation would acquire the terminal in
Wilmington, North Carolina, the sites at Belton, South Carolina;
Salisbury, North Carolina, Charlotte, North Carolina, (Doraville,
Georgia, later being substituted for Charlotte); improve the same
and exchange them with plaintiff for its terminal in Charleston.
Thereafter, Delhi-Taylor Oil Corporation acquired and improved
these properties, and on July 1, 1957, exchanged them with
plaintiff for its terminal in Charleston. Plaintiff's terminal in
Charleston consisted of real estate, pipe lines and storage tanks.
The four tracts it acquired from Delhi-Taylor Oil Corporation
were of like kind, and after receiving them, plaintiff continued in
the same business in which it had been engaged, utilizing the
four properties for the same purpose for which it had formerly
used the single property in North Charleston.
3. Contrary to the Government's contention that the true nature of
the transaction was that plaintiff sold to Delhi-Taylor, and that
Delhi-Taylor thereafter acted as a mere momentary conduit
through whom plaintiff purchased property and passed title and
who assumed and liquidated liabilities incurred by plaintiff for
the construction of terminals, the evidence compels but the one
conclusion that the parties from the inception intended an
exchange; that the improvements made by Delhi-Taylor such as
the construction of tanks and pipe lines were done by and on
behalf of Delhi-Taylor so as to put it in a position to accomplish
an exchange; and that an exchange of like properties in fact and
in law took place
4. The substance of the transaction was one in which plaintiff
owned a deep water terminal which Delhi-Taylor Oil Corporation
wanted to acquire; they were unable to agree upon a sale; that as
a result of prior corporate investigation and planning, which at
the time had no connection with this transaction, plaintiff knew
of certain property which it would be willing to accept in
exchange for its terminal provided Delhi-Taylor Oil Corporation
would acquire and improve the same, and that Delhi-Taylor did
acquire and improve the same on its own behalf so that it would
be in a position to make an exchange, and that an exchange in
fact took place. Plaintiff did not 'cash in' and invest the same in
another business nor did it receive cash and reinvest the same in
like property, but merely exchanged its property with Delhi-
Taylor Oil Corporation for like property and continued on as
before in its identical business.
CONCLUSIONS OF LAW
1. * * * *
2. Section 1002 of the Internal Revenue Code of 1954, provides
that upon the sale or exchange of property the entire amount of
the gain or loss shall be recognized except as otherwise
provided.
3. Section 1031(a) of the Internal Revenue Code of 1954,
provides: 'No gain or loss shall be recognized if property held
for productive use in trade or business or for investment * * *
is exchanged solely for property of a like kind to be held either
for productive use in trade or business or for investment.'
4. The purpose of Section 1031(a) is to save the taxpayer from the
immediate recognization of a gain, or to intermit the claim of a
loss where as a result of the transaction there has been a mere
change in the form of ownership and the taxpayer has not really
cashed in on the theoretical gain or lost out on a losing venture.
Portland Oil Co. v. Commissioner of Internal Revenue, (C.A.
1, 1940) 109 F.2d. 479.
5. The realities or substance of the transaction and the intention of
the parties govern, and the means employed by them to
accomplish an exchange rather than a sale are unimportant.
6. This transaction cannot be separated for tax purposes into its
component parts. The actual intention of the parties and what
was accomplished rather than the separate steps taken govern.
Century Electric Co. v. Commissioner of Internal Revenue,
(C.A. 8, 1951)
7. It was entirely proper and lawful for Delhi-Taylor Oil
Corporation to bind itself to exchange property it did not own
but could acquire in the future.
8. It is my opinion that the facts in this case compel the
conclusion that the substance of the transaction clearly brings it
within the provisions of Section 1031(a) of the Internal
Revenue Code of 1954.

It has been conceded that in the event plaintiff prevails it would not be entitled to
recover the full amount prayed for in the complaint and that the same would require
adjustment. Therefore, plaintiff should have judgment against the defendant for the
amount now determined by adjustment due it, together with interest thereon, to be
calculated by the Treasury Department.

Accordingly, an appropriate order for judgment may be submitted.

COASTAL TERMINALS, INC., Appellee,


v.
UNITED STATES of America, Appellant.
320 F.2d 333 (1963)

BARKSDALE, District Judge.

Coastal Terminals, Inc., a South Carolina Corporation, duly filed its income tax return
for the fiscal year ending June 30, 1957, and paid the tax shown by the return to be due.
Thereafter, the District Director of Internal Revenue, Columbia, S.C., asserted a
deficiency in the income tax paid, which deficiency the taxpayer paid under protest, and
filed its claim for a refund. Upon disallowance of its claim for refund, the taxpayer
instituted this action in the District Court for the Eastern District of South Carolina to
recover the amount paid by reason of the deficiency assessment. A trial being had by the
court without a jury, the court found the facts specially, stated separately its conclusions
of law thereon, and entered judgment in favor of the taxpayer for the amount sued for.
From this adverse judgment, the United States of America has prosecuted this appeal.

A number of years prior to 1957, a group of independent oil jobbers formed the
corporation, Coastal Terminals, Inc., for the purpose of having it provide facilities for the
storage of oil and other petroleum products. In 1957, and for a number of years prior
thereto, Coastal Terminals owned and operated a deepwater oil terminal at North
Charleston, S.C., the facility consisting of real estate, tanks, pipe lines and office space.
Prior to 1957, Coastal Terminals determined that it was to its advantage, and to the
advantage of its oil jobber stockholders, to acquire inland terminal facilities, to be
supplied with oil by Plantation Pipe Line. To this end, Coastal obtained options on three
sites contiguous to Plantation Pipe Line which would be suitable for the erection of
terminal facilities. The first such site, upon which an option was taken in December,
1955, was at Belton, S.C. Later options were taken on sites at Salisbury, N.C., and
Doraville, Ga. There was Existing at this time an operating terminal at Wilmington, N.C.,
which was owned by Coastal Terminals of North Carolina, a separate and distinct
corporation of which the taxpayer owned 60% Of the stock and which it hoped to acquire
and own outright in the future. Although at that time the taxpayer, Coastal Terminals, had
no funds available for the purchase of the sites upon which options had been taken or for
the erection of terminal facilities on such sites, as steel was in short supply, the taxpayer
obtained commitments from its principal supplier, Chicago Bridge and Iron Company,
for the necessary steel, it being understood between Chicago Bridge and Coastal that
these commitments might be cancelled if Coastal subsequently found itself unable to
finance the purchases. As early as August 1956, Coastal obtained commitments from
Chicago Bridge for steel construction at the Belton and Doraville locations.

In the Spring of 1957, Delhi-Taylor Oil Corporation approached Coastal with the view
of purchasing Coastal's oil terminal facilities at Charleston. Delhi- Taylor, a Delaware
corporation, had its principal offices in Dallas, Texas, and, operating as an independent
oil company, was engaged in exploration, production, refining and marketing activities.
At the outset, Delhi-Taylor offered to purchase Coastal's terminal facilities at Charleston
for $1,000,000.00 cash, and Coastal's asking price was $1,475,000.00. Eventually, Delhi-
Taylor offered $1,200,000.00, and Coastal refused to sell for less than $1,400,000.00. At
that time it was Coastal's intention to continue in the oil business, but it had no available
funds to convert the sites on the Plantation Pipe Line, on which it had taken options, into
operating terminals, and Coastal did not consider Delhi-Taylor's offering price of
$1,200,000.00 enough to accomplish that end. Since Coastal and Delhi-Taylor could not
agree on a sale, the idea of an exchange of properties was suggested and was discussed.
These discussions resulted in an agreement that Delhi-Taylor would acquire from Coastal
Terminals of North Carolina, its terminal in Wilmington, N.C., the sites at Belton, N.C.,
Salisbury, N.C., and Doraville, Ga., construct terminals on the sites, and exchange these
four terminals for Coastal's deep water terminal in Charleston.

On May 11, 1957, Coastal and Delhi-Taylor entered into a written agreement entitled,
'The State of South Carolina, Terminal Purchase and Sale Contract, Charleston, South
Carolina'. This agreement provided for the sale of taxpayer's Charleston facilities to
Delhi-Taylor for a cash consideration of $1,200,000.00, with an escrow deposit of
$60,000.00 as earnest money. The agreement further provided:

'It is understood that Seller is endeavoring to arrange for an exchange of like properties
consisting of terminal facilities at Wilmington, Charlotte and Salisbury, North Carolina
and Belton, South Carolina between the parties in lieu of the aforementioned cash
consideration or some part thereof, such exchange arrangement to be fully capable of
completion on or before July 1st, 1957, but unless Seller shall present, and Purchaser
shall at its sole option accept, such arrangement to exchange like property in lieu of
payment of the cash consideration aforementioned, prior to the 20th day of June 1957,
then this contract shall be closed upon the terms and conditions otherwise elsewhere
herein set forth.'

'Subject to the approval of title by Purchaser's attorneys, and in the event Purchaser's
attorneys, and the Surveyor find Seller's title to be good and marketable and free and
clear of all liens, encumbrances, restrictions and encroachments, and in the further event
that Seller has complied with and performed all other terms and conditions hereof,
Purchaser shall close the transaction on or before July 1, 1957, by paying to the Seller the
One Million, Two Hundred Thousand Dollar ($1,200,000.00) purchase price or
exchanging property of like kind and value, if such exchange of property can be arranged,
less the down payment, or earnest money hereinabove mentioned, at which time Seller
will deliver to Purchaser its general warranty deed conveying to purchaser a fee simple
title free and clear of all liens, encumbrances, restrictions and encroachments.'

This contract was drawn by Delhi-Taylor's counsel, no attorney for Coastal having
participated in the preparation of the contract, and Delhi-Taylor was most interested in
being assured that it would acquire Coastal's Charleston terminal on July 1, 1957.
Notwithstanding the fact that the written agreement apparently gave Delhi-Taylor the
option of acquiring Coastal's Charleston terminal, either by purchase for cash or by
exchange, the testimony of both Coastal's and Delhi-Taylor's negotiating representatives
is clear and positive that a sale for cash could not be agreed upon, and that their definite
agreement was for an exchange of properties. Thereafter, Coastal assigned its options to
purchase the sites on Plantation Pipe Line to Delhi-Taylor, assigned its commitments for
steel from Chicago Bridge and Iron Company to Delhi-Taylor, Delhi-Taylor contracted
with Kaminer Construction Company for the construction and installation of pipe
connections with the storage tanks acquired from Coastal Terminals of North Carolina its
existing terminal at Wilmington. The construction of the terminal facilities at the three
sites on Plantation Pipe Line proceeded promptly, with Delhi-Taylor checking on the
engineering details so that the terminals would be acceptable to Coastal, and by July 1,
1957, the terminals and connections had been substantially completed. On or prior to July
1, 1957, Delhi-Taylor paid for and conveyed the four terminals to Coastal, and Coastal
conveyed its deepwater terminal at Charleston to Delhi-Taylor.

The District Judge, sitting as the trier of facts without a jury, found that:

'The substance of the transaction was one in which plaintiff owned a deepwater
terminal which Delhi-Taylor Oil Corporation wanted to acquire; they were unable to
agree upon a sale; that as result of prior corporate investigation and planning, which at
the time had no connection with this transaction, plaintiff knew of certain property which
it would be willing to accept in exchange for its terminal provided Delihi-Taylor Oil
Corporation would acquire and improve the same, and that Delhi-Taylor did acquire and
improve the same on its own behalf so that it would be in a position to make an
exchange, and that an exchange in fact took place. Plaintiff did not 'cash in' and invest the
same in another business nor did it receive cash and reinvest the same in like property,
but merely exchanged its property with Delhi-Taylor Oil Corporation for like property
and continued on as before in its identical business.'

The Government contends that the transaction between Coastal and Delhi-Taylor was a
'sale' for gain, the gain from which is recognizable under Section 1002 of the Internal
Revenue Code of 1954.

On the other hand, the taxpayer contends that the transaction was an 'exchange' within
the meaning of Section 1031(a).

The Government alternately contends that, even if the transaction be deemed an


'exchange' within the meaning of Section 1031(a), the gain nonetheless is partially
taxable under Section 1031(b) and (d) to the extent of certain liabilities of the taxpayer
assumed by Delhi-Taylor.

The taxpayer disagrees with this contention and insists that at the time the exchange
was agreed upon, it had incurred no obligations to either Chicago Bridge or Kaminer, and
that the obligations incident to the undertaking to construct terminals to be exchanged
were entirely the obligations of Delhi-Taylor.

The purpose of Section 1031(a), as shown by its legislative history, is to defer


recognition of gain or loss when a direct exchange of property between the taxpayer and
another party takes place; a sale for cash does not qualify as a nontaxable exchange even
though the cash is immediately reinvested in like property.
We are of the opinion that, upon the evidence, the District Court's findings of fact and
conclusions of law were amply sustained by the authorities.

'Whether the transaction constituted a sale or an exchange for income tax purposes
depends on the intent of the parties and this intent is to be ascertained from all relevant
facts and circumstances, and of necessity the case is largely dependent upon
circumstantial evidence.' Sarkes Tazian, Inc. v. United States, (7th Cir.), 240 F.2d 467,
470.

'the transaction must be viewed as a whole, and each step, from the commencement of
negotiations to the consummation of the sale, is relevant.' Commissioner of Internal
Revenue v. Court Holding Co., 324 U.S. 331, 334, 65 S.Ct. 707, 708, 89 L.Ed. 981.

'The transaction here involved may not be separated into its component parts for tax
purposes. Tax consequences must depend on what actually was intended and
accomplished rather than on the separate steps taken to reach the desired end.' Century
Electric Co. v. Commissioner of Internal Revenue (8th Cir.), 192 F.2d 155, 159.

There was no impropriety or illegality in the undertaking of Delhi-Taylor to exchange


property which it did not own at the time of the undertaking. Howell Turpentine Co. v.
Commissioner of Internal Revenue, 162 F.2d 319, wherein (p. 322) the court quotes with
approval from American Jurisprudence, the following:

"It is not unusual for persons to agree to convey by a certain time notwithstanding they
have no title to the land at the time of the contract, and the validity of such agreements is
upheld. In such cases the vendor assumes the risk of acquiring the title and making the
conveyance, or responding in damages for the vendee's loss of his bargain. * * *
Whenever one is so situated with reference to the tract of land that he can acquire the title
thereto, either by the voluntary act of the parties holding the title, or by proceedings at
law or in equity, he is in position to make a valid agreement for the sale thereof without
disclosing the nature of this title.' 55 Am.Jur., Vendor and Purchaser, 12'.

In accord are Mercantile Trust Co. & Nelson v. Commissioner of Internal Revenue, 32
B.T.A. 82; W. D. Haden Co. v. Commissioner of Internal Revenue, 165 F.2d (5th Cir.)
588, and Alderson v. Commissioner of Internal Revenue (9th Cir.), 317 F.2d 790.

The Alderson case, supra, so far as we know, is the latest decision on the question
presented in the instant case. The Tax Court (38 T.C. 215) held that the transaction was a
taxable sale and not an exchange within the purview of Section 1031(a) of the Revenue
Code. Counsel for the Government relied heavily on this decision in their brief in the
instant case. However, prior to the argument of this case, the Court of Appeals for the
Ninth Circuit, by its opinion filed May 22, 1963, reversed the decision of the Tax Court,
holding that the transaction was an exchange within the purview of Section 1031(a).

The facts are quite analogous to those of the instant case. The Aldersons (hereinafter
referred to as 'taxpayers') entered into an agreement on May 21, 1957 with Alloy Die
Casting Company (hereinafter referred to as 'Alloy') to sell their Buena Park farm
property in Orange County, California, to Alloy for $172,871.40, and according to the
terms of the agreement Alloy deposited with Orange County Title Company, $17,205.00
toward the purchase of the property. From the outset, the taxpayers' desire was to
exchange their Buena Park property for other property of a like kind. They intended to
sell the property for cash only after they were unable to locate a suitable piece of property
to take in exchange. Alloy intended simply to effect a purchase of the property for cash.
Alloy did not learn that petitioners wished to exchange their property for like property
until the latter part of July, 1957. Sometime after the execution of the purchase and sale
agreement, taxpayers located certain property in Monterey County, referred to as the
Salinas property, which they desired to obtain in exchange for the Buena Park property.
On August 19, 1957, taxpayers and Alloy executed an amendment to their previous
agreement providing that the Salinas property would be acquired by Alloy and exchanged
for the Buena Park property in lieu of the originally contemplated cash sale transaction.
However, the amendment provided that, if this exchange were not effected by September
11, 1957, the original agreement with respect to a purchase for cash would be carried out.
On that same day, the daughter and agent of taxpayers delivered to the Salinas Title
Guarantee Company, 'Buyers' Instructions' reciting that $190,000.00 would be paid for
the Salinas property, that $19,000.00 was paid therewith out of taxpayers' money on
deposit with the title company, and authorizing the title company to convey the Salinas
property to Alloy provided a deed from Alloy to taxpayers could be immediately
recorded. The Salinas title company acquired title to the Salinas property for a purchase
price of $190,000.00, the funds being provided by the $19,000.00 deposited by taxpayers'
daughter, and $172,871.40 being paid to the title company by Alloy, the excess of the
amounts deposited being returned to taxpayers. The title company then conveyed the
Salinas property to Alloy, who in turn conveyed it by deed to taxpayers, and at the same
time the taxpayers conveyed the Buena Park property to Alloy. Taxpayers paid for all
documentary stamps on the deeds and all escrow fees.

Upon these facts, the Tax Court held that the transaction was a sale by taxpayers of
their Buena Park property to Alloy for cash, and a reinvestment by taxpayers of the
purchase price in the Salinas property, Alloy only acting as a conduit through which title
to the Salinas property passed.

In reversing the decision of the Tax Court, the Court of Appeals seemed impressed by
the fact that, from the outset, it was taxpayers' desire to effect an exchange of property.
The Court said:

'Petitioners, on finding the Salinas property, took steps to make it available to Alloy for
the exchange by signing buyer's instructions in the escrow of August 19, 1957, opened at
Salinas Title, but the fact is, as found by the Tax Court, that petitioners at that time
intended to accomplish an exchange of properties and that the Salinas property was
'acquired by Alloy' for the sole purpose of such exchange.

'True, the intermediate acts of the parties could have hewn closer to and have more
precisely depicted the ultimate desired result, but what actually occurred on September 3
or 4, 1957, was an exchange of deeds between petitioners and Alloy which effected an
exchange of the Buena Park property for the Salinas property. It is also noted by the court
that the buyer's instructions in the Salinas escrow did not conform to the seller's
instructions although the transfer from the original owner of the Salinas property to
Salinas Title was, as to the provisions at variance, pursuant to the terms of the buyer's
instructions. If Alloy had signed the said 'Buyer's Instructions' this litigation would have
been avoided, but even in the circumstances here involved the court concludes that the
intended exchange was accomplished.

'In the case at bar, the ultimate objective appears without question to have been the
exchange of property of like kind. As the court in the Helvering case (Gregory v.
Helvering, 293 U.S. 465, 55 S.Ct. 266, 79 L.Ed. 596) further observes:

"Putting aside, then, the question of motive in respect of taxation altogether, and fixing
the character of the proceeding by what actually occurred, what do we find?' (293 U.S.
page 469, 55 S.Ct. page 267). 'In the instant case we find a plan to exchange the
properties within the intent of the statute (1031 I.R.C. of 1954), and the acquiring of the
Salinas property by Alloy with the sole purpose of trading same for the Buena Park
property which does not make the transaction one within Section 1002, Internal Revenue
Code of 1954.'

In the instant case, we are of opinion that there was ample evidence to support the
conclusion of the District Court that the transaction between Coastal and Delhi-Taylor
was an 'exchange' within the purview of Sec. 1031(a) and not a 'sale' as contemplated by
Sec. 1002.

Nor can we agree with the Government's alternate contention that gain to Coastal was
recognizable under Sec. 1031(b) and (d) under the theory that Delhi-Taylor's payments to
Chicago Bridge and Kaminer for the construction of terminal facilities were payments by
Delhi-Taylor of obligations of Coastal. Before any work was done, and in fact, before
any binding legal obligations had been incurred by Coastal to either Chicago Bridge or
Kaminer, Delhi-Taylor undertook to have these terminals constructed by Chicago Bridge
and Kaminer in order to be in position to make the exchange with Coastal. So Delhi-
Taylor paid its own legally incurred obligations and not the obligations of Coastal.

It follows that the judgment of the District Court is hereby Affirmed.

SOURCE OF FUNDS FOR DISCHARGING DEBT ON AN EXCHANGE:


NORTH SHORE BUS CO.

In the older case of North Shore Bus Co., the Tax Court held, affirmed by the Second
Circuit, that the source of funds to discharge a debt could come from the seller and that
discharge of the old debt in question would not create income to the other party.
COMMISSIONER OF INTERNAL REVENUE
v.
NORTH SHORE BUS CO., Inc.

1944-1 U.S.T.C. 9345,


143 F.2d 114 (1944)

CHASE, Circuit Judge.

This petition to review a decision of the Tax Court of the United States requires us to
determine whether, when the respondent in 1936 turned in property held for productive
use in its business in part payment for like property to be held for like use, cash it
received in connection with the exchange to pay off a mortgage on the old property
turned in was income taxable to the respondent. The Tax Court held that it was not and
the Commissioner brought the petition to review.

On March 5, 1936, the respondent, a New York corporation which was operating
busses in the City of New York, ordered ten new motor coaches of the Twin Coach
Corporation for use in its business. The purchase price of these coaches was $118,964.80.
Under the terms of the order which the seller accepted, the respondent was to pay for the
new coaches by delivering to the seller ten old busses which the respondent had been
using in its business, and for which credit was to be given as will later appear, and
making forty-eight monthly installment payments of the balance due, for which it gave
the seller security. The exchange value of the old busses was agreed to be $30,000. They
had cost the respondent originally $107,481.50, which it had entirely deducted for
depreciation in its income tax returns filed before 1936. At the time of the exchange these
old busses were subject to a mortgage held by the Yellow Manufacturing Credit
Corporation on which approximately $24,000 remained unpaid. The Twin Coach
Corporation agreed to pay off that mortgage and to give the respondent credit for the
remaining $6000 on the purchase of the new coaches. In carrying out the agreement the
Twin Coach Corporation did not pay the amount due on the mortgage directly to the
mortgagee, however, but instead sent the respondent its check for that amount to be used
by it to pay off the mortgage. The respondent deposited that check in its bank account
and then with its own check for $23,960.99 paid the mortgage in full. The small
difference between the amount it actually paid on the mortgage and the $24,000 it
received to use for making the payment has been ignored by the parties and will be by us.

The new coaches were set up on the respondent's books at the full contract price of
$118,964.80 and its depreciation reserve was at the same time credited with the agreed
trade in value of $30,000.00 for the old busses.

The applicable statute and regulation are Sec. 112(b)(1) of the Revenue Act of 1936, 26
U.S.C.A.Int.Rev.Code, 112(b)(1), and Art. 112(b)-1 of Regulations 94.

The statute reads in its relevant part as follows:


'Sec. 112. Recognition of gain or loss.

'(b) Exchanges solely in kind--

'(1) Property held for productive use or investment. No gain or loss shall be recognized
if property held for productive use in trade or business or for investment (not including
stock in trade or other property held primarily for sale, nor stocks, bonds, notes, choses in
action, certificates of trust or beneficial interest, or other securities or evidences of
indebtedness or interest) is exchanged solely for property of a like kind to be held either
for productive use in trade or business or for investment.'

Art. 112(b)-1 of Regulations 94 reads in part:

'No gain or loss is recognized if (1) a taxpayer exchanges property held for productive
use in his trade or business, together with cash, for other property of like kind for the
same use, such as a truck for a new truck or a passenger automobile for a new passenger
automobile to be used for a like purpose.'

If there had been no mortgage lien on the old busses the exchange would
unquestionably have been within the statute and the regulation, which is obviously valid,
and no gain or loss would have been recognized. Had the old busses been traded in
subject to the mortgage which the respondent had remained bound to discharge there
would, of course, have been the same sort of an exchange taxwise for in either event any
gain the respondent might have made by getting more allowed for the old busses than
they were then worth would have been reflected in its cost basis for the new coaches and
its 'realization' been postponed.

What was actually done brought about no different tax consequences. The respondent
merely exchanged its busses for the new coaches and agreed to pay in addition the
difference between the purchase price of the new coaches and that part of the agreed
trade-in value of the old busses which was thus established to be its equity in them. If that
equity was overvalued that fact will be relevant whenever the basis of the new coaches is
determined for tax purposes.

Acting as the conduit through which the funds passed from Twin Coach to the
mortgagee whose mortgage was satisfied did not make the respondent the recipient of
any income. Nor does the fact that the seller of the new coaches provided the funds with
which to discharge the old mortgage debt make those funds the income of the respondent.
That phase of the transaction increased the secured debt which the respondent owed Twin
Coach by the amount of the check, and at most enabled it to exchange creditors when it
discharged the old mortgage. The tax court so found and that is what controls decision
now. Dobson v. Commissioner of Internal Revenue, 320 U.S. 489, 64 S.Ct. 239.
Affirmed.

REVENUE RULING 79-44


Where two parties, not related, and not being dealers in property, owned undivided
interests in two separate parcels, as tenants in common, is it possible that these two
parties, A and B, could undertake an exchange within Code Section 1031(a)?

An additional wrinkle addressed the fact that one of the parcels of the two in question,
after the exchange, had a mortgage on the property, while one of the other parcels did not
have such mortgage. Would these come within Code Section 1031?

To the extent there is debt relief, there is taxable gain. Thus, gain could be generated for
one party and not for the other.

REVENUE RULING 79-44


1979-1 C.B. 265

Exchange of jointly owned farm properties; one subject to mortgage. Two unrelated
farmers transferred their undivided one-half interests in two jointly owned parcels of
farmland, only one of which was subject to a mortgage, to each other so that each farmer
became the sole owner of one parcel and continued to use that parcel as farmland. The
farmer receiving the unmortgaged parcel gave the other a promissory note in the amount
of one-half the mortgage on the other parcel. The transfer is an exchange under section
1001(a) of the Code. Gain on the exchange is recognized only to the farmer receiving the
note and only to the extent of the fair market value of such note.

ISSUES

Is the transfer of interests in real property held by tenants in common that results in the
conversion of two jointly owned parcels into two individually owned parcels a
nontaxable partition or an exchange under section 1001(a) of the Internal Revenue Code
of 1954?

If the transfer is an exchange, does it qualify for treatment as a like-kind exchange


under section 1031 of the Code?

FACTS

Two unrelated individuals, A and B, neither of whom are dealers in real estate,
respectively owned undivided one-half interests in two separate parcels of land as tenants
in common. Both parcels were used in the taxpayers' business of farming. One parcel was
subject to a mortgage for which A and B were each personally liable in the face amount
of 1,000x dollars.

A and B rearranged their interests so that each owned 100 percent of a separate parcel.
At the time of the transaction, each parcel had a fair market value of 2,000x dollars and
an adjusted basis of 100x dollars. A received the parcel subject to the mortgage and B
received the remaining parcel, which was free of debt. B also executed a promissory note
to A in the amount of, and with a fair market value of, 500x dollars to compensate A for
taking the property subject to the mortgage. A and B continued to use the parcels in their
respective businesses of farming.

LAW AND ANALYSIS

Section 1001(a) of the Code provides that gain from the sale or other disposition of
property shall be the excess of the amount realized therefrom over the adjusted basis in
section 1011 for determining gain.

Section 1001(c) of the Code provides that the entire amount of the gain shall be
recognized unless an exception provided in subtitle A of the Code applies.

Section 1031(a) of the Code provides that no gain shall be recognized if property held
for productive use in trade or business or for investment is exchanged solely for property
of a like kind to be held either for productive use in trade or business or for investment.

Section 1031(b) of the Code provides that if other property (in addition to property
permitted to be received without recognition of gain) or money is received in an
exchange, any gain shall be recognized in an amount not in excess of the sum of money
and the fair market value of the other property.

Section 1.1031(d)--2 of the Income Tax Regulations provides that the amount of any
liabilities of a taxpayer assumed by the other party to an exchange is treated as money
received by the taxpayer upon the exchange. Example (2)(c) of this regulation illustrates
that the amount of a taxpayer's liabilities assumed by the other party to an exchange is
offset by the amount of money paid by the taxpayer and the amount of the other party's
liabilities assumed by the taxpayer as a result of the exchange. However, the amount of
cash or other property received by a taxpayer in an exchange is not offset by the
taxpayer's assumption of the liabilities of the other party in the exchange.

Rev. Rul. 73--476, 1973--2 C.B. 300, holds that any gain or loss realized by three
taxpayers who each exchanged an undivided interest in three separate parcels of real
estate that were not subject to mortgages for a 100 percent ownership of one parcel is not
recognized pursuant to section 1031(a) of the Code.

In this case, the transfer of interests in real property held by tenants in common that
resulted in the conversion of two jointly owned parcels into two individually owned
parcels is an exchange. The provisions of section 1001(a) of the Code apply to the
exchange for purposes of determining the amount of gain realized. However, because the
property interests exchanged are like-kind property that were being used in the taxpayers'
business of farming and have continued to be so used after the exchange, the provisions
of section 1031 apply to determine to what extent, if any, the gain is to be recognized.

As a result of the exchange, A owns 100 percent of one parcel of real estate, with a fair
market value of 2,000x dollars and subject to a mortgage of 1,000x dollars. The value of
the one-half interest received by A was 1,000x dollars, one-half of the fair market value
of the real estate. The value of the mortgage liability assumed by A as a result of the
exchange was 500x dollars. A also received a note from B for 500x dollars. The note
received by A is other property for purposes of section 1031(b) of the Code. A realized a
gain of 950x dollars computed as follows:

1,000x
Value of property received
dollars
Liabilities subject to which old property was
500x
transferred
Total consideration received 1,500x
Less: Adjusted basis of property transferred 50x
(one-half of 100x dollars)
Other property paid (note) 500x -- 550x
Gain realized 950x dollars

For purposes of section 1031(b) of the Code the amount of 'other property or money'
received by A is 500x dollars. Consideration received by A in the form of money or other
property is not offset by consideration given in the form of an assumption of liabilities or
receipt of property subject to a liability. Accordingly, under section 1031(b), 500x dollars
of the 950x dollar gain will be recognized. See section 1.1031(d)--2 of the regulations. B
received 100 percent ownership of the parcel of real estate that was not subject to a
mortgage. The value of the one-half interest received by B is 1,000x dollars, one-half of
the fair market value of the real estate. B realized a gain of 950x dollars computed as
follows:

1,000x
Value of property received
dollars
Liabilities subject to which old property was
500x
transferred
Total consideration received 1,500x
Less: Adjusted basis of property transferred 50x
(one-half of 100x dollars)
Other property paid (note) 500x -- 550x
Gain realized 950x dollars

For purposes of section 1031(b) of the Code, the amount of 'other property or money'
received by B is zero. Consideration received by B in the form of a transfer subject to a
liability of 500x dollars is offset by consideration given in the form of other property.
Accordingly, under section 1031 (b), B will not recognize any of the gain to be realized
from the exchange. See section 1.1031(d)--2 of the regulations.

HOLDING
The transfer of interests in real property held by tenants in common that resulted in the
conversion of two jointly owned parcels into two individually owned parcels is an
exchange under section 1031(a) of the Code.

Because the property interests that were exchanged are like-kind property that were
being used in the taxpayers' business of farming and have continued to be so used after
the exchange, the provisions of section 1031 of the Code apply. Under section 1031, A
will recognize the gain realized from the exchange, but not in excess of the fair market
value of the note received from B. B will not recognize any of the gain realized from the
exchange.

PRIVATE LETTER RULING 8003004

The following Ruling illustrates the application of the netting of debt relief. See also
Chapter 5 as to the discussion of boot.

PRIVATE LETTER RULING 8003004

ISSUE:

Whether Taxpayers may offset the boot received as a result of the assumption of their
mortgages by the other party to the exchange by the boot paid to the other party in the
form of a refinancing of the other party's mortgage.

FACTS:

In July of 1975, Taxpayers transferred three of their residential rental properties to B in


exchange for one large apartment complex. In the exchange B agreed to assume the
remaining amounts due on Taxpayers' three mortgages, which totaled $50,000x.
Taxpayers instructed their escrowee to refinance the remaining amount due on B's
mortgage, which equaled $400,000x. As part of this transaction, Taxpayers executed two
notes which exceeded $400,000x using B's property as collateral. B's mortgage was then
paid off with the funds obtained from these notes.

In August of 1976, Taxpayers made a similar exchange of properties. Under the escrow
agreement the third party agreed to assume the remaining mortgage of $25,000x on
Taxpayer's property. As their part of the exchange, Taxpayers signed a note in the
amount of $45,000x. The proceeds of this note were used to pay off the third party's
mortgage.

APPLICABLE LAW:

Section 1031(b) of the Code provides that when an exchange consists of like kind
property and other property, any gain from the transaction shall be recognized in an
amount not to exceed the fair market value of the other property.
Section 1.1031(b)--1(c) of the Income Tax Regulations states that consideration
received in the form of an assumption of liabilities (or a transfer subject to a liability) is
to be treated as 'other property or money' for the purposes of section 1031(b) of the Code.
Where, on an exchange described in section 1031(b), each party to the exchange either
assumes a liability of the other party or acquires property subject to a liability, then, in
determining the amount of 'other property or money' for purposes of section 1031(b),
consideration given in the form of an assumption of liabilities (or a receipt of property
subject to a liability) shall be offset against consideration received in the form of an
assumption of liabilities (or a transfer subject to a liability).

Example (2)(c) of section 1.1031(d)--2 of the regulations provides, in part, that


although consideration received in the form of cash or other property is not offset by
consideration given in the form of an assumption of liabilities or a receipt of property
subject to a liability, consideration given in the form of cash or other property is offset
against consideration received in the form of an assumption of liabilities or a transfer of
property subject to a liability.

RATIONALE:

The essence of the District Office's argument is that boot received by a person in a
section 1031 exchange may only be reduced by boot given in the exchange in the form of
an assumption of liabilities (or a receipt of property subject to a liability). In other words,
the District Office argues that boot may only be netted in the case of a reciprocal transfer
of mortgages where the party, in question, actually assumes the mortgage or takes the
property subject to that mortgage. In this case, the District Office argues that there was no
assumption of B's mortgage, basing its conclusion on the rationale of Maddox v.
Commissioner, 69 T.C. 854 (1978).

In Maddox the court held that a mortgage is not considered assumed for purposes of the
30 percent test under section 453(b)(2)(B) of the Code unless the transferor remains
either primarily or secondarily liable on that debt for the entire year. Thus, where a
mortgage is paid off completely in the first year of the sale, the transferor's liability is
extinguished and hence the transferor is deemed to have been paid cash equal to the value
of that sum. This normally means that the transferor has received an amount greater than
30 percent of the selling price in the first year. As a result, the transferor would not be
able to use the installment method of reporting gain under section 453 of the Code.

Relying on the holding in the Maddox case, the District Office argues that, in
substance, a cash payment was made to Taxpayers. Since section 1.1031(b)--1(c) of the
regulations speaks only in terms of a netting of liabilities and since Taxpayers, in this
case, neither assumed B's liability nor took the property subject to B's liability, Taxpayers
are not entitled to offset the boot received.

Taxpayers' representative points out that section 1.1031(b)--1(c) of the regulations must
be read in conjunction with Example (2)(c) of section 1.131(d)--2. Under Example (2)(c)
of section 1.1031(d)--2 of the regulations a person who receives boot by virtue of
surrendering property to which is attached a mortgage is permitted to offset that boot with
any other boot given in the exchange, whether the boot paid is cash or other property.

We agree with the analysis of Taxpayers' representative that boot received by


Taxpayers as a result of B's assumption of their mortgages should be reduced (or offset)
by any boot given up by Taxpayers, whether that boot be in the form of an assumption of
a mortgage or in the form of a cash payment.

In this case, it does not matter whether we characterize Taxpayers' payment of B's
mortgage as a cash payment or as an assumption of a liability. In either case, Taxpayers
would be entitled to offset the boot received (in the form of an assumption by B of the
mortgages on Taxpayers' properties) by the amount of the boot given. In both of the
transactions involved in this case (the 1975 and the 1976 exchange), the boot received by
Taxpayers when the third party assumed their mortgages was less than the boot given up.
Therefore, the boot received by Taxpayers was completely netted out. Consequently,
Taxpayers shall not recognize gain under section 1031(b) of the Code as a result of the
receipt of this boot.

CONCLUSION:

The amount of boot received by Taxpayers as a result of the other party's assumption of
their mortgages may be offset by the amount of boot paid by Taxpayers in the 1975 and
1976 exchanges in the form of a refinancing of the other party's mortgage.

DEBT RELIEF: NETTING:


PRIVATE LETTER RULING 9853028
1998 WL 908394

This Private Letter Ruling ties to two (2) additional Rulings under Private Letter Ruling
9853029 and 9853028.

This Ruling covered the question of debt relief as to the potential item of boot on a
Code §1031 exchange. The issue involved a specific focus on whether the debt involved
in the case could be netted, that is to net out the debt to which the taxpayer was relieved,
against the debt which the taxpayer went into on the replacement property.

Such netting was allowed in this case.

PRIVATE LETTER RULING 9853028


Internal Revenue Service (I.R.S.)
1998 WL 908394 (I.R.S.)
Issue: December 31, 1998
September 30, 1998

Dear
This responds to your three letters, dated November 21, 1997, requesting private letter
rulings for the above-referenced taxpayers. The rulings request a determination of how
§1031 of the Internal Revenue Code would apply to a transaction in which the three
taxpayers are the transferors of the relinquished property.

Facts

Partnerships A, B and C (hereinafter, "Taxpayers" when referred to collectively) are


each State X general partnerships, file income tax returns on a calendar year basis, and
use the cash method of accounting. The partners of each partnership are Individual Y and
Individual Z.

In November 1987, each partnership acquired a separate 100% fee simple interest in
specific blocks of Property, a garden apartment complex located in State W. Specifically,
Partnership A owns 16% of Property in fee simple, Partnership B owns 9% of Property in
fee simple and Partnership C owns 75% of Property in fee simple. Each partnership is in
the business of leasing its share of the apartment units of Property to tenants for profit.
Taxpayers are not dealers in real estate.

Property is encumbered by a mortgage in favor of Bank D with a current outstanding


balance of approximately $h. Taxpayers are jointly and severally liable on the mortgage.

In September 1997, Taxpayers received an offer from Buyer to purchase Property for
$i. Buyer intends to finance the acquisition by obtaining bond financing, which precludes
it from assuming the mortgage currently encumbering Property. Each partnership
accepted Buyer's offer because the disposition of Property at this time is consistent with
its business plan to upgrade its holdings from class "c" quality apartment complexes to
class "a" or "b" quality apartment complexes. Since each partnership wishes to continue
its business of operating and leasing apartments and continue its investment in
Replacement Property, another apartment complex, each Partnership has structured the
transaction as a deferred like-kind exchange.

On October 3, 1997, each partnership entered into a contract with Buyer for the sale of
Property. Pursuant to the sales contract, Buyer deposited $j with QI, which amount was
held in escrow by QI and applied to the purchase price of Property at closing on the
Closing Date. In order to qualify for nonrecognition under §1031 of the Code, the
transaction will be completed in the following steps:

Step Execution of Exchange Agreement and Assignment of Rights.


1: Taxpayers entered into an exchange agreement with QI who
serves as an intermediary for the exchange. [FN1] Under the
terms of the exchange agreement, Taxpayers expressly
assigned to QI all of their rights in the contract. The exchange
agreement provides that (i) QI has sole and exclusive
possession, dominion, control and use of all funds advanced by
Buyer in connection with its purchase of Property, including
interest earned thereon, and (ii) Taxpayers shall have no right,
power, or option to demand, call for, receive, pledge, borrow
and otherwise obtain the benefits of any such funds or interest.
These limitations will prevent Taxpayers from accessing the
proceeds from the transfer of Property, as set forth in
§1.1031(k)-1(g)(6) of the Income Tax Regulations.

On or before initial closing (described in Step 2) Buyer entered into a written


agreement with QI and Taxpayers wherein Buyer (i) consented and agreed to the
assignment of the Contract, (ii) agreed to accept title to Property by direct-deed from
Taxpayers, and (iii) agreed to pay the net proceeds due under the contract to QI. In
addition, all parties to the contract were notified in writing of the assignment of the
contract prior to the initial closing.

Step The Initial Closing. On Closing Date, QI caused each


2: partnership to transfer its interest in Property to Buyer pursuant
to the exchange agreement. Contemporaneously, Buyer
transferred approximately $h to Bank D (the mortgage pay-off
amount to extinguish the mortgage), and the balance of the $i
purchase price (the "exchange funds") was paid by Buyer to the
QI. QI deposited and maintains the exchange funds in an
interest bearing account in accordance with the exchange
agreement.
Step Identification of Replacement Property. On or before the 45th
3: day following the Closing Date, Taxpayers identified
Replacement Property, a property of like kind to the
relinquished property, Property, and made a written
identification notice of the same. The identification notice
described the replacement property in reasonable detail and
included such information as the legal description, street
address or distinguishable name of Replacement Property.
Step Acquisition of Replacement Property. On or before the 180th
4: day following the Closing Date (but in no event after the due
date of Taxpayers' tax returns for the taxable year in which the
initial closing occurs determined with regard to extensions)
Taxpayers will enter into a contract to permit QI to acquire
Replacement Property. On or before the "exchange closing"
(described in Step 5) Taxpayers will assign their rights in the
Replacement Property contract to QI. All parties to the
Replacement Property contract will be given written notice of
such assignment.

On or before the exchange closing, QI will make such deposits on account of


Replacement Property and disburse the balance of the exchange funds (plus interest
earned thereon), as necessary to acquire Replacement Property. In the event that the cost
of Replacement Property exceeds the available exchange funds, Taxpayers will deliver to
QI the amount of such deficiency prior to the exchange closing.

To finance the acquisition of Replacement Property, Taxpayers will borrow a sum of


money that equals or exceeds the $h debt that currently encumbers Property. Taxpayers
will be jointly and severally liable on the new indebtedness. They intend that this new
indebtedness will offset the relief from liability on retirement of the mortgage on
Property, consistent with §1.1031(b)-1(c) of the regulations.

Step The Exchange Closing. On or before the 180th day following


5: the Closing Date (but in no event after the due date of
Taxpayers' tax returns for the taxable year which the initial
closing occurs determined with regard to extensions) and
simultaneously with the acquisition of Replacement Property,
QI will convey (or cause to be conveyed) tenancy-in-common
interests in Replacement Property to Taxpayers as follows:
Partnership A, 16%; Partnership B, 9%; and Partnership C,
75%.

Taxpayers represent that they will not operate as a partnership because they will
provide no services, other than the customary services of maintenance and repair, in the
operation of Replacement Property. See §1.7701-1(a)(2) and Rev. Rul. 75-374, 1975-2
C.B. 261.

Rulings Requested

Taxpayers request a ruling that the consideration received by Taxpayers in the form of
the liability relieved upon the retirement of the mortgage on Property using Buyer's funds
may be netted against the consideration given by Taxpayers in the form of liability
incurred upon acquisition of Replacement Property.

Law and Analysis

Section 1031(a)(1) of the Internal Revenue Code provides that no gain or loss shall be
recognized on the exchange of property 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.

Section 1031(a)(3) of the Code provides that for purposes of this subsection, any
property received by the taxpayer shall be treated as property which is not of like kind if--
(A) such property is not identified as property to be received in the exchange on or before
the day which is 45 days after the date on which the taxpayer transfers the property
relinquished in the exchange, or (B) such property is received after the earlier of (i) the
day which is 180 days after the date on which the taxpayer transfers the property
relinquished in the exchange, or (ii) the due date (determined with regard to extension)
for the transferor's return of the tax imposed by this chapter for the taxable year in which
the transfer of the relinquished property occurs ("exchange period").

As presented, the transaction will satisfy these timing requirements for identification
and receipt of replacement property. Taxpayers identified Replacement Property within
45 days of the transfer of Property. Furthermore, Taxpayers will receive Replacement
Property within the statutory exchange period.

However, compliance with these timing rules will not assure Taxpayers of avoiding
actual or constructive receipt of cash or other non-like-kind property unless there is also
compliance with certain additional requirements. These rules are precautionary measures
(or "safe harbors") set forth in the regulations to help taxpayers ensure that the transaction
is indeed an exchange of like-kind properties as opposed to a sale/purchase. They were
promulgated to enable taxpayers to avoid actual or constructive receipt of money or other
property (not of like kind) between the time of relinquishment and the time of
replacement.

Section 1.1031(k)-1(f)(1) of the regulations provides, in part, that in the case of a


transfer of relinquished property in a deferred exchange, gain or loss may be recognized
if the taxpayer actually or constructively receives money or other property before the
taxpayer actually receives like-kind replacement property. If the taxpayer actually or
constructively receives money or other property in the full amount of the consideration
for the relinquished property before the taxpayer actually receives the like-kind
replacement property, the transaction will constitute a sale and not a deferred exchange
even though the taxpayer may ultimately receive like-kind replacement property.

Section 1.1031(k)-1(f)(2) explains that, except as provided in paragraph (g) of this


section (relating to safe harbors), for purposes of §1031 and this section, the
determination of whether (or the extent to which) the taxpayer is in actual or constructive
receipt of money or other property before the taxpayer actually receives like-kind
replacement property is made under the general rules concerning actual or constructive
receipt and without regard to the taxpayer's method of accounting. The taxpayer is in
actual receipt of money or property at the time the taxpayer actually receives the money
or property or receives the economic benefit of the money or property. The taxpayer is in
constructive receipt of money or property at the time the money or property is credited to
the taxpayer's account, set apart for the taxpayer, or otherwise made available so that the
taxpayer may draw upon it at any time or so that the taxpayer can draw upon it if notice
of intention to draw is given. Although the taxpayer is not in constructive receipt of
money or property if the taxpayer's control of its receipt is subject to substantial
limitations or restrictions, the taxpayer is in constructive receipt of the money or property
at the time the limitations or restrictions lapse, expire, or are waived. In addition, actual
or constructive receipt of money or property by an agent of the taxpayer (determined
without regard to paragraph (k) of this section) is actual or constructive receipt by the
taxpayer.
Section 1.1031(k)-1(g)(4)(i) of the regulations provides that in the case of a taxpayer's
transfer of relinquished property involving a qualified intermediary, the qualified
intermediary is not considered the agent of the taxpayer for purposes of §1031(a). In such
a case, the taxpayer's transfer of relinquished property and subsequent receipt of like-kind
replacement property is treated as an exchange and the determination of whether the
taxpayer is in actual or constructive receipt of money or other property before the
taxpayer actually receives like-kind replacement property is made as if the qualified
intermediary is not the agent of the taxpayer. Paragraph (g)(4)(ii) states that paragraph
(g)(4)(i) applies only if the agreement between the taxpayer and the qualified
intermediary expressly limits the rights of the taxpayer to receive, pledge, borrow, or
otherwise obtain the benefits of money or other property held by the qualified
intermediary as provided in §1.1031(k)-1(g)(6).

Section 1.1031(k)-1(g)(4)(iii) of the regulations states, in part, that a qualified


intermediary is a person who is not the taxpayer or a disqualified person (as defined in
paragraph (k) of this section), and enters into a written agreement with the taxpayer (the
"exchange agreement") and, as required by the exchange agreement, acquires the
relinquished property from the taxpayer, transfers the relinquished property, acquires the
replacement property, and transfers the replacement property to the taxpayer. Section
1.1031(k)-1(k) defines the term disqualified person, as a person who has acted as the
taxpayer's employee, attorney, accountant, investment banker or broker, or real estate
agent or broker within the 2-year period ending on the date of the transfer of the first of
the relinquished properties. However, the performance of services for the taxpayer with
respect to exchanges of property intended to qualify for nonrecognition of gain or loss
under §1031 and routine financial, title insurance, escrow or trust services by a financial
institution, title insurance company or escrow company is not taken into account.

Section 1.1031(k)-1(g)(6)(i) provides that an agreement limits a taxpayer's rights as


provided in this paragraph (g)(6) only if the agreement provides that the taxpayer has no
rights, except as provided in paragraphs (g)(6)(ii) and (g)(6)(iii) of this section, to
receive, pledge, borrow, or otherwise obtain the benefits of money or other property
before the end of the exchange period. Paragraph (g)(6)(ii) states that the agreement may
provide that if the taxpayer has not identified replacement property before the end of the
identification period, the taxpayer may have rights to receive, pledge, borrow, or
otherwise obtain the benefits of money or other property at any time after the end of the
identification period. Paragraph (g)(6)(iii)(A) states that the agreement may provide that
if the taxpayer has identified replacement property, the taxpayer may have rights to
receive, pledge, borrow, or otherwise obtain the benefits of money or other property after
the receipt by the taxpayer of all the replacement property to which the taxpayer is
entitled under the exchange agreement.

Section 1031(b) of the Code provides, in part, that in an exchange that would be within
the provisions of §1031(a) if it were not for the fact that the property received in the
exchange consists not only of property permitted to be received without recognition of
gain, but also of other property or money, then the gain, if any, to the recipient shall be
recognized but in an amount not in excess of the sum of such money and the fair market
value of such other property.

Section 1.1031(b)-1(c) of the regulations provides that consideration in the form of an


assumption of liabilities (or a transfer subject to a liability) is to be treated as "other
property or money" for the purposes of §1031(b). Where, in an exchange described in
§1031(b), each party either assumes a liability of the other party or acquires property
subject to a liability, then, in determining the amount of other property or money,
consideration given in the form of an assumption of liabilities (or the receipt of property
subject to a liability) is offset against consideration received in the form of an assumption
of liability (or transfer subject to a liability). Thus, when there are mortgages on both
sides of the transaction, the mortgages are netted and the difference becomes recognized
gain (boot) to the party transferring the property with the larger mortgage. See also
§1.1031(d)-2, Examples (1) and (2).

In Example (5) of §1.1031(k)-1(j)(3) of the regulations, the transferor, B, of


relinquished property in a deferred exchange transfers property that is encumbered with a
$30,000 mortgage to the transferee, C, on May 17, 1991. C assumes the mortgage on that
date. On July 15, 1991, B receives the replacement property and assumes a $20,000
mortgage encumbering the replacement property. The consideration received by B in the
form of the liability assumed by C ($30,000) is offset by the consideration given by B in
the form of the liability assumed by B ($20,000). The excess of the liability assumed by
C over the liability assumed by B, $10,000, is treated as "money or other property." Thus,
B recognizes gain under §1031(b) in the amount of $10,000.

In the present case, Taxpayers entered into an exchange agreement with QI wherein
they assigned all of their rights under the sales contract to QI. At the initial closing, QI
received the exchange funds and deposited these funds in an interest bearing account
pursuant to the exchange agreement. QI will have sole and exclusive possession,
dominion, control and use of the funds and any interest earned thereon, in accordance
with the exchange agreement.

Taxpayers represent that QI qualifies under §1.1031(k)-1(g)(4) of the regulations as a


"qualified intermediary" and that the transaction will satisfy the additional requirements
stated in §1.1031(k)-1(g)(6) of the regulations. Therefore, for purposes of this ruling, we
assume that QI qualifies an a qualified intermediary and is not an agent of Taxpayers.

Since QI received the exchange funds in accordance with the exchange agreement,
Taxpayers did not actually or constructively receive those funds. Accordingly, Taxpayers
will not actually or constructively receive money or other property in the full amount of
the consideration for the relinquished property before Taxpayers actually receive the like-
kind replacement property.

In addition to transferring the exchange funds to QI, Buyer transferred funds to pay off
and extinguish the mortgage on Property held by Bank D. Since Buyer is financing its
acquisition of Property with bonds, Buyer will not assume the mortgage or take Property
subject to the mortgage. On or before the 180th day following the initial closing,
Taxpayers will acquire Replacement Property by financing the acquisition with new debt
in an amount that will equal or exceed the Taxpayers' proportionate shares of the debt
encumbering Property.

Except for the fact that Buyer paid the mortgage on Property rather than assume it, the
present case is indistinguishable from Example 5. In both cases, the taxpayers are
relieved of a debt upon the transfer of the relinquished property and subsequently become
obligated under a new debt which is to encumber the replacement property. In example 5,
B is deemed to have received money or other property only to the extent that the liability
assumed by C exceeds the liability assumed by B.

Therefore, under these facts, we rule that the consideration received by Taxpayers in
the form of the liability relieved upon the retirement of the mortgage on Property, the
relinquished property, may be netted against the liability incurred by Taxpayers to
acquire Replacement Property.

Except as specifically ruled above, no opinion is expressed as to the federal tax


treatment of the transaction under any other provisions of the Code and the Income Tax
Regulations that may be applicable, or under any other general principles of federal
income taxation. No opinion is expressed as to the tax treatment of any conditions
existing at the time of or effects resulting from the transaction that are not specifically
covered by the above ruling.

PRIVATE LETTER RULING 8328011

Under this Private Letter Ruling, the issue focuses on whether liabilities which do not
involve the mortgage can be netted with the mortgage liabilities to determine the net
liabilities and the net relief, if any, which might generate gain under Code §1031 as a
form of boot.

This Ruling specifically holds that a netting of non-mortgage liabilities is allowable


when referencing the issue of boot under Code §1031.

PRIVATE LETTER RULING 8328011

Issues:
(1) Whether nonmortgage liabilities may be netted with mortgage
liabilities under section 1.1031(b)-1(c) of the Income Tax
Regulations.
(2) Whether a tenant's rental deposit or security deposit is a
liability for purposes of section 1.1031(b)-1(c) of the
regulations.
FACTS:
On June 22, 1978, T, the taxpayer, exchanged with X, the other party to the exchange, a
50 percent interest in Property A for Properties B and C. All of these parcels are real
property.

In determining T's recognized gain, the District Office computed the difference in the
net equities of the properties exchanged. T's net equity in Property A was computed to be
$145,796 (the fair market value of $385,000-- mortgage liabilities of $239,204). X's net
equity in Properties B and C was $116,129 (the fair market value of $545,000--mortgage
liabilities of $428,871). The differential figure of $29,667 ($145,796--$116,129)
constitutes the consideration that X had to pay to T for Property A. This differential is
necessarily composed of cash, non-like-kind property and the assumption of
nonmortgage liabilities. Subtracting the sales commission and certain other exchange
expenses from the differential, the District Office determined that T should recognize
gain equal to $12,418 ($29,667--$17,249 of exchange expenses).

In determining T's recognized gain in T's revised computations, T's accountant


computed the difference in the net equities exchanged, taking into account the
nonmortgage liabilities as well as the mortgage liabilities. T's net equity in Property A
was reported as $138,877 (the fair market value of $385,000-- liabilities assumed by X of
$246,123). X's net equity in Properties B and C was reported as $117,392 (the fair market
value of $545,000--liabilities assumed by T of $427,608). The differential of $21,485
($138,877--$117,392) equals the consideration that X had to pay to T for Property A.
Subtracting the exchange expenses from the differential, T's accountant determined that T
should recognize gain equal to $4,236 ($21,485--$17,249).

APPLICABLE LAW:

Section 1031(b) of the Internal Revenue Code provides that when an exchange consists
of like kind property and other property, any gain from the transaction shall be
recognized in an amount not to exceed the fair market value of the other property.

Section 1.1031(b)-1(c) of the regulations states that consideration received in the form
of an assumption of liabilities (or a transfer subject to a liability) is to be treated as "other
property or money" for the purposes of section 1031(b) of the Code. Where, on an
exchange described in section 1031(b), each party to the exchange either assumes a
liability of the other party or acquires property subject to a liability, then, in determining
the amount of "other property or money" for purposes of section 1031(b), consideration
given in the form of an assumption of liabilities (or a receipt of property subject to a
liability) shall be offset against consideration received in the form of an assumption of
liabilities (or a transfer subject to a liability).

Example (2)(c) of section 1.1031(d)-2 of the regulations provides, in part, that although
consideration received in the form of cash or other property is not offset by consideration
given in the form of an assumption of liabilities or a receipt of property subject to a
liability, consideration given in the form of cash or other property is offset against
consideration received in the form of an assumption of liabilities or a transfer of property
subject to a liability.

Rev.Rul. 72-456, 1972-2 C.B. 468, indicates that the recognized gain is equal to the
lesser of the realized gain or net cash (or other property) received. The net cash (or other
property) received consists of the cash and non-like- kind property received less the
expenses of the exchange such as the brokerage commission.

RATIONALE:

The first issue to be resolved is whether nonmortgage liabilities may be netted under
section 1031 of the Code. Section 1.1031(b)-1(c) of the regulations provides, in part, that
consideration given in the form of an assumption of liabilities (or a receipt of property
subject to a liability) shall be offset against consideration received in the form of an
assumption of liabilities (or a transfer subject to a liability). This part of the regulations
specifically recognizes the fact that nonmortgage liabilities enter into the computation of
net liabilities. Accordingly, it was improper for the District Office to determine the net
equities of the properties exchanged without taking into account the nonmortgage
liabilities assumed.

Having determined that nonmortgage liabilities assumed are part of the netting process,
we must ascertain which of the items listed by T's accountant are liabilities. T's
accountant assumes that all items listed in the escrow statement are liabilities. The parties
involved here have not described the items listed in the escrow statement. Therefore we
cannot make a definitive statement as to which of the items are liabilities. Of the items
listed with respect to Property A, eight of the items are nonexchange expense items.
These constitute the following: interest 5/1/78 to closing, late charge, interest 6/15/78 to
6/30/78, Mr. E, interest 6/15/78 to 6/30/78, trust fund deficit, pro rata rents ($2,430 paid
to 7/1/78), and rent deposits. The first five items are labeled interest by T's accountant
and the last two items are labeled deposits. With respect to Properties B and C the major
item at issue is the impound account balance of $3,802.78, representing prepaid rents.

The five items of interest listed above presumably are liabilities of T. The assumption
of these liabilities must be taken into account in the netting of equities. The more
troublesome items are those relating to rental deposits. T's accountant argues that security
and rent deposits under Local Law are liabilities.

The liabilities referred to in section 1031 of the Code relate to sums certain due at a
fixed or determinable date of maturity. Section 1.1031(b)-1(c) of the regulations provides
that the assumption of a liability is to be treated as money or other property received. The
reason for this characterization is that a person who borrows money and is thereafter
released from this debt has effectively been paid money (or other property). Accordingly,
the release of the indebtedness triggers a realization event.

Under Rev.Rul. 75-363, 1975-2 C.B. 463, a security deposit is generally treated as a
grantor trust subject to section 671 of the Code. The landlord of a security deposit acts as
a fiduciary with respect to that account. When a tenant's lease is terminated, the security
deposit must be repaid to the tenant to the extent there is no damage to the property. The
landlord's liability to return the security deposit upon termination of the lease is the same
as any fiduciary's duty to return moneys contributed to a trust. The transfer of a security
deposit from one landlord to another is the equivalent of a substitution of fiduciaries. It
cannot be said that the original landlord has been relieved of a liability by the transferee
landlord with respect to the security deposit. The original landlord owes no liability; he
simply holds the sums deposited as an agent for the tenants.

The fact that a tenant has prepaid his rent does not make the landlord any less a
fiduciary with respect to that deposit. From an accounting standpoint prepaid rent results
in a deferred credit since the amount may have to be paid back if the lease is terminated
early.

In Rev.Rul. 73-301, 1973-2 C.B. 215, the Service was confronted with the question of
whether the assumption of a deferred credit account on the books of the taxpayer is the
assumption of a liability for tax purposes. The Service concluded that deferred credits,
representing prepaid income, should not be treated as liabilities for purposes of section
752 of the Code. Accordingly, we conclude that the deferred credits here, representing
prepaid rent, are not liabilities for purposes of section 1031 of the Code.

CONCLUSIONS:
(1) In determining the recognized gain, nonmortgage liabilities
should be netted with mortgage liabilities.
(2) Items listed in the escrow account that relate to sums certain,
due at a fixed or determinable date of maturity, are liabilities
for purposes of section 1031 of the Code.
PRIVATE LETTER RULING 8528038

In the following Ruling, the Treasury is opining as to its position relative to a


transaction involving questions as to like-kind property, the nature and character of the
property, its grade or quality, questions of boot, the need to hold the property for
investment or trade or business, as opposed to resale, and many additional sub-issues. It
is a mosaic of numerous exchange issues.

PRIVATE LETTER RULING 8528038

Dear ____:

This is in response to a letter from your authorized representatives, dated November 26,
1984 requesting rulings under section 1031 of the Internal Revenue Code.

You have represented that X, Y, and Z propose to exchange certain parcels of real
property (the "Exchange Agreement") in a transaction which qualifies under the tax-free
exchange provisions of section 1031 of the Code. X owns property b which has a fair
market value of $f. Property b is subject to a mortgage whose outstanding principal
balance as of the date of the contemplated exchange will equal approximately $g. The
adjusted basis of property b in the hands of X is approximately $h. By letter dated March
20, 1985, BK consented to the transfer of property b pursuant to the Exchange Agreement
and agreed to not exercise its right to accelerate the indebtedness secured by the mortgage
encumbering property b.

Y owns property c which has a fair market value of $i. Property c is subject to no
indebtedness, and the adjusted basis of property c in the hands of Y is approximately $j.
Prior to closing under the Exchange Agreement, Y will acquire an office condominium
which has a fair market value of $k ("property d"). Property d will be subject to a
mortgage of approximately $m as of the date of the contemplated exchange. The adjusted
basis of property d in the hands of Y will equal $k. You have represented that under the
laws of state A, a condominium is real property.

Prior to closing under the Exchange Agreement, Z will acquire office condominiums
("property e"), to be constructed, pursuant to a Construction Contract. The fair market
value of property e, after completion, will be approximately $n.

At closing under the Exchange Agreement, the following exchanges and transfers will
occur simultaneously:

(1) X shall convey property b (subject to the indebtedness thereon)


to Z. Because Z does not desire to retain the indebtedness on
property b, it is contemplated that Z will pay the foregoing
indebtedness in full after it acquires property b.
(2) Y shall pay Z in cash or by certified check, an amount equal to
the value of property e less the value of property b (the value
of property b shall be less the indebtedness encumbering
property b as of closing).
(3) Z shall pay the purchase price of property e to the developer
under the Construction Contract who, in turn, shall convey
property e to Z.
(4) Z shall convey property e to Y.
(5) Y shall place a mortgage of approximately $p on property e
after it acquires such property from Z.
(6) Y shall convey property c and property d (subject to the
indebtedness thereon) to X, and shall also pay X, in cash or by
certified check, an amount equal to the value of property b (net
of mortgage) less the combined value of the property c and
property d (the value of property d shall be less the
indebtedness encumbering property d at closing).

You have requested that we rule that:

1. With respect to Y, the proposed exchange transaction qualifies


as a tax- free exchange under section 1031 of the Code and
regulations thereunder; and
2. As a result of the proposed transaction, Y shall recognize gain, if
any, to the extent provided for in section 1031(b) of the Code
and sections 1.1031(b)-1 and 1.1031(d)-2 of the Income Tax
Regulations.

Section 1031(a)(1) 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.

Section 1.1031(a)-1(a) of the regulations provides, in part, that property held for
productive use in a trade or business may be exchanged for property held for investment.
Similarly, property held for investment may be exchanged for property held for
productive use in a trade or business.

Section 1.1031(a)-1(b) of the regulations states, in part, that the words "like kind" have
reference to the nature or character of the property and not to its grade or quality. One
kind or class of property may not be exchanged for property of a different kind or class.
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.

Section 1031(b) of the Code provides, in part, that if an exchange would be within the
provisions of section 1031(a) of the Code, if it were not for the fact that the property
received in the exchange consists not only of property permitted by such provisions to be
received without the recognition of gain, but also of other property or money (boot), then
the gain, if any, to the recipient shall be recognized, but in an amount not in excess of the
sum of such money and the fair market value of such other property.

Section 1.1031(d)-2 of the regulations provides, in part, that the amount of any
liabilities of the taxpayer assumed by the other party to the exchange (or of any liabilities
to which the property exchanged by the taxpayer is subject) is to be treated as money
received by the taxpayer upon the exchange, whether or not the assumption resulted in a
recognition of gain or loss to the taxpayer under the law applicable to the year in which
the exchange was made.

It is represented that after the proposed exchange, Y intends to hold property e either
for investment or for productive use in a trade or business. Therefore, we rule that with
respect to property c held by Y, no gain or loss shall be recognized on the proposed
transfer of property c for property e pursuant to section 1031(a)(1) of the Code; however,
since property d is also being transferred and was not previously held for investment or
for use in a trade or business, as required by section 1031(a)(1) of the Code, any gain or
loss realized on the proposed exchange of property d will be recognized.
We further rule that pursuant to section 1031(b) of the Code and sections 1.1031(b)-1
and 1.1031(d)-2 of the regulations that Y shall recognize gain, if any, to the extent of
consideration received in the form of a transfer of property subject to a liability; however,
consideration received in the form of a transfer of property subject to a liability is offset
against consideration given in the form of cash.

PROPERTY TO BE CONSTRUCTED
PRIVATE LETTER RULING 9031015

This Ruling addresses the question as to whether one can have a tax-deferred
transaction under Code §1031 for property that is to be constructed.

The Ruling holds that, given the facts, the transaction was not properly structured for
such exchange, although such exchange is possible.

Consistent with this possibility of exchanging for property to be constructed, see


Appendix 1, Treasury Reg. §1.1031(a)-(3) as to newly-constructed property and
exchange.

PRIVATE LETTER RULING 9031015


Section 1031 -- Like-Kind Exchanges
Publication Date: August 3, 1990
May 4, 1990

Dear * * *

This is in response to your letter requesting a private letter ruling dated November 27,
1989, and your supplementary correspondence of December 23, 1989, February 2, 1990
and February 15, 1990.

The following submitted facts appear to be the most relevant for resolving the issue(s)
submitted in this case.

X is a general contractor in the building construction business and the owner of ten
rental houses and a vacant lot. On July 1, 1989, X entered into an agreement with Y 'to
trade ten (10) rental houses . . . for $250,000.00.' The proceeds of this transaction are to
be used to pay off an existing mortgage of $100,000.00. The balance is to be deposited
with an escrow agent. At about the same time, title to the above mentioned vacant lot will
be conveyed by deed to the same escrow agent. The trade proceeds, along with additional
borrowed funds, will be used to finance the construction of an apartment building on the
vacant lot. The escrow agent will pay all costs incurred during the construction and X
will supervise the project as the general contractor. After completion of the project, the
former vacant lot, by then improved with an apartment building, will be conveyed by
deed back to X.
X has asked that we determine whether the above described transaction qualifies as a
'tax-free exchange under the current or forthcoming Internal Revenue Code.'

Section 1001(a) of the Internal Revenue Code provides that the gain from the sale or
other disposition of property shall be the excess of the amount realized therefrom over the
adjusted basis provided in section 1011 for determining gain and the loss shall be the
excess of the adjusted basis provided in such section for determining loss over the
amount realized.

Section 1001(c) of the Code states that except as otherwise provided, the entire amount
of gain or loss realized, as determined under this section, on the sale or exchange of
property shall be recognized.

For individual taxpayers, the most commonly applied exceptions to the above cited
general rule requiring gain recognition are found in sections 1031 through 1042 of the
Code. Of those twelve Code sections, it appears that section 1031, pertaining to the
exchange of property held for productive use or investment, is the one provision that
relates most to what the taxpayer is requesting. It provides at subsection (a)(1) 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 to be held either for productive use in a trade or business or for investment.
Thus, the general requirements of section 1031 are threefold: (1) there must be an
exchange; (2) the properties exchanged must be of like kind; and (3) the property
transferred and the property received must be held for productive use in a trade or
business, or for investment. Nixon v. Commissioner, T.C.M. 1987-318.

In the transaction submitted for our consideration, X is exchanging real estate for cash
which will be placed in escrow and used for the construction of improvements on a lot
which will also be placed in escrow. It appears from the facts that the ten rental houses
and the vacant lot are property held for productive use in a trade or business or for
investment, as also the apartment building may be, when completed. Accordingly, the
transaction will eventually satisfy the third requirement of section 1031 of the Code as
analyzed in Nixon. However, the first two requirements of section 1031, that there be an
exchange of properties and that the properties be of like kind, will not be satisfied. There
is no exchange because Y only contributes cash, thus rendering the transaction a sale. See
Barker v. Commissioner, 74 TC 555, 560-61 (1980); and Bloomington Coca-Cola
Bottling Co. v. Commissioner, 189 F.2d 14, at 16 (7th Cir. 1951). There being no
exchange, it follows that there can be no exchange of like kind properties. Furthermore,
Y's cash is not like kind to X's rental houses.

Even if the transaction were restructured so that Y constructs the apartment building to
exchange it with X for the rental houses and pays no cash to X, it will still not qualify as
a like kind exchange, assuming the rental houses are to be conveyed with the underlying
real estate as both land and improvements. Rev. Rul. 67-255, 1967-2 C.B. 270, holds that
unimproved land is not of like kind to improvements on the land. Accordingly, the
exchange of rental houses for an apartment building built on X's land would not qualify
as a nontaxable exchange under section 1031 of the Code. An apartment building,
without the land, is not of like kind to either land improved with rental houses or to a
vacant lot.

Therefore, based solely on the facts and representations made, we hold that the
transaction as described above will not qualify as a like kind exchange under section
1031 of the Code.

No opinion is expressed as to the tax treatment of this transaction under the provisions
of any other section of the Code or regulations which may be applicable thereto or the tax
treatment of any conditions existing at the time of, or effects resulting from, the
transaction described above which are not specifically covered in the above ruling.

A copy of this letter should be attached to the federal income tax return for the year in
which the transaction in question occurs. This ruling is directed only to the taxpayer who
requested it. Section 6110(j)(3) of the Code provides that it may not be used or cited as
precedent. Sincerely,

(For nonsimultaneous exchanges of property to be constructed, see the Proposed


Regulations in Chapter 10 herein.)

BOOT AND EXCHANGING:

The question has been raised in a few cases as to the proximity of refinancing in
connection with the exchange arrangement. Generally speaking, most cases and
authorities support the position that such refinancing, relative to the exchange, will not
taint the tax deferred transaction. Notwithstanding this statement, one might argue the
step transaction concept. But, once again, most authorities do not have a problem with
this issue. See supra for a discussion of this issue in more detail. See also the Georgetown
University Law Center Continuing Education Program in May, 1994, on the topic of
"1031 Exchanges" addressing this issue and citing Fredericks v. Commissioner, TC
Memo 1994-27 (5/94).

DOES DEBT RELIEF CONSTITUTE BOOT?


WITTIG

In the case of Lewis G. Wittig v. Comm., T. C. Memo 1995-461, the Tax Court
concluded that the taxpayer could not net the debt on the property relinquished with that
of the property acquired, given that the property acquired involved new purchase money
mortgages.

However, on reconsideration, the Tax Court withdrew its decision. The parties have
settled the case.
Louis G. WITTIG, Petitioner,
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent.

United States Tax Court.


No. 673-94.
T.C. Memo.1995-461.
Sep. 27, 1995.

MEMORANDUM FINDINGS OF FACT AND OPINION

SWIFT, Judge:

Respondent determined a deficiency in and additions to petitioner's Federal income tax


as follows:

The issues for decision are: (1) Whether gain realized by petitioner on the sale of real
property should be treated as nontaxable under the like-kind EXCHANGE provisions of
section 1031(a);

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. Petitioner resided in Nassau,
New York, when he filed his petition.

In 1972, petitioner earned an accounting degree from the State University of New York
in Albany. Upon graduation, petitioner was employed for 10 years by the State of New
York, and petitioner ultimately achieved the position of audit supervisor.

During the late 1970's, petitioner purchased a number of apartment buildings in Albany,
New York, and petitioner began, on a part-time basis, renovating and managing the rental
units in the buildings.

In 1980, petitioner purchased two apartment buildings located at 714 and 718 Madison
Avenue, Albany, New York (the Madison Property). Petitioner restored the Madison
Property and managed the rental units.

In 1983, petitioner resigned from his position with the State of New York to engage full
time in the business of purchasing, renovating, and managing apartment buildings and
other real property.

In 1985, petitioner became concerned that real property in Albany, New York, had
stopped appreciating in value, and petitioner began to look for apartment buildings to
purchase in less developed areas outside the Albany metropolitan area.
On October 29, 1985, petitioner executed a contract (Contract # 1) to purchase from
SFP Holding Corp. (SFP) for $850,000 two apartment. buildings in Nassau, New York
(Nassau Property). The closing of petitioner's purchase of the Nassau Property and the
transfer of title to petitioner was scheduled for March 1, 1986. Upon entering into
Contract # 1, petitioner informed Charles Papa, one of the owners of SFP, that petitioner
expected to sell the Madison Property to raise funds necessary to purchase and improve
the Nassau Property. Pursuant to the terms of Contract # 1, petitioner's purchase of the
Nassau. Property was contingent upon transfer of title to the Madison Property by
February 15, 1986, and, as indicated, petitioner's purchase of the Nassau Property was to
be consummated on March 1, 1986.

Petitioner hired David Bacon (Bacon), an attorney, to structure petitioner's sale of the
Madison Property and petitioner's purchase of the Nassau Property as a section 1031(a)
like-kind EXCHANGE. Bacon, after consulting with another attorney more experienced
with like-kind EXCHANGES, agreed to assist petitioner to structure the transaction to
meet the provisions of a section 1031(a) like- kind EXCHANGE.

Immediately after executing Contract # 1, petitioner placed the Madison Property on


the market, and in November of 1985, petitioner entered into a contract to sell to Lynne
Dolan (Dolan) the Madison Property for $395,000. Dolan, however, failed to obtain
financing for her purchase of the Madison Property, and the contract was rescinded.

On January 29, 1986, petitioner entered into another contract to sell to Steven
Feigenbaum the Madison Property for $405,000 (Contract # 2). Petitioner and
Feigenbaum agreed that Contract # 2 would be reviewed by Bacon as to its qualification
under the like-kind EXCHANGE provisions of section 1031(a).

Petitioner, Feigenbaum, and Bacon then signed a, rider to Contract # 2, identifying the
Madison Property as the like-kind property to be EXCHANGED for the Nassau Property,
and the rider states that the EXCHANGE was intended to qualify as a section 1031(a)
like-kind EXCHANGE. Additionally, as a part of the rider, Feigenbaum agreed to
cooperate in acquiring the Nassau Property and to cooperate in creating a trust (the
Madison Trust) to effect the EXCHANGE of the Madison Property for the Nassau
Property.

Transfer to Feigenbaum of title to the Madison Property was scheduled for April 1,
1986. On January 29, 1986, as required in Contract # 2, Feigenbaum deposited a $15,000
downpayment into an escrow account.

Because the transfer of the Madison Property did not occur by February 15, 1986, as
originally anticipated and required by Contract # 1, petitioner and SFP did not
consummate petitioner's purchase of the Nassau Property on the originally scheduled
settlement date of March 1, 1986.
In March of 1986, petitioner entered into an oral contract with SFP for purchase by
petitioner of the Nassau Property under the same terms as the prior written contract with
regard to the purchase of the Nassau Property, but no closing date was specified.

On June 6, 1986, petitioner, Feigenbaum, and Bacon, as trustee, executed an


EXCHANGE Agreement and established the Madison Trust. The EXCHANGE
Agreement referenced Contract # 2 and the rider to Contract # 2. The EXCHANGE
Agreement stated that its purpose was to qualify the EXCHANGE of the Madison
Property for the Nassau Property as a like-kind EXCHANGE, and it identified the Nassau
Property as the EXCHANGE property.

Under the terms of the EXCHANGE Agreement--

(1) petitioner was to transfer fee simple title to the Madison


Property directly to Feigenbaum;
(2) Feigenbaum was to transfer $390,000, the balance of the
purchase price for the Madison Property, to the trustee of the
Madison Trust;
(3) the escrow agent was to transfer to the trustee of the Madison
Trust the $15,000 downpayment that Feigenbaum had made in
January of 1986;
(4) the net funds from sale of the Madison Property were to be
held by the trustee as the "EXCHANGE Valuation Amount";
(5) the trustee was to apply the EXCHANGE Valuation Amount
to the purchase of the Nassau Property, and the trustee was to
direct that the deed to the Nassau Property be transferred
directly to petitioner;
(6) if there was a cash shortage, petitioner was to pay the
difference in cash or from the proceeds of a purchase money
mortgage that petitioner would obtain on the Nassau Property;
(7) if any cash surplus remained, it was to be distributed to
petitioner after the EXCHANGE.

SFP was not a party to the EXCHANGE Agreement, but SFP was notified of the
agreement, and SFP apparently agreed to the stated terms of the EXCHANGE.

The Madison Trust identified the Nassau Property as the EXCHANGE property. It
vested in the trustee sole authority over funds contributed to the trust from petitioner's
sale of the Madison Property, and it provided that the trustee was to acquire the Nassau
Property with the trust's funds. The Madison Trust states specifically that if, for any
reason, the trustee is unable to complete the purchase of the Nassau Property, petitioner
has the right to designate other property as the EXCHANGE property.

On June 6, 1986, the Madison Property was sold. As purchaser of the Madison
Property, Feigenbaum paid $390,000 to Bacon as trustee of the Madison Trust, and
Bacon deposited the net funds of $260,519 in the trust account. [FN1] The escrow agent
apparently transferred to the trustee the $15,000 downpayment Feigenbaum had made in
January of 1986, and petitioner deeded the Madison Property directly to Feigenbaum.

On June 24, 1986,, the Nassau Property was purchased from SFP for $850,000. Of the
funds held by the Madison Trust, Bacon transferred to SFP $188,225 as part payment of
the $850,000 purchase price for the Nassau Property. Petitioner obtained two mortgages,
totaling $687,500, to satisfy the balance of the $850,000 purchase price and closing costs
associated with the purchase of the Nassau Property. SFP deeded the Nassau Property
directly to petitioner for the $850,000 consideration it received.

After closing on the purchase of the Nassau Property, Bacon distributed the remaining
trust funds of $89,224 to petitioner, and petitioner used this sum during 1986,to make
repairs and improvements on the Nassau Property. [FN2]

Bacon, as trustee, did not sign either Contract # 1 or Contract # 2. Feigenbaum never
held title to the Nassau Property, nor did Feigenbaum contract to purchase the Nassau
Property.

On petitioner's 1986 Federal income tax return, petitioner did not report the $120,103
[FN3] capital gain he realized from sale of the Madison Property,

On audit, respondent determined that petitioner's sale of the Madison Property and
petitioner's purchase of the Nassau Property did not qualify for section 1031(a) like-kind
EXCHANGE treatment. Additionally, respondent determined additions to tax under
section 6653(a)(1)(A) and (B) for negligence and under section 6661 for substantial
understatement of income tax.

OPINION

Section 1031(a) Like-Kind EXCHANGE

Section 1001(c) requires generally that gain or loss realized on a sale or EXCHANGE
of property is to be recognized for Federal income tax purposes. Section 1031(a),
however, provides for nonrecognition of gain or loss where property that is held for
productive use in a trade or business or that is held as an investment is EXCHANGED
solely for property of like kind. Under section 1031(b), to the extent money or other
property not of like kind (i.e., "boot") is also received as part of an otherwise qualified
like-kind EXCHANGE, gain is to be recognized. Relief of a taxpayer's mortgage liability
is considered boot received. Sec. 1031(d); Barker v. Commissioner, 74 T.C. 555, 568
(1980); sec. 1.1031(b)-1(c), Income Tax Regs. The amount of boot received is decreased
by the taxpayer's EXCHANGE expenses. See Blatt v. Commissioner, T.C. Memo.1994-
48; sec. 1.1031(d)-2, Example (2), Income Tax Regs.

Section 1031(a) like-kind EXCHANGE treatment does not apply to transactions that do
not qualify as EXCHANGES. Thus, where property, in one transaction, is sold for cash
and where the cash is reinvested in a separate and independent transaction in the purchase
of other property, like-kind EXCHANGE treatment is not available, and gain realized on
the sale of the first property will be recognized. Coastal Terminals, Inc. v. United States,
320 F.2d 333, 337 (4th Cir.1963); Barker v. Commissioner, 74 T.C. 555, 561 (1980). The
difficulty lies in distinguishing an EXCHANGE of property from a sale of property
followed by a reinvestment of the sale proceeds in other property. As has been explained-
-

The "EXCHANGE" requirement poses an analytical problem because it runs headlong


into the familiar tax law maxim that the substance of a transaction controls over form. In
a sense, the substance of a transaction in which the taxpayer sells property and
immediately reinvests the proceeds in like-kind property is not much different from the
substance of a transaction in which two parcels are EXCHANGED without cash. Bell
Lines, Inc. v. United States, 480 F.2d 710, 711 (4th Cir.1973). Yet, if the EXCHANGE
requirement is to have any significance at all, the perhaps formalistic difference between
the two types of transactions must, at least on occasion, engender different results. * * *
[Barker v. Commissioner, supra at 561.]

In analyzing multiparty transactions, courts have been liberal in treating transactions as


like-kind EXCHANGES under section 1031. For example, it has been held that a transfer
of the properties need not be simultaneous, Starker v. United States, 602 F.2d 1341 (9th
Cir.1979), and that intermediary trustees or escrow agents need not acquire title to either
property, Biggs v. Commissioner, 69 T.C. 905 (1978), affd. 632 F.2d 1171 (5th
Cir.1980).

Where, however, the taxpayer receives actual or constructive receipt of the proceeds
from sale of the first property, the taxpayer will generally be treated as having sold the
first property and then as having used the sale proceeds to purchase the second property
(i.e., as not having "EXCHANGED" the property). Where the taxpayer receives
unrestricted control over the cash proceeds from sale of the first property, where no
method is used to ensure that a portion of the sale proceeds is used to acquire the second
property, or where the relationship between the taxpayer and the trustee or escrow agent
constitutes merely an agency relationship, the taxpayer will be treated as having
constructive receipt of the sale proceeds. Carlton v. United States, 385 F.2d 238 (5th
Cir.1967); Greene v. Commissioner, T.C. Memo.1991-403; Nixon v. Commissioner, T.C.
Memo.1987-318.

Where an agreement between the taxpayer and an escrow agent regarding how and to
whom the sale proceeds are to be disbursed is made at the taxpayer's own behest, and
where the taxpayer retains the right to alter the escrow instructions, the taxpayer may be
treated to be in constructive receipt of the sale proceeds. K.K. Klein v. Commissioner,
T.C. Memo.1993-491.

Similarly, where one side of a transaction is substantially implemented before the


attempted like-kind EXCHANGE is formulated, the transaction may not be treated as an
EXCHANGE. Estate of Bowers v. Commissioner, 94 T.C. 582, 591 (1990).
In the instant case, the parties agree that the Madison Property and the Nassau Property
qualify as like-kind EXCHANGE property and that the end result of the transaction
before us was that petitioner received property similar to the rental property he sold.
Respondent, however, contends that the transaction before us fails to satisfy the
requirements of section 1031(a) because of the following:

(1) Petitioner agreed in October of 1985 to purchase from SFP the


Nassau Property months before he agreed in January of 1986
to sell to Feigenbaum the Madison Property, allegedly
establishing that petitioner originally had no intent to
participate in a like-kind EXCHANGE;
(2) Neither petitioner's sale of the Madison Property nor
petitioner's purchase of the Nassau Property, was contingent
upon the other, allegedly establishing that the two transactions
were not part of an "integrated plan" for an EXCHANGE; and
(3) SFP was not a party to the trust agreement, the transfers of title
to each property occurred directly between petitioner and SFP
and between petitioner and Feigenbaum, the trustee did not
ever receive legal title to either property, and the trustee was
also petitioner's attorney, the cumulative effect of which
allegedly establishes that the trust was a sham and a mere
conduit for the transfer of funds between the parties;

Alternatively, if the transaction qualifies as a like-kind EXCHANGE, respondent


contends that petitioner must still recognize gain on the "boot" he received (namely, the
$89,224 in cash that petitioner received from the Madison Trust and the $124,042
mortgage liability on the Madison Property that was paid off).

Petitioner contends that the transaction before us meets the requirements of section
1031(a). Petitioner contends that Contract # 2 and the rider thereto, the EXCHANGE
Agreement, the Madison Trust, and the deposit of the entire $260,519 in net proceeds
from sale of the Madison Property into the Madison Trust account, establish that the
EXCHANGE qualifies as a section 1031(a) like- kind EXCHANGE.

In calculating the amount of boot, if any, that petitioner should recognize on the
transaction, petitioner contends that the two new mortgages for which he became liable
on the Nassau Property in the total amount of $687,500 should be taken into account and
should offset the boot (namely, the $89,224 in cash and the $124,042 mortgage liability
that was paid off).

Petitioner has the burden to establish that the transaction qualifies as a like-kind
EXCHANGE under section 1031. Rule 142(a); Welch v. Helvering, 290 U.S. 111 (1933).

Petitioner received new business property in consideration for his old business
property. Petitioner conditioned sale of his Madison Property on receiving like-kind
EXCHANGE treatment, if not with the Nassau Property then with other property.
Petitioner enlisted the cooperation of Feigenbaum (purchaser of the Madison Property)
and acquired the approval of SFP (seller of the EXCHANGE property). The
EXCHANGE Agreement and the Madison Trust authorized the trustee to acquire the
Nassau Property and restricted petitioner from gaining access to the proceeds of the sale
of the Madison Property except to the extent of any cash surplus that was not applied to
the purchase of the Nassau Property.

The EXCHANGE Agreement, the Madison Trust, and the rider to Contract # 2 all
indicate that the transaction was designed and intended to qualify for section 1031(a)
like-kind EXCHANGE tax treatment. The above documents identify the Nassau Property
as the EXCHANGE property, and they all require Feigenbaum's cooperation to effect the
EXCHANGE. Feigenbaum was to pay and did pay directly to the trustee of the Madison
Trust the entire purchase price of the Madison Property. Those proceeds became the
EXCHANGE Valuation Amount that was used to purchase the Nassau Property. When
the original contract to purchase the Nassau Property expired, SFP agreed to the
EXCHANGE Agreement and was willing to orally renew the sales contract on the
Nassau Property under the same terms.

Ultimately, on June 6, 1986, petitioner and Feigenbaum consummated petitioner's sale


of the Madison Property, and Bacon, as trustee, not as petitioner's attorney, deposited the
$260,519 from the sale into the Madison Trust. Eighteen days later, pursuant to the terms
of the Madison Trust, $188,225 of the EXCHANGE Valuation Amount was applied by
the trustee to the purchase of the Nassau Property. The actions of the parties and the
agreements lead us to conclude that there was an integrated plan that was fully carried
out, the result of which was a valid section 1031(a) like-kind EXCHANGE. We so hold.

Respondent argues that when petitioner first contracted to purchase the Nassau Property
petitioner failed to manifest a sufficient intent to EXCHANGE the two properties. We
disagree. Prior to consummation of either transaction, the parties to the transaction
manifested the intent to EXCHANGE the properties and took steps to consummate the
EXCHANGE.

The fact that petitioner may not have formalized the EXCHANGE agreement until after
he entered into the contract to purchase the Nassau Property is not particularly
significant. Alderson v. Commissioner, 317 F.2d 790 (9th Cir.1963), revg. 38 T.C. 215
(1962); Brauer v. Commissioner, 74 T.C. 1134, 1141 (1980).

Further, in a multiparty EXCHANGE which uses a trust to effect the EXCHANGE,


there is no absolute requirement that title to the property pass through the trust. Biggs v.
Commissioner, 632 F.2d 1171 (5th Cir.1980); W.D. Haden Co. v. Commissioner, 165
F.2d 588 (5th Cir.1948), affg. a Memorandum Opinion of this Court. The proceeds from
the sale of the Madison Property were held by the trustee with the specific mandate that
they be applied to acquire EXCHANGE property. The trustee did indeed apply a majority
of those funds to acquire the Nassau Property.
For similar reasons, we conclude that the Madison Trust was not a sham and that Bacon
was not petitioner's agent in the transaction. Both the form of the Madison Trust and the
substance of the transaction carried out through the trust convince us that the transaction
constituted a valid EXCHANGE.

Both petitioner and Feigenbaum were beneficiaries of the trust, and Bacon was
identified as the trustee. Proceeds of the sale of the Madison Property constituted the
corpus delivered to the trustee who deposited and managed it pursuant to the terms of
Articles 2 through 5 of the Madison Trust agreement. Petitioner parted with all control
over the trust corpus. If no other suitable EXCHANGE property was located, the
Madison Trust would be terminated, and only upon that termination could petitioner
demand and receive delivery of the trust assets. Thus, the proceeds from sale of
petitioner's Madison Property were subject to substantial limitations under the terms of
the Madison Trust agreement.

In practice, the parties adhered to the terms and formalities of the Madison Trust.
Feigenbaum paid $405,000 for the Madison Property. Of that $405,000, a portion was
used to satisfy a pre-existing mortgage on the property and closing costs, and the balance
was deposited in the trust. The trust used part of the deposited funds to pay for the Nassau
Property, and it was deeded by the seller directly to petitioner. Petitioner received the
Nassau Property as the culmination of an integrated plan involving the EXCHANGE of
the Madison Property. Petitioner did not have the power to alter the Madison Trust
agreement or to impose his will on the trustee, and petitioner did not actually control the
trustee in the management or administration of the trust.

We conclude that petitioner was not in constructive receipt of the proceeds from sale of
the Madison Property, and we conclude that the EXCHANGE by petitioner of the
Madison Property for the Nassau Property constituted a like-kind EXCHANGE within
the meaning of section 1031(a).

As explained, with regard to respondent's alternative argument concerning boot,


petitioner argues that the cash boot of $89,224 and the relief from the mortgage liability
of $124,042 on the Madison property should be reduced by $687,500, the total amount of
the new mortgages on which he became liable with respect to the Nassau Property.

Petitioner has complicated an issue that the regulations make quite clear. Where each
party to a like-kind EXCHANGE assumes a pre-existing liability of the other party or
acquires property subject to a pre-existing liability of the other party, the taxpayer may
offset or reduce the amount of boot received in the EXCHANGE from the relief of his
own liability by the amount of the pre- existing liability of the other party which the
taxpayer has assumed. Garcia v. Commissioner, 80 T.C. 491, 504 (1983); sec. 1.1031(b)-
1(c), Income Tax Regs. The regulations illustrate that the liabilities which qualify to
offset or reduce any taxable boot received are those to which the property received was
subject prior to the EXCHANGE and which are then assumed by the taxpayer (either by
a formal assumption of the liability or by receipt of the property subject to the liability) as
part of the EXCHANGE. See sec. 1.1031(d)-2, Example (2), Income Tax Regs.
It is true that by encumbering the Nassau Property with new mortgages petitioner
became liable for new mortgage liabilities of $687,500, but those liabilities were not
liabilities that encumbered the Nassau Property prior to the EXCHANGE. Accordingly,
the $89,224 in cash boot that petitioner received and the $124,042 in boot that petitioner
received as a result of petitioner's relief from the mortgage liability on the Madison
Property may not be offset by the $687,500 in new mortgage liabilities on the Nassau
Property.

DISCHARGE OF DEBT: SALE OR EXCHANGE?

With regard to Code §108, the Service has again been successful in asserting its
position that a transfer of property in discharge of the debt (cancellation of indebtedness -
COD), can generate a taxable transaction to the extent that the mortgage exceeds the
adjusted basis. This was true in the case of Thomas Bressi Jr. v. Commissioner, T.C.
Memo 1991-651.

The Court also held that the transfer of property to the creditor constitutes a sale or
exchange; therefore, it can generate taxable income.

Although the taxpayers attempted to argue that they did not have taxable income under
the concept of Code §108, being insolvent, the Court held that such factual position was
not shown by the taxpayers. Also, taxpayers did not receive relief under Code §111,
arguing that they had no tax benefit from prior deductions. The taxpayers could not
factually show this posture.

1. (See Levine, West text, Section 572.)


2. (For a discussion of wraparound mortgages and deeds of
trust, along with contracts for deed or land contracts, and
when this issue is important as to installment sales, see
Levine, West text, Chapter 22.)

CHAPTER 10:

JUST SAY "NO" TO REVERSE EXCHANGES


by: Dr. Mark Lee Levine

I. INTRODUCTION: EXCHANGES IN GENERAL:


The position for a tax-deferred exchange on the Federal level arose some years ago. Its
historical foundation is a result of statutes in the 1920s. 1/
The specifics of the Revenue Act of 1924 provided: "Upon the sale or exchange of
property, the entire amount of gain or loss, determined under Code §202, shall be
recognized, except as hereinafter provided in this Section." 2/

This Section went on to provide under (b)(1): "No gain or loss shall be recognized if
property held for productive use in trade or business or for investment (not including
stock in trade or other property held primarily for sale, nor stocks, bonds, notes, choses in
action, certificates of trust or beneficial interest, or other securities or evidence of
indebtedness or interest) is exchanged solely for property of a like kind to be held either
for productive use in trade or business or for investment. . . ." 3/

Having established the long history of the exchange position back in the 1920s, the
current Code Section reads much the same. 4/

Relative to this same type of language, Code §1031 currently provides: "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." 5/

However, in the 1920s, and consistently, until the 1970s, with few exceptions, there
was very little discussion on the issue as to whether an exchange required a simultaneous
transaction. That is, was there a need to have a transfer of one property by the
transferor/seller of the "relinquished property," 6/ and simultaneously receiving the
qualified like-kind property in return, which is often referred to as the replacement
property? 7/

© Copyright by Dr. Mark Lee Levine, Denver, Colorado, l999. All rights reserved.

Reprinted with permission from Florida Real Estate Journal (October 16-31, 1999).

Although there was very little discussion prior to the 1970s, as to the issue as to
whether an exchange did or did not have to be simultaneously undertaken, i.e., with the
transferred property or relinquished property deeded from the "seller/grantor," and the
replacement property being received at the same time by the seller from the "buyer."

With the advent of a number of other decisions in the last 20 years, the issue of an
nonsimultaneous exchange has arisen more often. These are sometimes referred to as
"nonsimultaneous exchanges" or "deferred exchanges." 8/

The intent of this short Note is not to examine in detail the historical position of
nonsimultaneous exchanges, nor is it to look for justification of the same. After the
advent of several cases, most noteworthy being referred to as the Starker cases, 9/
Congress, shortly thereafter, passed legislation to react to this issue. (For a detailed
examination of the historical position of the Starker cases 10/ and an examination of the
historical developments from 1975 to the present as to nonsimultaneous exchanges, see
the authorities cited in the Footnotes.)
The Starker decisions generated new legislation in which Congress addressed the issue
as to whether the nonsimultaneous exchange could be open for a short or a long period of
time, and what additional requirements were necessary to comply with the provisions of
the 1984 change by Congress, addressing nonsimultaneous/deferred exchanges. 11/

The legislative changes by Congress resulted in a modification of Code §1031, adding


Code §1031(a)(3). That added what is now referred to as the "45-day and 180-day tests."
12/ In summary form, this Section requires that a taxpayer who desires to have a
nonsimultaneous exchange needs to comply with the specific timing requirements under
the Code Section indicated. There are requirements to identify or make known, within the
meaning of the Regulations, 13/ the property which is to be received (Replacement
Property) after the Relinquished Property is transferred. That received property or
replacement property must be clearly indicated or "identified" 14/ as required under Code
§1031(a)(3).

The Regulations also provide that, although the property must be properly identified,
the identification is not, alone, sufficient. Generally speaking, the taxpayer must receive
the replacement property within 180 days of transfer of the relinquished property. 15/
(There are exceptions to the 180-day rule, where that can be lessened. For a discussion of
this issue, see the Levine text. 16/)

Notwithstanding the language noted and the government's position as to the timing of
relinquishing property and replacing the property, and without specifically examining the
details of the exchange rules, the focus of this Note is to determine the setting in which a
taxpayer can have a transfer, first, to the seller-relinquisher of property, as the
replacement property, prior to the seller's transfer of the Relinquished Property.

To illustrate, is it possible that Taxpayer X can receive replacement property Y-1, from
Y, prior to X transferring X's property X-1? Will this come within the provisions of a
nonsimultaneous exchange? This is the focus of this Note, given recent discussions in the
tax literature on this topic.

II. HISTORY OF REVERSE EXCHANGE ISSUES:


The history of nonsimultaneous exchanges developed mainly in the last 25 years, even
though the fundamental basis for the exchange rules occurred back in 1921.

Subsequent to the statutory change in the language of Code §1031 in 1984 17/ is the
issue of whether it is proper within the statutory provisions, to have a nonsimultaneous
exchange (deferred exchange) in which the replacement property is received prior to
transferring the relinquished property. This is often referred to, as noted, as a "reverse
Starker" position. There is no basis for labeling this as a "reverse Starker" position, since
Starker did not involve a reverse position. That is, Starkers relinquished their property
and received the replacement property at a later time. They did not receive the
replacement property first, subsequently transferring their relinquished property.
Nevertheless, these transactions are often called "reverse Starker." Again, the question is
whether one can properly have a "nonsimultaneous exchange" that is structured in what
has been labeled as a "reverse Starker."

The Regulations 18/ and the government's position is that a nonsimultaneous exchange
cannot take place if it is structured in the form of a "reverse Starker" position, or what
might generally be labeled as a "reverse exchange." 19/

This means, as noted, that the taxpayer/transferor cannot receive his or her replacement
property prior to transferring the relinquished property. 20/

Using the prior example, X must transfer his X-1 property to Y prior to receiving the
replacement property, Y-1, from Mr. Y. If X first receives the Y-1 property, prior to the
transfer of his X-1 property, the Government's position has been (subject to the
discussion below) that such nonsimultaneous reverse exchange will not qualify under
Code §1031 for a deferral.

III. WHY THE NEED TO "STILL" SAY NO TO A REVERSE


NONSIMULTANEOUS EXCHANGE:
As stated, nonsimultaneous exchanges were accepted as a result of case law, arguably
Private Letter Rulings 20/ and the change in Code §1031, identified earlier, by Congress
in 1984. 21/

The advice that most conservative tax attorneys, CPAs and other tax advisors gave,
when addressing this area, was to be conservative and to not suggest to their clients to
risk exposure with a reverse exchange.

Obviously, the risk to the taxpayer is, if the exchange is not qualified, because of the
reverse position, and, therefore, Code §1031 does not apply, there can be total
recognition of the taxable gain. 22/

Knowing the risks that are involved, the conservative answer had been to recommend
that clients structure their exchanges to be certain they are not in a reverse posture.

However, recently some individuals have argued that the government, in a Private
Letter Ruling, 23/ approved such reverse structured exchanges as coming within Code
§1031.

One such article, written by Gary Gorman, argued that because of a Private Letter
Ruling, issued in 1998, 24/ the Government has implicitly approved the reverse exchange
as coming within Code §1031. Mr. Gorman noted in his article that the Ruling approved
the position. He stated in his article: "The Ruling thus represents a tacit approval of the
concept and use of reverse exchanges in general." 25/ However, when reviewing the
Ruling, Mr. Gorman acknowledged that the IRS was not explicit. In fact, he said, when
referred to the IRS, that: "They don't define the term reverse exchanges. They don't
explain the concept. They don't mention the utility it will take to create the reverse
exchange relationship." 26/
When citing the Ruling, Mr. Gorman went on to state that: "Well I doubt that this
Ruling will open any great floodgates for reverse exchange, the understated way that the
IRS deals with it in this Ruling gives us assurance that reverse exchanges are not the
potentially fierce monster that many believe them to be." 27/

Each tax advisor, with his or her client, must discuss the authorities and risks that are
involved in such positions. However, there is a dearth of authority, at best, for the
position, as I see it, discussed by Mr. Gorman in implying 28/ the "tacit" position that the
IRS has approved nonsimultaneous exchanges on a reverse format.

Mr. Gorman is not alone in suggesting that reverse Starker-type exchanges are within
the Internal Revenue Code and not subject to a valid challenge by the Government.
However, Mr. Gorman's article brings out the basic flavor of this position, as announced
by some practitioners who advocate use of the reverse exchange.

IV. YOU CAN (WITH YOUR CLIENT) BE FAMOUS -- BUT EITHER WAY,
YOU LOSE:
It is certainly my position that advising your client to undertake a reverse Starker
position, or what has been labeled as a nonsimultaneous exchange in a reverse exchange
format, is a no-win situation for the tax advisor and for the client.

If ultimately challenged and the taxpayer is "successful" in avoiding the taxable


position and in supporting the posture that the reverse exchange is within the meaning
and intent by Congress under Code §1031, the great heartache, cost, time, risk and
expenses are costly for the taxpayer.

On the other hand, if the court rules against the taxpayer on a reverse exchange,
assuming a challenge by the government, the taxpayer suffers from all of the ailments
and disadvantages noted above; and, in addition, the taxpayer loses the tax-deferred
exchange, thereby generating taxable income. (Further, the taxpayer can have additional
liability for interest and penalties in many settings.)

For the taxpayer to even consider a reverse exchange, given the dearth of authority for
such position, the government's formal stated policy opposing a reverse exchange, the
weak "authority" 29/ for support under a Private Letter Ruling, and the consistent
statements by the Service when reviewing the initial Regulations in this area in opposing
reverse exchanges, should be sufficient reasons for most tax advisors and clients to avoid
the reverse exchange.

To structure an exchange as a reverse Starker-type position is normally a setting that


does not have to take place. That is, in most instances, whether with the use of
intermediaries or otherwise, taxpayers can structure a simultaneous or nonsimultaneous
exchange whereby the transferor/seller of the property relinquishes that property
simultaneously with, or prior to receiving, the replacement property, thereby avoiding a
reverse Starker.
The ability to avoid the battle and have someone else's name in lights for contesting and
raising issues of a reverse Starker posture is a worthwhile goal that clients will
appreciate. This may also avoid the issue of possible liability for the professional who
structured an exchange as a non-qualified reverse Starker.

Being conservative is not always bad. Avoiding a reverse Starker structure is not even
what one would classify as being conservative. It, apparently, is the law, notwithstanding
the reference to the earlier-mentioned Private Letter Ruling. 30/

© Copyright by Dr. Mark Lee Levine, Denver, Colorado, l999. All rights reserved.

FOOTNOTES
1. The legislative history is supported from 1921 and was modified
to reach the basic format of today's exchange position in 1924.
For more on this issue, see Levine, Mark Lee, Exchanging Real
Estate, Volume 1, Page 1-2, PROFESSIONAL
PUBLICATIONS AND EDUCATION, INC., Denver, Colorado
(1999). See also BNA Portfolio #61-3rd, Page B-9. See also the
specific Revenue Act of 1924, Chapter 234, Section 203, 43
Stat. 256.
2. Id., Revenue Act of 1924, Chapter 234.
3. Id.
4. See 26 U.S.C.A. §1031.
5. See Code §1031(a)(1).
6. "Relinquished property" is referred to under Treasury Reg.
§1.1031(k).
7. Id.
8. See the Levine text, cited supra, Footnote 1, Chapter 10.
9. Id.
10. See the Levine text, cited supra, Footnote 1. For a historical
development of these cases, see T. J. Starker v. United States,
432 F. Supp. 864 (D.C. Ore. 1977); T. J. Starker v. U.S., 602
F.2d 1341 (9th Cir., 1979). See also Private Letter Ruling
7938087, Private Letter Rul. 8005049 and the additional
authorities cited in the Levine text, noted supra, Footnote 1. See
also the article by Levine, Mark Lee, "Did the Deficit Reduction
Act Resurrect Or Bury Starker?" Commercial Investment
Journal (Winter, 1985). That article is reproduced in the Levine
text, cited supra, Footnote 1, Chapter 10.
11. See the Levine text, cited supra, Footnote 1, Chapter 10, Page
10-36.
12. See Code §1031(a)(3).
13. Id.
14. Id.
15. Id. See Treasury Reg. §1.1031(k).
16. See the Levine text, cited supra, Footnote 1, Appendix 1-2.
17. See Code §1031(a)(3).
18. See the Preamble to the Regulations under Treasury Reg.
§1.1031(k).
19. Id.
20. See Treasury Reg. §1.1031(k).
21. See Footnote 12. See also the discussion of this historical
position of the change in this Code Section.
22. Other arguments might apply in this setting, such as use of an
installment sale, if applicable. For this issue, see Code §453 and
the discussion of the same in the Levine text, cited supra,
Footnote 1, Chapter 13. See also Private Letter Ruling 9509021
and Private Letter Ruling 9509022.
23. See Private Letter Ruling 9823045. See also the Levine text on
this issue, cited supra, Footnote 1.
24. Id.
25. Gorman, Gary, "IRS Acknowledges Reverse 1031," Denver
Realtor News 7 (August, 1999).
26. Id.
27. Id., Page 9.
28. Id.
29. See Private Letter Ruling 9823045, cited supra, Footnote 23.
30. Id.
CAVEAT EXCHANGER: "DE JA VU ALL OVER AGAIN"
by: Dr. Mark Lee Levine

This article focuses on the risks a taxpayer takes when undertaking an exchange, with
escrow, where the escrow party (intermediary) defaults.

I. INTRODUCTION:
I would hope that Yogi Berra will indulge my incorporating his cryptic one liner, "De ja
vu all over again," in the title to this article. This sardonic phrase seems to be most
apropos, given that I have argued on prior occasions that we should change the tax-
deferred exchange rules by simplifying the process to defer gain when we "sell" and
reinvest the proceeds from the "sale." The potential pitfalls in this article support this
position.

Taxpayers have been forewarned on numerous occasions, 1/ when undertaking tax-


deferred exchanges and using intermediaries (escrow parties), that the area can be
complex. Care must be exercised to comply with the requirements in the Federal tax law
for exchanges. It behooves all of us to reflect on the basic requirements for a tax-deferred
exchange, whether undertaking a simultaneous exchange or a nonsimultaneous (deferred)
exchange. 2/
Once the fundamental requirements for the use of a tax-deferred exchange under Code
§1031 3/, with their rules, 4/ and the use of an intermediary 5/ have been reviewed, the
exchange can be examined to see what happens if an escrow agent does not perform. 6/
The bottom line is that the exchange treatment may be lost.

* With thanks to Yogi Berra

© Copyright by Dr. Mark Lee Levine, Denver, Colorado, 2000. All rights reserved.

II. HISTORICAL PERSPECTIVE OF CODE §1031 AND NONSIMULTANEOUS


EXCHANGES:
The historical position under Code §1031, back in 1921 7/ and up to approximately
1968 8/ seldom addressed an exchange that did not occur simultaneously, between the
"buyer" and the "seller." That is, under normal circumstances, the buyer will transfer his
or her monies or other payment for the property, and the seller will transfer his or her
property to the buyer. However, with the advent of a few cases, followed by the Starker
cases 9/ and the changes in the 1984 Code, 10/ the issue arose as to the requirements
necessary to undertake an exchange where the parties do not transfer their properties at a
simultaneous point. In most instances, the nonsimultaneous exchange results in the
taxpayer-seller transferring his or her property, often identified as "relinquished
property," 11/ now, for the promise, and support for that promise, to receive other like-
kind, qualified Code §1031 property, at a later date and on a timely basis. 12/

With the advent of the nonsimultaneous flavor of exchanges, there was a need to
determine many of the guidelines that would apply in such settings. Questions arose as to
who might hold the property on either side, either the property relinquished by the seller
or that transferred by the buyer; and, who would control the timing of these events? Does
the concept of constructive receipt 13/ apply? What constitutes a "sale," as opposed to an
"exchange?" And, there were a myriad of other questions. Some of these queries were
answered as a result of Regulations. 14/

III. CURRENT CONCERNS:


Many issues remain that were not resolved by the Regulations. Therefore, numerous
Private Letter Rulings, cases and other authorities have addressed the conundrum of tax
issues that have arisen because of nonsimultaneous exchanges. These concerns relate to
the essence of this article, with particular emphasis on the question as to what happens
when someone who is acting as a qualified intermediary, 15/ within the meaning of the
Regulations mentioned, defaults or fails to properly act? Does this mean that the taxpayer
will be given some relief position, or is the taxpayer burdened with the failure of the
intermediary to comply with the requirements to assure the tax-deferred status as an
exchange? In most instances, the answer, coming from the cases, Rulings and other
authorities, is that it is the taxpayer that suffers the adverse consequences of the failure of
the intermediaries to properly act.

One of the main concerns arose because of the nature of Code §1031 and the
Regulations, relative to the nonsimultaneous exchange, sometimes referred to as a
"deferred exchange," as labeled in the Regulations, when a third party acts on behalf of a
party or parties, thereby hopefully preventing adverse tax results. When such third party
(intermediary) is used, a common issue that could result in a position in favor of the
government and against the taxpayer is an argument that although a taxpayer might have
transferred his or her property to such intermediary, with the intent to receive like-kind
qualified property in an exchange, the argument may be that the seller is deemed to have
received the property (often cash) acquired by the intermediary, because the seller has
"control" over the transaction. (This issue is sometimes labeled as a "constructive receipt"
issue.)

To avoid this issue, the Regulations that were promulgated under Code §1031 provided
that a third party, not an agent (intermediary) of the seller, should hold the funds in
question that might be paid, by a buyer, allowing the intermediary to hold those funds to
avoid both the actual and constructive receipt of the monies by the taxpayer-seller, and to
otherwise comply with Code §1031.

Without attempting to cover in detail these Regulations, noted under Treasury Reg.
§1.1031(k), the essence is that the intermediary must act independently, and according to
proper instructions, to hold the funds, as indicated earlier.

The problematic issue is: What if the intermediary fails to properly act and is in
violation of the intermediary's contract with the seller? Can this lead to adverse tax
implications to the buyer? A failure to properly act may be the result of the intermediary's
negligence, fraud, theft or other improper actions. However, even if the actions are
improper, and this gives rise to a claim, civilly, by the taxpayer-seller against the
intermediary, the tax question remains: Is the seller's potential exchange damaged by the
intermediary's improper actions?

I have addressed this issue in prior articles and presentations relative to situations where
the taxpayer is damaged because the intermediary, maybe involuntarily, is facing a
bankruptcy. In the articles indicated, I have mentioned a few cases in which the courts
have shown little sympathy or empathy for the taxpayer who was damaged, through no
intentional act by the taxpayer, when such bankruptcy occurs. That is, as many familiar
with exchanges know, the technical requirements of timing the investment normally
requires that the property relinquished by the seller must also result in the seller timely
identifying the replacement property. A "timely" basis for identification normally means
that within 45 days from the transfer of the relinquished property by the seller to the
intermediary, the seller must identify the property the seller is to receive. (Further, there
is generally a 180-day rule that requires the taxpayer to not only identify the property, but
also to actually close and receive the replacement property within the 180 days of the
transfer of the relinquished property by the taxpayer-seller; there are few exceptions.)

The cases in question create a problem for the taxpayer-seller, because the taxpayer, in
attempting to meet all of the requirements of Code §1031, including the Regulations to
timely replace the relinquished property, may be thwarted as a result of the taxpayer
discovering that the intermediary, who was to handle the transaction, was placed into
bankruptcy. This has occurred.

The conclusions by all of the courts in these cases have been that the taxpayers are not
entitled to any relief from the adverse tax implications that might be present for the
taxpayer-seller in failing to meet Code §1031 on a timely basis for replacement, even
though the taxpayer was not the generating cause of the failure to timely meet the
requirements. Although the tax law has relief provisions in it in other Sections of the
Code, no such provision exists in this Section; and, no court has allowed the taxpayer to
simply avoid the timing requirements that are required under the Code and the
Regulations indicated simply because the taxpayer's intermediary failed to properly and
timely meet the requirements of the Code.

This issue has been further addressed with a more abhorrent fact situation in a setting
where the intermediary absconded with the "escrowed" funds. The question that must
now be addressed is whether, in this extreme case, the taxpayer would receive any relief
relative to the tax issue (and without regard to the more important issue of receiving a
return of funds because of the criminal actions by the intermediary).

IV. IMPACT OF DEFAULT IN TIMELY MEETING REPLACEMENT RULES


WHEN THE INTERMEDIARY COMMITS A CRIMINAL ACT:
Thus, the focus of this Note is to deal with the question of timely performing the
exchange requirements for a nonsimultaneous exchange under Code §1031. This issue
was recently examined by the 1999 Court of Appeals decision out of Georgia on the issue
of a nonsimultaneous exchange that failed to meet timing requirements because of the
intermediary's conversion of the funds that were to be held in escrow for and on behalf of
the taxpayer.

The issue 29/ was addressed in the case of Deer Creek, Inc. v. Section 1031 Services,
Inc., et. al., 510 F.E.2d 853 (Ga. App. 1999). In the Georgia Deer Creek case, a number
of individuals undertook Code §1031 transactions and utilized a Company entitled
Section 1031 Services, Inc. to support the requirements under Code §1031 for an
intermediary or facilitator to complete the exchange requirements.

Mr. James Gideon owned the Section 1031 Services Company. Allegedly, Gideon
commingled funds in the escrow account, withdrew millions of dollars of those funds,
and, as one might guess, chose to leave the country. The net result was that there were a
number of individuals who attempted to try to collect "their" monies from the account.
Although the case focused on the basic position of "who gets stuck" with the loss of the
monies, since there were multiple parties involved and a limited amount of funds that
were available, the case also, implicitly, raised the issue, for tax people, of the impact of
such position on the Code §1031 transaction. (Obviously, this was the lesser issue for the
taxpayers. Although the failure of the reinvestment to meet Code §1031 might have been
present, the issue for the plaintiff was to seek a return of the monies, even if that meant
paying taxes out of such funds.)
The Court ruled on the propriety of the claims by the various plaintiffs as to the amount
of monies that were available. It was not a tax case. However, one can see the impact on
the exchange position by the failure to timely complete the Code §1031 issue.

This is not the only case in which there has been a potential loss of the deferred
exchange position because of a failure to timely meet the requirements under Code §1031
for replacing the property. It is not the only case in which funds have been lost because of
an intermediary or third party absconding or failing to account for funds that were in their
control.

V. CONCLUSION:
All of the cases in which a third party has control of funds that are owned by another
party should give each transferor of those funds cause to consider, as a paramount issue,
the protection of those funds. The key issue should be the assurance that the funds will be
properly directed and utilized as required by the owner of those funds. Unfortunately,
there has been, and continues to be, too much focus by taxpayers on saving taxes and
eliminating that burden. Taxpayers have often thrown caution to the wind in many
instances in failing to use reasonable steps, whether personally, or through their
representative, to protect their funds. This must be the primary concern for the taxpayer.

There has been a tendency by some to merely push the safety of funds issue aside as
one that is an unusual, hybrid and erratic mutation that will never occur. However, a
series of cases on intermediaries being placed into bankruptcy, in which trustees have
contended that the monies held by the intermediary are in fact those of the trustee, and
not those of the seller, coupled with the recent Deer Creek case in which the intermediary
absconded with the funds, should direct the taxpayer's attention to the need to ignore the
tax implications until they, first, address the security implications, for the taxpayer's
funds. Once the funds are properly protected, the need to meet the requirements for the
tax-deferred exchange treatment of those funds can be addressed as a secondary issue.

© Copyright by Dr. Mark Lee Levine, Denver, Colorado, 2000. All rights reserved.

FOOTNOTES

1. For an examination of this issue, addressed in previous articles,


see Levine, Mark Lee, Exchanging Real Estate, Vol. 2, Page
10-168a, published by Professional Publications and Education,
Inc. (1999). See also the article by Levine, Mark Lee, "The
Impact of A Tax-Deferred Exchange Under Code §1031 When
An Intermediary Enters Bankruptcy," Journal of Property
Management 20, Institute of Real Estate Management
(November/December, 1998).
2. The question as to undertaking a simultaneous exchange or a
nonsimultaneous exchange was not a topic in most instances
until the advent of the now-famous Starker decisions. These
included: Bruce Starker v. United States (Starker I), 75-1
U.S.T.C. 9443 (D.C. Ore. 1975); Starker, T. J., v. United States
(Starker II), 77-2 U.S.T.C. 9512, 432 F. Supp. 864 (D.C. Ore.
1977); and Starker, T. J., v. United States (Starker II on
Appeal), 79-2 U.S.T.C. 9541, 602 F.2d 1341 (9th Cir. 1979),
aff'g and rem'g 77-2 U.S.T.C. 9512, 432 F. Supp. 864 (D.C.
Ore. 1977.
3. Code §1031 is technically referred to as 26 U.S.C.A. Section
1031, but will be referred to herein by reference to the general
label of "Code §1031."
4. Code §1031 generally provides that gain will not be recognized
under the Internal Revenue Code for Federal income tax
purposes if there is an exchange of property that meets certain
requirements; e.g., it was used in the trade or business or for
investment. For more details and a discussion of these
requirements, see Code §1031(a) and a discussion of the
exchange rules in the Levine text, cited supra, Footnote 1.
5. Intermediaries became a topic of discussion as a result of the
modifications in 1984 to Code §1031, allowing a
nonsimultaneous exchange and the advent of the promulgation
of Regulations under Code §1031, specifically, Treasury Reg.
§1.1031(k). For further details on intermediaries, see Treasury
Reg. §1.1031(k)-1(g).
6. The question as to the impact of a default by an intermediary on
the Code §1031 tax-deferred exchange has been discussed in
cases where a default occurred. Specifically, some of these
cases are enumerated in the article, cited supra, Footnote 1.
7. Code §1031 in 1921. See the Levine text, supra, Note 1,
Chapter .
8. Redwing Carrier v. Tomlinson, 399 F.2d 652 (5th Cir., 1968).
9. See supra, Footnote 2.
10. See Footnote 8.
11. "Relinquished property" is that property transferred by the
seller.
12. See Code §1031(a)(3).
13. "Constructive receipt" is a term that denotes a deemed receipt
of the property, even if there is not an actual receipt.
14. Treasury Reg. §1.1031(k).
15. "Qualified intermediary" is defined in Treasury Reg.
§1.1031(k).
NONSIMULTANEOUS EXCHANGE OF PERSONALTY:
RED WING CARRIERS, INC.

In the 1968 Fifth Circuit decision of Red Wing Carriers, Inc., Circuit Judge Goldberg
identified the case as involving another attempt by a taxpayer to insulate himself against
taxation with proper armor. The Court held that the question in the case was whether the
taxpayer could shape what essentially was an integrated purchase and trade-in transaction
of new and used trucks into two separate transactions to recognize an immediate gain at
capital gain rates and, simultaneously, take a larger depreciation deduction from ordinary
income because of a higher basis.

The Court of Appeals agreed with the District Court that the transaction was a Section
1031 exchange, not two separate sales. This meant that the gain would not be taxed as
capital gain because the taxpayer did not have the recognized gain he intended. In
addition, there would be a lower basis, and, therefore, less write-off for depreciation
purposes.

This type of situation can take place on a smaller scale, although the principle is the
same: X transfers the car used in his trade or business to a dealer for cash; and, in a
"separately-structured" transaction, he purchases a new automobile or vehicle. The intent,
as in Red Wing Carriers, Inc., might be to have two separate transactions, if one was to
tie to the Red Wing Carriers, Inc., approach. However, the Court could take the position,
as it did in Red Wing Carriers, Inc., that the transactions were interrelated, and, therefore,
should be treated as a single §1031 exchange.

Another example of an attempt to place form over substance, in this case to fit within
Section 1031, is the Swaim case, which follows this case.

REDWING CARRIERS, INC., and Rockana Carriers, Inc.,


by Redwing Carriers, Inc., Appellants,
v.
Laurie W. TOMLINSON,
former Director of Internal Revenue for the District of Florida, Appellee.

68-2 U.S.T.C. Para. 9540


399 F.2d 652 (5th Cir. 1968)

GOLDBERG, Circuit Judge:


This case involves another attempt by a taxpayer to insulate himself from the incidence
of taxation by means of paper armor. The question presented is whether a taxpayer may
shape what is essentially an integrated purchase and trade-in transaction of new and used
trucks into two separate transactions in order to recognize an immediate gain at capital
gains rates and concomitantly to take a larger depreciation deduction from ordinary
income. We agree with the district court that this transaction is an exchange rather than
two sales, and thus comes within the coverage of Section 1031 of the Internal Revenue
Code.[FN1]

This appeal involves income tax liabilities for the calendar years 1958 through 1961 in
the total amount of $66,630.33. The plaintiff below and appellant here, Redwing Carriers,
Inc.,[FN2] paid the assessments in question and sued in the district court for a refund
with interest.
The following facts were substantially stipulated, and the district court's findings on the
few disputed fact questions were not clearly erroneous.[FN3] Redwing is a Florida
corporation engaged in the business of hauling bulk commodities as a common carrier,
subject to regulation by the Interstate Commerce Commission. Trucksales, Inc., a Florida
corporation engaged in the business of selling trucks, parts and equipment, is a wholly-
owned subsidiary of Redwing. During the years in question Trucksales was a franchised
dealer for G.M.C. trucks. Charles E. Mendez, as president and chairman of the board of
both Redwing and Trucksales, was the moving force behind the transactions in question.

During 1958 Trucksales purchased twenty-eight new G.M.C. diesel tractor trucks from
G.M.C. for cash. At or about the same time Redwing transferred title to twenty-seven
used trucks to G.M.C. for cash. In 1959 and 1961 essentially identical transactions
involving thirty-six and fourteen trucks, respectively, were executed. Also during 1959
transactions in like form were executed with White Motor Company.

Because it is an extremely profitable trucking concern, Redwing is considered a


prestige account by both G.M.C. and White Motor Company. Thus Mendez, who handled
all negotiations in these transactions, was in a strong bargaining position and was able to
insist upon casting these purchases of new equipment and trade-ins in the form of
separate purchases of the new and sales of the old.

Mendez did not specify which corporation he was representing at any time to either
White or G.M.C., and it made no difference to the manufacturers whether they were
dealing with Redwing or with Trucksales. Both Redwing and Trucksales used the same
Tampa address on the checks used in these transactions, even though Trucksales is
located in Fort Lauderdale and even though it used a Fort Lauderdale bank account for all
of its other business activities. Most of the trucks involved were delivered by White and
G.M.C. directly to Redwing in Tampa, despite the fact that they were ostensibly being
sold to Trucksales in Fort Lauderdale for resale to Redwing.

In addition to the above indicia of transactional unity, the district court found a definite
contractual interdependency between the sale of new trucks and the trade-in of old trucks.
In its findings of fact the court noted: 'There would have been no purchase by plaintiffs of
new trucks or tractors without concurrent and binding agreements to purchase plaintiff's
used equipment.'[FN4]

The district court further found that G.M.C. viewed these transactions as trade-ins
which were occasioned by the purchase of new equipment and that the form of selling the
old and purchasing the new was arranged solely on Mendez' insistence. A.G.M.C.
executive testified that the price which G.M.C. paid for the used trucks was in excess of
their fair market value and that G.M.C. would be able to calculate a profit only by
viewing the purchases of used trucks and sales of new trucks as one transaction.[FN5]

It is apparent that Mendez sculptured these transactions so as to achieve the best


possible tax results for Redwing. Instead of obtaining customary discounts from the retail
price of the new trucks, Mendez would insist that the manufacturers add the discount
amount to the price of the used trucks being repurchased. The gain of the trade-in price
over the depreciated basis of the used trucks would be recognized at capital gains rates,
and the basis of the new trucks for depreciation purposes would be inflated. As a result,
Redwing's depreciation deductions from ordinary income would also be inflated,
resulting in considerable tax savings.[FN6]

As is obvious from the above facts, these Mendez-dominated transactions were


severable in form only. On substance, the sale was in bondage to the purchase and the
purchase indissolubly dependent upon the sale. If Redwing had not carried out the
agreement to buy the new trucks, the auto makers would have had no juristic obligation
to purchase the used trucks. The buying and selling were synchronous parts meshed into
the same transaction and not independent transactions.

Section 1031 requires the non-recognition of gain or loss in transactions when in theory
the taxpayer may have realized gain or loss, but in substance his economic interest in the
property has remained virtually unchanged by the transaction. Century Electric Co. v.
Commissioner of Internal Revenue, 8, Cir. 1951, 192 F.2d 155, 159, cert. den., 342 U.S.
954, 72 S.Ct. 625, 96 L.Ed. 708. Compare Trenton Cotton Oil Co. v. Commissioner of
Internal Revenue, 6 Cir. 1945, 147 F.2d 33, 36.[FN7] With its paper armor crumpled,
Redwing's transactions are brought directly within the ambit of Section 1031, and, more
specifically, within that of Treas. Reg. 1.1031(a)-1(c):

'(c) No gain or loss is recognized if (1) a taxpayer exchanges property held for
productive use in his trade or business, together with cash for other property of like kind
for the same use such as a truck for a new truck or a passenger automobile for a new
passenger automobile to be used for a like purpose; * * *'

Because of the expertise of Internal Revenue Service in interpreting the Internal


Revenue Code which it is charged with administering, Treasury regulations come to us
with great persuasive force. When, as here, the regulation has long continued without
substantial change, applying to unamended or substantially reenacted states, the
regulation is deemed to have the effect of law. United States v. Correll, 1967, 389 U.S.
299, 88 S.Ct. 445, 19 L.Ed.2d 537, 543; Fribourg Nav. Co. v. Commissioner, 1966, 383
U.S. 272, 283, 86 S.Ct. 862, 868, 15 L.Ed.2d 751, 758. In Vitter v. United States, 5 Cir.
1960, 279 F.2d 445, cert. den., 364 U.S. 928, 81 S.Ct. 353, 5 L.Ed.2d 266, Judge Brown,
speaking for our Court, articulated this rule of construction as follows:

'When a Treasury Regulation interprets a section of the Code and the Regulation
remains in effect and unchanged for a long period of time, re-enactment of the statute
without change is presumed to show congressional approval of the Regulation which
thereby acquires the force and effect of law * * *

The Treasury's interpretation of 1031(a) was also manifested in Revenue Ruling 61-
119, 1961-1 Cum.Bull. 395. This Ruling bears directly on the exact question at bar:
'Where a taxpayer sells old equipment used in his trade or business to a dealer and
purchases new equipment of like kind from the dealer under circumstances which
indicate that the sale and the purchase are reciprocal and mutually dependent
transactions, the sale and purchase is an exchange of property within the meaning of
section 1031 of the Internal Revenue Code of 1954, even though the sale and purchase
are accomplished by separately executed contracts and are treated as unrelated
transactions by the taxpayer and the dealer for record keeping purposes.'

The district court in its conclusions of law relied heavily on that Ruling, and we agree.
Although the Ruling does not have the force and effect of law, we find it to be a
persuasive interpretation of the Code and Regulations.

Equally well established is the corollary that an integrated transaction may not be
separated into its components for the purposes of taxation by either the Internal Revenue
Service or the taxpayer.

. . . A tax-free exchange cannot be transformed into two sales by the arbitrary


separation of time and exchange of cash. See Commissioner of Internal Revenue v. North
Shore Bus Co., 2 Cir. 1944, 143 F.2d 114, which held that a trade-in of used busses in
connection with a purchase of new ones was an exchange governed by the predecessor of
Section 1031 despite the taxpayer's receipt of cash from the seller in order to pay off the
mortgage on the used busses.

The appellant attempts to bolster its defenses, however, with a decision from our Court,
Carlton v. United States, 5 Cir. 1967, 385 F.2d 238. In that case the taxpayer had sold
ranch property to a purchasing corporation for cash. As part of this sale, the purchaser
had assigned to the taxpayer contracts to purchase two similar tracts of land, which
purchases the taxpayer had immediately consummated. Although it was stipulated that
both the taxpayer and the purchaser had intended to effect an exchange--indeed that they
had performed the three-way transaction merely to avoid unnecessary duplication in title
transfer-- we refused to accept the taxpayer's classification of the overall transaction as a
tax-free exchange under Section 1031.

The appellant would have us follow Carlton here as if that case had ignored
transactional substance and instead had viewed the whole only as an aggregate of
separate, unrelated transfers. On the contrary, in that case we gave weight to the various
individual transfers only because they were separate and unrelated. In Carlton we were
reviewing a three-way transaction in which the taxpayer had received, in return for
property, cash which was not restricted in use to the purchase of like property. The most
that could be said for the transactional relationship in Carlton was that the sale for cash
between the taxpayer and a purchaser had been complementary with the later purchase of
like property between the taxpayer and a seller. In the case at bar, however, there were
only two parties to each exchange of trucks (ignoring intracorporate fictional
distinctions), and the alleged 'sale' and 'trade-in sales,' instead of being separate, were
related by contractual interdependency.
In Carlton both the transfers of land and the interparty obligations were severable and,
in fact, severed. Here we find, as did the district court, the same transactional twining
from beginning to end. Carlton, then, is clearly distinguishable and certainly does not
stand as an obstacle to the pertinent tax considerations which we have discussed
supra.[FN9]

Taxation is transactional and not cuneiform. Our tax laws are not so supple that scraps
of paper, regardless of their calligraphy, can transmute trade-ins into sales. Although
Redwing's transfers may have been paper sales, they were actual exchanges. A taxpayer
may engineer his transactions to minimize taxes, but he cannot make a transaction appear
to be what it is not. Documents record transactions, but they do not always become the
sole criteria for transactional analysis.

Affirmed.

FN6. in 1962 the Internal Revenue Code was amended by the addition of Section 1245,
the depreciation recapture provision, to make it no longer desirable to handle transactions
in this manner. In essence, Section 1245 withdraws capital gains treatment from gains on
the disposition of depreciable personal property and certain other tangible property
(exclusive of buildings and their structural components) to the extent that depreciation
had been deducted for such property by the seller in previous years. It permits only the
excess of the sales price over the original cost to be treated as a capital gain and requires
that the remainder be treated as ordinary income. See Mertens, Federal Income Taxation,
Code Commentary 1245.

FN7. As for Redwing's contention that the provisions of Section 1031 are taxpayer
elective, see United States v. Vardine. 2 Cir. 1962, 305 F.2d 60,66, where this contention
was definitively answered as follows: '(Section) 1031 and its predecessor are mandatory,
and not optional; a taxpayer cannot elect not to use them.'

BEZDJIAN

Distinguishing this case from the issue as to whether an exchange must or must not be
simultaneous, the Court held that the taxpayers did not meet the elements for a tax-
deferred exchange. The factual steps, as the Court noted, were as follows:

1. Petitioners deposited $10,000 into a title insurance escrow.


2. Petitioners arranged a $165,000 loan.
3. The lender loaned the money into the escrow.
4. The title insurance company disbursed part of the escrow
monies to a Third Party, Shell.
5. The title insurance escrow recorded the deed conveying the
subject property in question.
6. A new loan was arranged from another bank by another party to
the transaction.
7. The bank deposited this new money into the escrow.
8. Additional funds were deposited into escrow by one of the
parties.
9. The escrow money was transferred to one of the banks as
repayment of one of the loans indicated earlier.

The details of the above steps are recorded in the case that follows this introduction.
However, the basic point is emphasized that the transaction was not an exchange, but it
was a sale. The Court made it very clear that it was a sale and not an exchange,
notwithstanding Starker, nonsimultaneous exchange positions and numerous other
arguments made by the taxpayer.

GARBIS S. BEZDJIAN AND MAIDA M. BEZDJIAN, Petitioners


v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

T.C. Memo. 1987-140

MEMORANDUM FINDINGS OF FACT AND OPINION

CLAPP, JUDGE:
Respondent determined deficiencies in petitioners' 1978 and 1979 Federal income taxes
in the amounts of $37,594.00 and $2,417.00, respectively. The issue for decision is
whether the transaction described below satisfies the 'exchange' requirement of section
1031. [FN1]

FINDINGS OF FACT

Some of the facts have been stipulated and are found accordingly. The stipulation of
facts and the exhibits attached thereto are incorporated by this reference.

During 1978, Shell Oil Company (Shell), conveyed to petitioners property located at
1199 Broadway/Laguna, Burlingame, California (Broadway property), and petitioners
conveyed to Roberta and Barbara Levey (Leveys) property located at 1236 El Camino
Real, Burlingame, California (El Camino property).

Prior to March 21, 1978, Garbis Bezdjian (petitioner) and representatives of Shell
negotiated for the sale of the Broadway property from Shell to petitioner. The
representatives informed petitioner that the price of the property was $175,000. Petitioner
asked the representatives if Shell was interested in exchanging the Broadway property for
other real property. The representatives refused to participate in such an exchange and
informed petitioner that Shell was only interested in selling the property for cash.

On March 21, 1978, Shell informed petitioner that he had 30 days to purchase the
property for $175,000 and that the sale had to close by September 15, 1978.
On April 13, 1978, petitioner deposited $10,000 of earnest money with Shell. Two days
later, petitioner offered, as consideration for the purchase of the Broadway property, to
deposit $175,000 in escrow at the Title Insurance and Trust Company (Title Insurance
escrow) by September 15, 1978. On May 18, 1978, Shell accepted petitioner's offer.

Three days after petitioner and Shell executed a written contract, petitioner contacted
Armen Sossikian (Sossikian), a real estate agent, to discuss with him the sale of the El
Camino property. Petitioner told Sossikian that he wanted him to close the Broadway and
El Camino properties simultaneously and that the proceeds from the sale of the El
Camino property were to go to Shell via the Title Insurance escrow.

Because petitioner and Sossikian could not find a buyer for the El Camino property
prior to September 15, 1978, the date of the Broadway property closing, petitioner
negotiated a $165,000 loan from the Chartered Bank of London (Chartered Bank). As
security for said loan, he executed a promissory note and deeds of trust on the El Camino
property and his personal residence.

On August 22, 1978, Chartered Bank transferred the $165,000, which petitioner
borrowed, to the Title Insurance escrow. On September 6, 1978, the Title Insurance
escrow disbursed the funds in the escrow to Shell and recorded the deed which
transferred the Broadway property from Shell to petitioner.

On September 25, 1978, the Leveys, after refusing to participate in an exchange of the
El Camino property for other real property, offered to purchase the El Camino property
for $257,500. On that same day, petitioners accepted the Leveys' offer. Subsequent to
petitioners' acceptance, the Leveys had trouble financing their purchase, and because of
said trouble, petitioners and the Leveys modified their contract so that the purchase price
would be $10,000 less, i.e., $247,500.

On October 6, 1978, petitioner opened an escrow at the Founders Title Company


(Founders escrow) for the sale of the El Camino property.

To finance their purchase of the El Camino property, the Leveys obtained a $79,500
loan from Chartered Bank and assumed a $67,335.63 mortgage on the property. By
December 4, 1978, Chartered Bank had deposited the $79,500, which the Leveys
borrowed, and the Leveys had deposited the balance of the funds needed to purchase the
El Camino property, in the Founders escrow.

On December 4, 1978, Founders escrow recorded a deed, which conveyed the El


Camino Property to the Leveys, and disbursed $170,683.27 to Chartered Bank as
repayment for petitioners $165,000 loan, plus accrued interest.

The following diagram chronologically depicts the steps which the participants took to
effect the transfers:

1. Petitioners deposit $10,000 into the Title Insurance escrow;


2. Petitioners arrange a $165,000 loan from the Chartered Bank;
3. Chartered Bank deposits $165,000 into the Title Insurance
escrow;
4. Title Insurance escrow disburses the $175,000 ($165,000 K
$10,000), which is in escrow, to Shell;
5. Title Insurance escrow records the deed which conveys the
Broadway property from Shell to petitioner;
6. The Leveys arrange a $79,500 loan from the Chartered Bank;
7. Chartered Bank deposits $79,500 into the Founders escrow;
8. The Leveys deposit into the Founders escrow the balance of
the funds needed to purchase the El Camino property;
9. Founders escrow transfers to Chartered Bank $170,638.27 as
repayment for petitioners' $165,000 loan plus accrued interest;
and
10. Founders escrow records the deed which conveys the El
Camino property from petitioners to the Leveys.

Petitioners realized a gain from the sale of the El Camino Property, but did not
recognize said gain because they claimed that the transaction was subject to the
nonrecognition provisions of section 1031. In a notice of deficiency, respondent
determined that section 1031 did not apply because, pursuant to said section, petitioners'
purchase of the Broadway property and sale of the El Camino property were not an
'exchange.'

OPINION

Section 1031(a) provides that no gain or loss shall be recognized if property held for
productive use in a trade or business or for investment is EXCHANGED solely for
property of a like kind. A sale of property followed by a separate and unrelated purchase
of property is not an 'exchange' pursuant to section 1031. If petitioner's transfer and
receipt of property were interdependent parts of an overall plan, the result of which was
an exchange of like-kind properties, section 1031 applies. Biggs v. Commissioner, 69
T.C. 905, 914 (1978), affd. 632 F.2d 1171 (5th Cir. 1981). If the taxpayer sells property
for cash and reinvests said cash in like-kind property, section 1031 does not apply, even
if the taxpayer reinvests said cash just a few days after the sale. Starker v. United States,
602 F.2d 1341, 1352 (9th Cir. 1979). Barker v. Commissioner, 74 T.C. 555, 560-561
(1980).

Petitioners contend that section 1031(a) applies because: 1) pursuant to their intent, the
transfers were part of an overall plan; 2) the substance rather than the form of the
transfers controls the tax consequences, and, in the present case, the substance of the
transaction was the receipt of the Broadway property followed by the transfer of like-kind
property, i.e., the El Camino property; 3) the step transaction doctrine supports a finding
that they effected a like-kind exchange; 4) the transfers had to be an 'exchange,' and not a
sale, because they did not have an unfettered right to the El Camino proceeds; and 5) the
legislative intent of section 1031 supports their position.

Respondent contends that section 1031(a) does not apply because, pursuant to section
1031, petitioner did not 'exchange' the El Camino property for the Broadway property.
We agree with respondent.

PETITIONERS' INTENT

Petitioners transferred $175,000 to Shell via the Title Insurance escrow, and the Title
Insurance escrow recorded the deed which conveyed the Broadway property from Shell
to petitioners. Petitioners subsequently conveyed the El Camino property to the Leveys
via the Founders escrow, and the Leveys transferred cash, which the Chartered Bank
claimed as repayment for petitioners' loan, to the Founders escrow. Petitioners did not
'exchange' like-kind property; [FN2] they conveyed the El Camino property for cash.
Although petitioners contend that they intended to effect an exchange of like-kind
properties, such an exchange did not occur. In fact, petitioners attempted to work out an
exchange and were rebuffed by both Shell and the Leveys. Petitioners cite, inter alia,
Alderson v. Commissioner, 317 F.2d 790 (9th Cir. 1963), Starker v. United States, supra,
and Biggs v. Commissioner, supra. In each of those cases, the taxpayer's intent was
coupled with the taxpayer's transfer of real property to a person who, or entity which, in
turn, transferred real property to the taxpayer. See Alderson v. Commissioner, supra
(taxpayer transferred California land to a person who transferred California land to the
taxpayer); Starker v. United States, supra at 1342-1343 (taxpayer transferred Washington
and Oregon land to Crown Zellerbach Corporation which transferred both real property
and a contract right to purchase real property to the taxpayer); and Biggs v.
Commissioner, supra (taxpayer transferred a Maryland farm to a person who transferred a
contract right to purchase a Virginia farm to the taxpayer). In the present case, although
petitioners intended to effect an exchange of like-kind property, they did not transfer the
El Camino property to a person who transferred real property to them; they transferred
the El Camino property to the Leveys for cash.

SUBSTANCE-OVER-FORM

The substance of a transaction in which the taxpayer sells property and immediately
reinvests the proceeds in like-kind property is not much different from the substance of a
transaction in which two parcels are exchanged without cash. * * * Yet, if the exchange
requirement is to have any significance at all, the perhaps formalistic difference between
the two types of transactions must, at least on occasion, engender different results. Barker
v. Commissioner, supra at 561; citations omitted.

In the present case, the substance of the transaction was not such that 'two parcels were
exchanged without cash.' Petitioners purchased the Broadway property and subsequently
sold the El Camino property for cash. The substance of the transaction was a purchase
followed by a sale.
STEP TRANSACTION DOCTRINE

'The step-transaction doctrine is a particular manifestation of the more general tax law
principle that purely formal distinctions cannot obscure the substance of a transaction.'
Superior Coach of Florida, Inc. v. Commissioner, 80 T.C. 895, 905 (1983). The doctrine
treats a series of separate steps as a single transaction if they are in substance integrated,
interdependent and aimed at a particular result. Superior Coach of Florida v.
Commissioner, supra. In the present case, petitioners did not convey their property to a
person who, in turn, transferred real property to them. They conveyed the El Camino
property to the Leveys who, in turn, transferred cash to them. Thus, the transfers fail the
'exchange' requirement of section 1031 even if the transfers were integrated,
interdependent and aimed at a particular result.

WAS IT AN 'EXCHANGE' BECAUSE PETITIONERS DID NOT HAVE AN


UNFETTERED RIGHT TO THE EL CAMINO PROCEEDS?

Petitioners sold the El Camino property to the Leveys. They did not receive the sale
proceeds; the Chartered Bank claimed said proceeds as repayment for the loan which
petitioners obtained to purchase the Broadway property.

An 'exchange' occurs pursuant to section 1031 if a taxpayer transfers property to a


person who transfers like-kind property to the taxpayer. See Alderson v. Commissioner,
supra. In the present case, regardless of whether petitioners received the proceeds from
the sale to the Leveys, or whether the Chartered Bank claimed the proceeds for
repayment of petitioners' loan, petitioners did not convey the El Camino property for
like-kind property; they conveyed it for cash.

LEGISLATIVE INTENT

Petitioners contend that the legislative intent of section 1031 supports their position.
Specifically, they state that an exchange of business or investment assets should not
trigger recognition of gain or loss if a taxpayer is not 'cashing in' his/her investment.
Petitioners' argument does not persuade us. First, the statute (section 1031) requires an
'exchange,' and petitioners have not satisfied that requirement. Second, we have held that
petitioners have sold/'cashed in' their investment in the El Camino property. Finally, in
Starker v. United States, supra, a case upon which petitioners rely heavily, the Ninth
Circuit stated:

the 'underlying purpose' of section 1031 is not entirely clear. The legislative history
reveals that the provision was designed to avoid the imposition of a tax on those who do
not 'cash in' on their investments in trade or business property. Congress appeared to be
concerned that taxpayers would not have the cash to pay a tax on the capital gain if the
exchange triggered recognition. This does not explain the precise limits of section 1031,
however; if those taxpayers sell their property for cash and reinvest that cash in like- kind
property, they cannot enjoy the section's benefits, even if the reinvestment takes place
just a few days after the sale. Thus, some taxpayers with liquidity problems resulting
from a replacement of their business property are not covered by the section. The
liquidity rationale must therefore be limited. Starker v. United States, supra at 1352.

Petitioners also contend that the Tax Reform Act of 1984 supports their position
because the Tax Reform Act of 1984 permits NON-SIMULTANEOUS exchanges in
certain circumstances. This argument does not affect our decision. We have held, supra,
that petitioners did not satisfy the 'exchange' requirement of section 1031; we have not
held that section 1031 does not apply because the transfers were not simultaneous.

WAKEHAM

The Wakeham case (an unpublished Appellate decision) reaffirms the concept of the
prior Bezdjian case that a sale, followed by a reinvestment, is not an exchange within
Code §1031.

NOTE: NOT DESIGNED FOR PUBLICATION!! [914 F.2d 265 (1990)]

Derrick WAKEHAM, Selma Wakeham, Plaintiffs-Appellants,


v.
UNITED STATES of America, Defendant-Appellee.

United States Court of Appeals, Ninth Circuit.


Argued and Submitted Aug. 7, 1990.
Decided Sept. 7, 1990.

Appeal from the United States District Court for the Central District of California;
James M. Ideman, District Judge, Presiding. C.D.Cal.

AFFIRMED.
Before POOLE, CYNTHIA HOLCOMB HALL and DAVID R. THOMPSON,
Circuit Judges.

MEMORANDUM [FN*] OVERVIEW


Selma and Derrick Wakeham appeal the district court's judgment that a series of real
estate transactions they entered into did not qualify for tax exemption under 26
U.S.C.§1031.

BACKGROUND

On April 3, 1978, the Wakehams signed escrow instructions in an attempt to acquire a


50-unit apartment complex in Carlsbad, California. ("Carlsbad" property). The sellers of
the Carlsbad unit were Da-De and Vivian Wei Chiang. The escrow instructions
contemplated the possibility that the transaction would be part of a tax-free exchange.

On September 29, 1978 the escrow instructions were amended to include Jerome M.
Sattler as an additional buyer. Bayhall Venture was substituted for the Chiangs as the
designated seller. Under the agreement the Carlsbad property would be divided up with
the Wakehams acquiring a 77.77778% interest and Sattler acquiring a 22.22222% share.
The agreement also listed possible tax- free exchange properties as:

3668 Marina (sic) Ave.


Santa Ana, CA ["Marine" property]

And/or 2330 East Ball Road


Anaheim, CA ["Ball" property]

And/or 2619 Orion,


Santa Ana, CA ["Orion" property]

It was contemplated that purchasers would be found for the Marine, Ball and Orion
properties prior to the Carlsbad closing date and that simultaneous transactions would
take place between the Wakehams and Sattler, the purchasers of the three properties and
Bayhall Venture. The escrow agent was to be notified which properties would be
exchanged by November 17, 1978. The escrow was to close no later than November 28,
1978.

On November 17, 1978 the Carlsbad escrow instructions were amended to provide for
alternative methods of closing:

1. Accept funds from Stewart Title Co. of Santa Ana, said funds
being equity held by the undersigned in property known as 2330
East Ball Road, Anaheim, California, OR
2. To close this escrow (# 4279-C) without the close of the Santa
Ana escrow, in which case escrow # 4279-C will close as a
straight sale rather than an exchange.

The Wakehams were unable to secure the sales of the Ball, Orion or Marine properties
prior to November 28, 1978. Instead, to effect the Carlsbad sale, they obtained short-term
swing loans from Crocker National Bank. The loan documents did not specifically
designate what the proceeds would be used for. However, the funds were deposited
directly into the escrow. The loans were secured by deeds of trust on the Ball, Marine and
Orion properties as well as the Wakehams' residence. On November 28, 1978, the
Wakehams used the proceeds from the loans and a promissory note to acquire the
Carlsbad property.

The Wakehams sold the Ball, Orion and Marine properties in December 1978, April
1979 and May 1979, respectively. The net proceeds after satisfying the loans used to
purchase the Carlsbad properties and various other charges were, in the order sold,
$38,510.65, $35,952.63 and $35,131.99. The Wakehams used this surplus to repay the
loan secured by their personal residence.
For the taxable year 1978, the Wakehams filed a return on April 15, 1979 treating the
disposition of the Ball property as a taxable sale. They filed an amended return on
February 4, 1982, reassessing the sale as a tax-free like-kind exchange. As a result of the
like-kind status, the Wakehams sought a refund of $20,906.00. On June 5, 1984, the IRS
denied the refund claim stating that the sale of the Ball property did not qualify under
Section 1031 because "the property was not exchanged either solely or partly for property
in kind."

For the taxable year 1979, the Wakehams first treated the sales of the Orion and Marine
properties as taxable sales but then filed an amended return treating those dispositions as
tax-free like-kind exchanges. The amended return claimed a total refund of $26,079.00.
In October 1981, the Wakehams received a refund of that sum, plus interest.

On December 10, 1984, a demand was made by the IRS for repayment of the 1979 tax
refund in the total amount of $60,644.27. The Wakehams paid all of the tax and part of
the interest on March 10, 1986. On November 14, 1986 they filed a claim for refund of
that amount. The IRS denied the claim and the Wakehams filed the instant suit. [FN1]

After considering the stipulated facts and the parties' arguments on the briefs, the
district court found that the sales were not like-kind exchanges but rather separate,
independent transactions. Accordingly, it dismissed the Wakehams' complaint with
prejudice on September 26, 1988. The judgment was entered on September 28, 1988 and
the Wakehams timely appealed on November 28, 1988. This court has jurisdiction under
28 U.S.C.§1291.

STANDARD OF REVIEW

The trial court's conclusion that the Wakehams' transactions did not constitute a like-
kind exchange within the meaning of 26 U.S.C. §1031 is legal in nature and as a result is
entitled to de novo review by this court. United States v. McConney, 728 F.2d 1195,
1201 (9th Cir.) (en banc), cert. denied, 469 U.S. 824 (1984).

DISCUSSION

26 U.S.C. §1031(A) is an exception to the general rule requiring recognition of gain or


loss upon the sale or exchange of property. Under 26 U.S.C. §1031(A) if property held
for productive use is exchanged for like-kind property, the taxable gain is not realized
until the acquired property is disposed. [FN2] The sole question presented for review is
whether the Wakehams exchanged the Ball, Orion and Marine properties for the Carlsbad
property. [FN3]

The Wakehams make essentially three arguments to support an exchange: (1) the Ball,
Orion, Marine and Carlsbad transactions were mutually interdependent; (2) they did not
"cash in" on the Ball, Marine and Orion properties; (3) the controlling element in this
case is the intent underlying the transactions and they intended to effect a like-kind
exchange. All three arguments are without merit.
The reasoning behind an exchange is mutual dependency--the reciprocal transfer of
property. See, e.g., Bezdjian v. Commissioner of Internal Revenue Service, 53 T.C.M.
(CCH) 368 (1987), aff'd, 845 F.2d 217 (9th Cir.1988); Starker v. United States, 602 F.2d
1341 (9th Cir.1979); Leslie Co. v. Commissioner of Internal Revenue Service, 539 F.2d
943, 949 (3rd Cir.1976); Carlton v. United States, 385 F.2d 238 (5th Cir.1967). The
Wakehams' transactions did not constitute an "exchange" within the meaning of Section
1031 because the transactions were not mutually interdependent nor did they constitute
the reciprocal transfer of property. Moreover, mere intent to effect a like-kind exchange
does not render the transaction tax free.

A. Interdependence
Courts have not limited a Section 1031 exchange to a two-party transaction. Properly
structured multi-party transactions can qualify for tax- free treatment. Alderson v.
Commissioner, 317 F.2d 790, 793-795 (9th Cir.1963). Further, this circuit has held that a
like-kind exchange need not occur simultaneously. Starker v. United States, 602 F.2d
1341, 1354-1355 (9th Cir.1979). However, in order to qualify for tax deferred treatment
in a multi- party transaction there must be mutually interdependent contracts which are
part of an integrated plan. See Biggs v. Commissioner of Internal Revenue Service, 632
F.2d 1171, 1178 (5th Cir.1980) (taxpayer was entitled to tax deferred treatment under
Section 1031 where all transactions were interdependent and culminated in an exchange
rather than a sale and a separate purchase); Lee v. Commissioner of Internal Revenue, 51
T.C.M. (CCH) 1438 (1986) (no like-kind exchange where a purchase and sale were
executed via independent escrows although the sales proceeds were applied to the
purchase price); Rogers v. Commissioner, 44 T.C. 126, 133-134 (1965), aff'd per curiam,
377 F.2d 534 (9th Cir.1967) (no like-kind exchange where property was sold before
exchange took place).

The Wakehams argue the Carlsbad and three individual property transactions were
mutually interdependent. They assert that the fact that they obtained a swing loan does
not make this a cash transaction as the essence of a swing loan is to bridge an economic
gap between two mutually dependent transactions. However, contrary to the allegation of
mutual interdependence, the Carlsbad purchase does not appear to have been dependent
upon the sale of the other three properties. Bayhall Venture's receipt of its funds was in
no way tied to the sale of the three individual properties. It appears to have received cash
for the Carlsbad property and was then out of the picture. Nor were the sale of the other
three properties dependent upon the Carlsbad sale.

Although the Wakehams argue that the swing loans somehow make the transactions
interdependent, they failed to produce any evidence that the bank in any way restricted
the use of the loans to the purchase of the Carlsbad property. Further, there is no evidence
that the repayment of the loans had to come from the sale of the three properties. The
bank would have been satisfied with repayment regardless of the source.

The escrow expressly provided if buyers were not found prior to the Carlsbad closing
date then the Carlsbad escrow would close as a "straight sale rather than an exchange."
The sales of the Ball, Orion and Marine properties were not consummated by the closing
date. In an effort to close the Carlsbad deal, the Wakehams obtained short-term swing
loans from the Crocker National Bank and closed in a straight sale manner.

B. Reciprocal Transfer
Appellants further argue that they did not cash-in their investment and therefore these
transactions constitute like-kind exchanges. In the business venture context, the venture
should continue after the exchange without any real economic change and without
realization of any cash. Carlton v. United States, 385 F.2d 238, 242 (5th Cir.1967) ("[t]he
very essence of an exchange is the transfer of property between owners, while the mark
of a sale is the receipt of cash for the property"). One who sells property for cash and
reinvests that cash in like-kind property is not covered by Section 1031 even if the
reinvestment takes place just a few days after the sale. Bezdjian, 845 F.2d at 218-219;
Starker 602 F.2d at 1352; Carlton, 385 F.2d at 241; Rogers v. Commissioner, 44 T.C.
126, 133 (1965), aff'd per curiam, 377 F.2d 534 (9th Cir.1967). Here, the Wakehams paid
cash to obtain the Carlsbad property and received cash from the sale of the Ball, Orion
and Marine properties. Although the Wakehams argue that they did not "cash in," there is
no evidence that either the Bayhall Venture or the three individual purchasers exchanged
anything but cash for real property.

In Bezdjian v. Commissioner of Internal Revenue Service, 53 T.C.M. (CCH) 368


(1987) aff'd 845 F.2d 217 (9th Cir.1988), this court considered facts substantially similar
to those at issue in the instant case and concluded that no like-kind exchange took place.
In that case, Shell Oil Company offered to sell the Bezdjians a gas station known as "the
Broadway property." In an effort to close the deal, the Bezdjians offered to exchange
their El Camino property for the Broadway parcel. Shell refused the exchange offer and
instead insisted on a cash transaction.

As in this case, a buyer could not be found for the El Camino property prior to the
closing of the Shell escrow. The Bezdjians obtained a loan secured by a deed of trust on
their residence and the El Camino property and used the proceeds of the loan to buy the
Broadway property. The bank transferred the funds directly into the escrow. The funds
were then transferred to Shell and title transferred to the Bezdjians.

Approximately three weeks later, the Bezdjians agreed to sell the El Camino property
to the Leveys. Another escrow was opened to facilitate the sale of that property. The
Leveys assumed the mortgage and paid the remainder of the purchase price in cash. The
cash portion of the purchase price was deposited into the second escrow. A deed was then
issued to the Leveys. Escrow funds were disbursed to the bank to repay the loan taken out
by the Bezdjians in connection with the Broadway property.

The Bezdjians treated the transactions as a like-kind exchange under Section 1031. The
Internal Revenue Service characterized the transaction as a taxable separate purchase and
sale and notified the Bezdjians of their tax deficiency. The Bezdjians filed a civil action
and the tax court ordered the petitioners to pay the deficiency, finding there was no like-
kind exchange. The Bezdjians appealed and this court affirmed, holding:
While the Bezdjians may have wanted to structure such an exchange, there is no
evidence that Shell or the Leveys agreed to participate in one. Moreover, the record
indicates that the Bezdjians neither conveyed real property to Shell in exchange for the
Broadway property nor received real property from the Leveys in exchange for the El
Camino property. We conclude there was no exchange of property of a like kind.
Bezdijan, 845 F.2d at 219.

As in Bezdjian, the taxpayers in this case failed to understand that the essence of a
Section 1031 transaction is an "exchange" of property or an interest in property for other
property of a like-kind. Here, Bayhall Venture was willing to structure the transaction
such that the deal could be consummated with funds from the sale of the three properties
owned by the Wakehams. However, it was not willing to make the sale dependent upon
such funding. The escrow expressly provided if buyers were not found prior to the
Carlsbad closing date then the Carlsbad escrow would close as a "straight sale rather than
an exchange."

The Wakehams argue that Starker v. United States, 602 F.2d 1341 (9th Cir.1979),
supports their argument that a like-kind exchange took place. However, Starker is
inapposite. In that case, the court found a like-kind exchange was effectuated where
Starker exchanged property for a third-party purchaser's rights to like-kind property. The
court in Starker held that the rights to the property amounted to a fee interest and as such,
an exchange of like-kind property had in fact taken place. The Starker court distinguished
between receipt of cash and reciprocal transfer of like-kind property and found there was
a reciprocal transfer of property.

In contrast, no such exchange of property took place between Bayhall Venture and the
Wakehams or the three individual purchasers and the Wakehams. As in Bezdjian, Bayhall
Venture was paid in cash from the proceeds of the loans. Later, the three individual
purchasers paid cash for the parcels they obtained. There is no indication that any of these
transactions were reciprocal. Bayhall Venture did not acquire an interest in the three
individual properties nor did the individual purchasers acquired an interest in Carlsbad.

C. Intent
While the Wakehams may have wanted to structure a tax free exchange, mere intent
does not render the transaction tax free. Carlton v. United States, 385 F.2d 238, 243 (5th
Cir.1967) (and cases cited). The substance of a transaction and not the end result
determines a transaction's tax consequences. Carlton, 385 F.2d at 241-243. See also
Bezdjian v. Commissioner of Internal Revenue Service, 53 T.C.M. (CCH) 368 (1987),
aff'd, 845 F.2d 217 (9th Cir.1988). The Wakehams' intent to effectuate a like-kind
exchange does not turn otherwise independent transactions into tax-free interdependent
ones.

CONCLUSION

The Crocker National Bank lent the Wakehams cash with which they purchased the
Carlsbad property. They repaid these loans with the proceeds from the sale of the three
individual properties. The Wakehams neither conveyed real property to Bayhall Venture
in exchange for the Carlsbad property nor received real property from any of the three
individual purchasers for the Orion, Marine and Ball parcels. In light of the foregoing, no
like-kind exchange took place between the parties. The judgment of the district court is
hereby AFFIRMED. FN* This disposition is not appropriate for publication and may not
be cited to or by the courts of this circuit except as provided by 9th Cir.R. 36-3. FN1 In
this suit, the Wakehams seek $20,906.00 plus interest and attorney's fees for the 1978 tax
year and $26,079.00 plus interest and attorney's fees for the 1979 tax year. FN2 26 U.S.C.
§1031(A) provides: 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 trade or
business or for investment. FN3 The United States does not contest that the three
individual properties and the Carlsbad properties are "like kind" within the meaning of
the statute, nor that those properties were held for "productive use in a trade or business
or for investment."

SWAIM

This is a 5th Circuit decision in 1981 which reviewed a prior District Court decision of
1979.

This decision was affirmed in part and reversed in part. As to the exchange issue, the
Court held that a nonsimultaneous transfer was not a valid Code §1031 exchange.

The taxpayers had sold real property to individuals in question and received notes, cash
and certain mortgage interests. Subsequent to this, and some months later, the taxpayers
received real estate in exchange for the notes, cash and mortgages they had received.

Inasmuch as the transactions in question did not have contractual interdependence, such
transaction would not qualify within Code §1031.

As to the issue of Code §1031, the District Court was affirmed in finding that there was
not a qualified Code §1031 transaction. The Court cited a number of other cases in
supporting its position. It also cited the concept and statement of the Tax Court as to
fairness when it stated, referring to the Barker case: "But there is no equity in tax law . . .
and such must be the result if the limitation in §1031 to excepts is to have any meaning."
(The Barker Court was referring to prior cases that had developed this statement and
position.)

EMSY H. SWAIM and Annie Swaim


v.
United States of America.

79-2 USTC P 9462 (1979)


HIGGENBOTTOM, District Judge.
Memorandum Opinion and Order
This case presents two unrelated questions of whether the plaintiffs, in disposing of one
piece of property in Hale County, Texas, effected a tax-free exchange of like kind
property, and whether they, by selling a second piece of property in Concho County,
Texas, realized taxable gain in 1965 or in 1966.

I. Hale County Transaction.


The plaintiffs, who owned a tract of land in Hale County, Texas, entered into an
agreement with Eddie P. Zimmerman and Merlin E. Gary ("Z&G") to exchange that
property for certain other property in Maverick County. According to the terms of the
contract, the total value of the Hale County property was $101,150-$425 per acre.
Because of a $41,400 mortgage, the Swaims' equity in the land was $59,750. Plaintiffs
were to receive that precise amount in cash and notes and Z&G were to assume the
mortgage. Z&G's Maverick County property was valued at $105 per acre. Including the
$2,500 in improvements that the contract required Z&G to make, the value of the
Maverick County property according to the contract was $297,632. The contract stated
that Z&G were to receive precisely that amount from the Swaims in money or money's
worth. Specifically, they were to receive $30,000 in cash, an additional $20,000 by April,
1965, $102,632 in promissory notes, $25,000 in the form of a note assumed by plaintiffs,
and $120,000 in the form of mortgage assumption.

The contract further specified that the exchange of deeds would occur simultaneously
by April 1, 1965. As it happened, however, when the plaintiffs were ready to transfer the
Hale County deed, Z&G had not made the agreed improvements on the Maverick County
land. Consequently that deed was placed in escrow pending the completion of the
improvements. Despite this cloud over the Maverick County transfer, the Swaims
transferred the deed to the Hale County property to Z&G on February 2, 1965 and
received that same day the agreed cash and notes. Immediately and pursuant to an earlier
agreement, Z&G sold the Hale County property to a third party, the Masters. Swaim
acted as agent in effecting this sale to the Masters. In mid-May, 1965, three months after
the Hale County property had been sold and resold, Z&G ended the uncertainty in the
sale of the Maverick property by completing certain improvements. The land was then
deed to the Swaims for agreed cash and notes.

The Swaims claim that this sale and purchase was actually at least in part a nontaxable
exchange within the meaning of §1031 of the Internal Revenue Code of 1954. Under
§1031, no gain is recognized if:

(1) the property held for productive use in trade or business or for
investment;
(2) is exchange;
(3) for property of like kind;
(4) to be held for productive use in trade or business or for
investment.

The government does not dispute that the Swaims held the Hale County property for
use in their trade or business, or that the two properties were of like kind. Rather, the
government attacks the transactions on the grounds that they were not an exchange and
that the Maverick County property was not held for productive use in the Swaims' trade
or business. Because this court does not find that the two sales were an exchange within
the meaning of §1031, it is not necessary to resolve the question of whether the Swaims
held the Maverick County property for productive use in their trade or business.

The term "exchange" as it appears in §1031 has been construed to include a wide
variety of transactions. The least complicated is the situation in which two people, each
owning property that the other wants, simply agrees to swap. A variant of this (and either
the most usually occurring or the most litigated) is the so-called "threecorner" exchange
in which the taxpayer desires to exchange rather than sell his property but the potential
buyer does not own property that the taxpayer wishes to receive in exchange. The buyer,
to accommodate the taxpayer, acquires property of the taxpayer's choice from a third
party, then exchanges it for the property held by the taxpayer. Courts have consistently
approved such exchanges. See, e.g., Alderson v. Commissioner [63-2 USTC P 9499], 317
F. 2d 790 (9th Cir. 1963); W. D. Haden Co. v. CommissioneR (48 USTC P 9147], 165 F.
2d 588 (5th Cir. 1948); Biggs v. Commissioner [CCH Dec. 35,035], 69 T. C. 905 (1978);
J. H. Baird Publishing Co. v. Commissioner [CCH Dec. 25,816], 39 T. C. 608 (1968).

Courts have also permitted a number of deviations from the standard three- corner
exchange. For example, the timing of the deed exchange need not be simultaneous. J. H.
Baird Publishing Co. v. Commissioner, supra. Moreover, the taxpayer can advance
money toward the purchase price of the property held by the third party. 124 Front Street,
Inc. v. Commissioner [CCH Dec. 33,448], 65 T. C. 6 (1975). The Tax Court has even
allowed nonrecognition for a transaction in which the buyer never actually held legal title
to the property to be exchanged but instead transferred to the taxpayer the contractual
right to acquire that property from the third party. Biggs v. Commissioner, supra. This
may be at the periphery of the acceptable variant. Compare with Carlton v. United States
[67-2 USTC P 9625], 385 F. 2d 238 (5th Cir. 1967).

The courts have allowed taxpayers great latitude in structuring their transactions inside
the ultimate limit that a transaction is entitled to nonrecognition only if deferral of
taxation will not offend the purpose of §1031. That is, looking through form, the inquiry
is whether the transaction as actually completed is in fact consistent with the purposes of
the tax code exception to the general rule of recognition.

Section 1031 was designed to postpone the recognition of gain or loss where property
used in a business is exchanged for other property in the course of the business. In those
circumstances the taxpayer has not received any gain or suffered any loss in a general and
economic sense. Nor has the exchange of property resulted in the termination of one
venture and assumption of another. The business venture operated before the exchange
without any real economic change or alteration, and without realization of any cash or
readily liquifiable asset. Carlton v. United States, supra, 385 F. 2d at 241.

Because an investor who exchanges X property for Y property may have no liquid
assets to pay taxes on his gain, §1031 allows him to postpone recognizing his gain until
such time as his investment becomes liquid. An examination of Carlton demonstrates that
the Hale County transaction was not the sort of transaction that & 1031 was intended to
include. In Carlton the taxpayer and General Development Corp. ("General") entered into
an option contract pursuant to which General, at Carlton's request, was to acquire certain
property from a third party, then exchange it for Carlton's property. In fact, however,
General paid Carlton cash for his property and transferred to him not the deed to the third
party's property but the contractual right to purchase that property. Emphasizing that a
sale and repurchase do not qualify for §1031 treatment, the court refused to classify the
transaction as an exchange. Looking to the transaction as a whole to determine its
substance, the court found that Carlton in actuality had received cash for his property and
not another parcel of land. The court stated:

The very essence of an exchange is the transfer of property between owners, while the
mark of a sale is the receipt of cash for the property. Id. at 242.

The court placed particular reliance on the fact that Carlton's use of the cash he received
was unfettered; General had not earmarked the funds for Carlton to use in purchasing the
property from the third party. Judge Gewin's emphasis upon the receipt of cash is
warranted. Postponement of the payment of cash by §1031 is bottomed on the economic
reality that taxpayers who exchanged property to that extent have not liquidated their
assets sufficiently to pay taxes. No taxes on the transactions are forgiven. They are
delayed until the assets are liquidated by another taxable event.

In this case, as in Carlton, the Swaims received the full equity value of the Hale County
property in money or money's worth-not land. Likewise, Z&G received the precise value
of the Maverick County property in money or money's worth only. Because of the delay
in affecting the Maverick County transfer, the Swaims received full payment for the Hale
County land months before they received the Maverick deed. Their use of that $59,730
was completely unrestricted. The very fact that the disposition of the Hale County
property was completed in its entirety without completion of the Maverick County
transfer emphasizes the "cashing in" nature of the Hale County sale. The flow of cash and
money's worth was not made up at all of any value assigned to the Maverick County
property. Like the transactions in Carlton, these were at the most "complimentary;" they
lacked the "contractual interdependence" that the Fifth Circuit has held is so essential to
an exchange. Redwing Carriers, Inc. v. Tomlinson [68-2 USTC P 9540], 399 F. 2d 652,
655, 659 (5th Cir. 1968). Not only were the transactions severable; they were in fact
severed. Id. at 659. The taxpayer sold to the buyer his property for cash and notes, then
later purchased from the buyer like property.

Plaintiffs emphasize that the parties intended to enter into a tax-free exchange and that
at the end of the transaction, they held property that was the same sort as they had owned
originally. There is no question that the parties hoped that their transaction would finally
end in a tax-free exchange. A court, however, cannot "close [its] eyes to the realities of
the transaction and merely look at the beginning and end of a transaction without
observing the steps taken to reach that end." Carlton v. United States, supra, 385 F. 2d at
241. While a taxpayer's professed intent is significant, it does not determine the tax
consequences of his action, id. at 243; and while the end result of a transaction may
provide some clue as to the nature of the transaction itself, the conclusion of intent must
accommodate what actually occurred. That result determines the proper tax treatment.
What actually occurred in this case was that the plaintiffs worked a substantial change in
their original investment. They liquidated their interest in the Hale County property, had
free use of the funds, and later purchased other land. A holding that these complimentary,
not interdependent, transactions constitute an exchange would be contrary to the purposes
of §1031.

In weighing the professions of intent, it is significant that despite the hope of the
Swaims that a tax-free exchange would be accomplished, they were willing to sell their
Hale County property even if they failed to obtain the Maverick County property. That
willingness was proved by the fact that the Swaims sold their Hale County property to
Z&G and acted as agent in its resale to the Masters. They were paid and their Hale
County property was irretrievably sold. Some months later the sale of the Maverick
County property was accomplished, but in months immediately after the sale by the
Swaims, their purchase of the Maverick County property was by no means certain. In
Alderson v. C.I.R., 317 F. 2d 790 (9th Cir. 1963), the Ninth Circuit accepted a three-
cornered exchange as a nontaxable exchange. In doing so, that court emphasized:

From the outset, petitioner desired to exchange their Buena Park property for other
property of a like kind. They intended to sell the property for cash only if they were
unable to locate a suitable piece of property to take in exchange. . . . . at 792 (emphasis
supplied).

Having sold the Hale County property for cash months before it was clear that they
would purchase the Maverick County property, the Swaims are not in a position to claim
that they intended to sell for cash only if they did not in turn receive the Maverick County
property.

The Swaims would argue that this result places form over substance in that they could
have placed the proceeds of the Hale County sale in escrow and later simultaneously
closed; that the courts have not required simultaneous closings; finally, that they in fact
did acquire the Maverick County property despite the interim uncertainty. Certainly form
ought not control over substance, but the substance is that having liquidated, the Swaims
are not entitled to invoke the protection of a tax code provision limited to taxpayers who
did not.

NONSIMULTANEOUS EXCHANGE: CONSTRUCTIVE RECEIPT:


HILLYER

The issues that the Court decided in the Hillyer case involved whether the corporation's
transfer of land and subsequent activities constituted a Code §1031 exchange and whether
there was a constructive or actual receipt of cash in the alleged exchange.

(1) The Court concluded that, although some of the technical


requirement under the Treasury Regulations for the exchange
were met, the proper drafting of the Escrow Agreement was
not present. As such, there was no restriction on the cash;
therefore, the transaction equated to a sale, as opposed to an
exchange.
(2) The Court was asked to decide whether a tax-deferred
exchange took place where there was an escrow arrangement
that did not comply with the current position of the Regulation.
Because of a constructive receipt issue on the funds that were
involved in the disposition of the relinquished property,
without proper structure, the exchange treatment was defeated.
Michael HILLYER and Teresa Hillyer, et al., [FN1] Petitioners,
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent.

Nos. 22118-94 to 22121-94.


United States Tax Court.
T.C. Memo. 1996-214
1996 WL 219687 (U.S.Tax Ct.),
71 T.C.M. (CCH) 2945, T.C.M. (P-H) 96,214
May 2, 1996.

MEMORANDUM OPINION

KORNER, Judge:
Pursuant to respondent's motion, granted on August 9, 1995, the above dockets were
consolidated in this Court for trial, briefing, and opinion. The cases were thereafter
submitted to the Court on a full stipulation of facts and exhibits without trial, pursuant to
Rule 122.

The issues that the Court must decide are:

(1) Whether the corporation's transfer of land to Penn-Daniels, Inc., and its subsequent
acquisition of land from Scott Coggeshall and the Coggeshall Construction Co.
(Coggeshall property), and land from Marcellene J. Inness was an exchange of like-kind
property within the meaning of section 1031(a); and

The corporation's place of business was at Macomb (McDonough County), Illinois. The
corporation had been engaged in the general construction business in that vicinity since
1966. The Coggeshall Construction Co. (the Coggeshall Co.) and its predecessor had
been engaged in the general construction business, including road building, in this same
area since 1952. The corporation has acted as subcontractor with respect to construction
contracts entered into by the Coggeshall Co. from time to time in the past. In late 1988 or
early 1989, the corporation determined that concrete and asphalt work would constitute a
natural extension of the corporation's existing construction activities, and principals of
the corporation and the Coggeshall Co. in 1989 discussed the idea of the corporation's
acquiring an interest in certain property on Deere Road, Macomb, Illinois, which was
industrial property owned by Scott Coggeshall, on which the Coggeshall Co. owned an
asphalt plant. In addition, the Coggeshall Co. owned other equipment on property owned
by J. W. Collins, also located in Macomb, Illinois. The equipment in these two properties
was owned by the Coggeshall Co. in connection with its construction and related
activities (the whole (land and equipment) is referred to as the Coggeshall property).

In May 1989, and again in January 1991, the corporation sought to lease the Coggeshall
property from the owners. Both offers were rejected. Between November 1990 and
February 1991, there were also negotiations for the purchase of the Coggeshall property
by the corporation. In September 1989, Scott Coggeshall and the Coggeshall Co. entered
into a management agreement with and option to sell the Coggeshall property to the
Chester Bross Construction Co. (Bross) for a period ending October 1, 1990, which
agreement was extended by the parties until November 1, 1991. Because of the failure by
Bross to pay equipment rental, utilities, and taxes, the property was repossessed by Scott
Coggeshall and the Coggeshall Co. on January 7, 1992. The Bross agreement expired on
November 1, 1991.

On September 21, 1990, the corporation entered into a contract to purchase 9.53 acres
of real estate (Phoenix property), which was zoned industrial and was located next to the
corporation's offices and shop in Macomb, Illinois. The Phoenix property was purchased
and held for productive use in the corporation's trade or business or for investment in
connection with its construction activities. The purchase price of the property was
$105,000. On August 9, 1991, the adjusted basis of the Phoenix property in the hands of
the corporation was $57,085.

Penn-Daniels, Inc., is a Delaware corporation authorized to do business in Illinois. It


operates a chain of retail stores. Around 1990, Penn-Daniels developed an interest in
acquiring property in Macomb, Illinois, as the prospective location for a new store. It
engaged the services of EST Acquisitions, Inc. (EST), to act as its agent in locating and
securing a store site in Macomb. In January 1991, the corporation and EST entered into a
real estate purchase agreement, as amended, for the sale of the Phoenix property by the
corporation to Penn-Daniels for $382,000. Said purchase agreement, assigned by EST to
Penn-Daniels, provided that the corporation, as seller, might choose to designate certain
properties, allegedly for purposes of achieving a tax-free exchange under section 1031,
and Penn-Daniels, as buyer, agreed to participate in such exchange, provided that the
corporation, as seller, would reimburse the buyer for all expenses associated therewith,
that the buyer would not actually take title to any such designated exchange property, and
that the buyer would not be exposed to any liability as the result thereof. The parties to
the agreement understood that the obligation of Penn-Daniels as buyer to participate in
any such designated exchange would terminate upon the closing of the sale.

Closing of the sale of the Phoenix property was held on August 9, 1991. The
corporation received at settlement the closing amount of $354,065.21 and tendered the
appropriate deed to Penn-Daniels for the Phoenix property. With reference to the prior
agreement between the corporation and Penn-Daniels, as amended, the corporation
thereupon placed the settlement funds it had received with the Citizens National Bank of
Macomb as agent under an escrow agreement, under which the corporation reserved the
right to designate certain replacement properties. In significant part, the escrow
agreement provided that the bank would hold the sales proceeds for the direction of the
corporation in the acquisition of replacement properties for the period of 180 days. The
corporation was obligated to "direct" the acquisition of such properties within 45 days of
the deposit of the money with the bank. No affirmative acts were required from Penn-
Daniels, as buyer of the Phoenix properties (except to cooperate (prior to the Phoenix
settlement) in the acquisition of desired replacement properties); in fact none were asked,
and none were performed.

On September 20, 1991, the corporation notified the Citizens National Bank, as escrow
agent, of the designation of three properties which the corporation intended as
replacement properties for the purposes of section 1031(a)(3). These properties were
designated as the "McClure quarries in Tennessee Township, Colchester, Illinois," which
were not acquired by the corporation; the Coggeshall property; and "property zoned M-2
located south and east of Route 41 in Galesburg Township, Knox County, Illinois"
(owner and size not specified).

On January 30, 1992, the corporation, Scott Coggeshall, and the Coggeshall Co.
executed a purchase agreement (Coggeshall purchase agreement) with respect to the
Coggeshall property for a total purchase price of $577,370, including $321,000 for the
real estate owned by Scott Coggeshall and the asphalt plant located thereon owned by the
Coggeshall Co. and $256,370 for other miscellaneous equipment, including the asphalt
plant owned by the Coggeshall Co., but located on land owned by Collins. Payment for
this purchase was accomplished by an immediate payment of $300,000 at closing to the
sellers, as a downpayment, with the $277,370 balance to be payable over 4 years. This
arrangement for deferred payment was solemnized by a second escrow agreement
established by the parties with the Citizens National Bank of Macomb. The Coggeshall
property was to be held by the corporation as investment property or for use by the
corporation in connection with its trade or business. The Coggeshall property on Deere
Road is of like-kind with that of the Phoenix property. Respondent does not contend that
the items detailed in the stipulation with respect to the Deere Road asphalt site in the
Coggeshall property should not be considered real property, and has conceded on brief
that such items are to be considered real estate.

On March 30, 1992, however, the Coggeshall Co. determined that the Coggeshall Co.
could not transfer the plant equipment on the Collins site by reason of a landlord's lien
asserted by J. W. Collins; such equipment located on the Collins' property, as stipulated
by the parties, was accordingly eliminated from the contract, and the purchase price of
the Coggeshall property was accordingly reduced from $577,370 to $510,007.

On January 30, 1992, apparently independently of the Coggeshall purchase, the


corporation and Marcellene J. Inness entered into a contract for the sale to it of certain
property for $46,361. The transaction closed the same day, on January 30, 1992, with the
payment of this sum to the direction of Marcellene J. Inness from the "escrow" account at
the Citizens National Bank of Macomb, taken from the funds entrusted to it by the
corporation, to be disbursed at its direction, and the Inness warranty deed to the
corporation was recorded.

The proceeds of the Phoenix property sale settlement of August 9, 1991, which had
been retained by the Citizens National Bank under the existing escrow agreement, were
disbursed as follows:

In these cases, we are met again with the tension between section 1001(c), which
broadly provides on the one hand that in the case of a sale, the amount of gain or loss
shall be recognized, and, on the other hand, the requirement of section 1031(a), which
allows for the nonrecognition of gain or loss where like-kind properties are exchanged to
be used in a productive trade or business or for investment. The touchstone of section
1031, at least in this context, is the requirement that there be an exchange of like-kind
business or investment properties, as distinguished from a cash sale of property by the
taxpayer and a reinvestment of the proceeds in other property.

* * * , courts have acknowledged that transactions that take the form of a cash sale and
reinvestment cannot, in substance, constitute an exchange for purposes of section 1031,
even though the end result is the same as a reciprocal exchange of properties. Bell Lines,
Inc. v. United States, 480 F.2d 710, 714 (4th Cir. 1973); Carlton v. United States, 385
F.2d 238, 241 (5th Cir. 1967). Thus, our inquiry is narrowly focused on whether the
corporation's disposition of the Phoenix property in this case was a sale, as argued by
respondent, or an exchange for the Coggeshall and Inness properties, as argued by
petitioners.

Petitioners contend that the series of transactions here culminating in the acquisition of
the Coggeshall property and the Inness property with funds resulting from the Phoenix
property transfer, were steps in an integrated transaction, the substance of which was an
exchange of properties within section 1031(a).

In some multiparty transactions, the taxpayer desires to exchange, rather than to sell,
his property, but the potential buyer owns no property that the taxpayer wishes to receive
in exchange. Thus, some cases involve three or more parties and multiple conveyances of
property in an effort to structure an exchange instead of a sale and reinvestment. In some
of them, these multiparty transactions have been held to constitute an exchange within the
meaning of section 1031. In so holding, the courts have allowed taxpayers great latitude
in structuring their transactions and have allowed nonsimultaneous exchanges, see
Starker v. United States, 602 F.2d 1341 (9th Cir. 1979); deposit of proceeds into a bank
account controlled by an independent third party before an exchange property is located,
J.H. Baird Publishing Co. v. Commissioner, 39 T.C. 608 (1962); transactions in which
the intermediary did not acquire legal title to the exchange property, Biggs v.
Commissioner, 69 T.C. 905, affd. 632 F.2d 1171 (5th Cir. 1980); and change from a sale
transaction to an exchange transaction even though the property to be received on the
exchange was not identified as of the date the original agreement was made, Alderson v.
Commissioner, 317 F.2d 790 (9th Cir. 1963), revg. 38 T.C. 215 (1962).
These multiparty cases have explained that section 1031 "only requires that as the end
result of an agreement, property be received as consideration for property transferred by
the taxpayer without his receipt of, or control over, cash". Coupe v. Commissioner, 52
T.C. 394, 409 (1969).

On the other hand, receipt of or control over cash proceeds by a taxpayer will prevent
characterization of a multiparty transaction as an exchange. In the Deficit Reduction Act
of 1984, Pub. L. 98-369, sec. 77(a), 98 Stat. 596, an attempt was made to clarify some of
the uncertainties that exist in this area by the enactment of a new section 1031(a)(3),
which provides:

For purposes of this subsection, any property received by the taxpayer shall be treated
as property which is not like-kind property if--

1. such property is not identified as property to be received in the


exchange on or before the day which is 45 days after the date on
which the taxpayer transfers the property relinquished in the
exchange, or
2. such property is received after the earlier of--
- the day which is 180 days after the date on which the taxpayer
transfers the property relinquished in the exchange, or
- the due date (determined with regard to extension) for the
transferor's return of the tax imposed by this chapter for the
taxable year in which the transfer of the relinquished property
occurs.

Further attempting to clarify the new statutory provisions under section 1031, section
1.1031(k)-1, Income Tax Regs., effective on or after June 10, 1991, provides in section
1.1031(k)-1(c)(3), Income Tax Regs.:

Replacement property is identified only if it is unambiguously described in the written


document or agreement. Real property generally is unambiguously described if it is
described by a legal description, street address, or distinguishable name * * *

Section 1.1031(k)-1(c)(4), Income Tax Regs., further provides that the number of
replacement properties that will qualify under section 1031(a) to be designated by the
taxpayer may not exceed three in number.

Once again, the new regulations, in section 1.1031(k)-1(f), Income Tax Regs.,
reemphasize:

NONSIMULTANEOUS EXCHANGE/ESCROW: CHASE

For an example of how NOT to attempt to use an escrow arrangement, see Chase v.
Comm. This case, involving a partnership, attempted to have a distribution of part of the
asset, an apartment building, from the partnership to one of its general partners. That
general partner in turn was to undertake a tax-deferred exchange, nonsimultaneous in
nature, with the use of an escrow arrangement, among other items. The transaction was
ill-conceived, poorly executed and in turn, the property sold resulted in a taxpayer
transaction. This is certainly not a bonafide explanation of a qualified nonsimultaneous
exchange.

DELWIN G. CHASE AND GAIL J. CHASE, Petitioners


v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

92 T.C. No. 53 (1989)


FAY, JUDGE:
Respondent determined a deficiency in petitioners' Federal income tax for the 1980
taxable year in the amount of $1,074,874. After concessions, the following issues are
presented for decision:

(1) Did petitioners satisfy section 1031 [FN1] on the disposition of the John Muir
Apartments?

We hold that, applying the substance over form doctrine, the John Muir Investors, a
partnership, rather than petitioners disposed of the John Muir Apartments. Further, we
hold that petitioners, as partners of John Muir Investors, are not entitled to the benefits of
section 1031 nonrecognition.

FINDINGS OF FACT

Some of the facts have been stipulated. The stipulated facts and attached exhibits are
incorporated herein by this reference.

Petitioners Delwin G. Chase ('Mr. Chase') and Gail J. Chase ('Mrs. Chase'), resided in
Alamo, California, at the time their petition herein was filed. Petitioners filed a joint
Federal income tax return for the year at issue.

DISPOSITION OF THE JOHN MUIR APARTMENTS

On January 26, 1978, Mr. Chase formed John Muir Investors ('JMI'), a California
limited partnership. JMI was formed for the purpose of purchasing, operating and holding
the John Muir Apartments, an apartment building located in San Francisco, California
(hereinafter referred to as the Apartments), which were purchased by JMI on March 31,
1978, for $19,041,024. Subsequently, Triton Financial Corporation ('Triton') was added
as a general partner of JMI. Triton was a corporation in which petitioner held a
substantial interest. Mr. Chase and Triton were general partners who had the exclusive
right to manage JMI.

Pursuant to JMI's limited partnership agreement, once limited partners made


contributions to JMI, they were prohibited from receiving distributions of property, other
than cash, in liquidation of their capital contributions to JMI. A section of the JMI limited
partnership agreement entitled 'status of limited partners' provided as follows:

No limited partner shall have the right to withdraw or reduce his invested capital except
as a result of the termination of the partnership or as otherwise provided by law. No
limited partner shall have the right to bring an action for partition against the partnership.
No limited partner shall have the right to demand or receive property other than cash in
return for his contribution, and no limited partner shall have priority over any other
limited partner either as to the return of his invested capital or as to profit, losses or
distribution.

After JMI held the Apartments for approximately one year, there developed a high level
of speculative interest in San Francisco in purchasing apartment buildings for conversion
to condominium units for sale to individuals. This speculative interest caused the value of
real estate capable of being converted to condominium units, such as the Apartments, to
appreciate. By mid 1979, JMI was attempting to find a buyer for the Apartments.

On January 20, 1980, JMI accepted an offer ('first offer') to purchase the Apartments
from an unrelated individual for $28,421,000. Subsequent to JMI's acceptance of the first
offer, but prior to the scheduled closing date, petitioners attempted to structure the sale of
the Apartments in such a way that they would not have to recognize any taxable gain. To
accomplish this, Mr. Chase caused JMI to distribute to himself and his wife a deed to an
undivided 46.3527 percent interest in the Apartments in liquidation of petitioners'
46.3527 percent limited partnership interest in JMI. Petitioners attempted to structure the
subsequent disposition of the Apartments pursuant to the first offer so that, as to them,
such disposition would be treated for Federal tax purposes as a nontaxable
nonsimultaneous exchange of real property for other real property.

On February 5, 1980, the first offer expired due to the failure of the buyer to deposit
funds into escrow by such date as required by the escrow agreement. However, there was
a second offer for the purchase of the Apartments on March 21, 1980, at which time an
agent of RWT Enterprises, Inc. ('RWT'), wrote a letter of intent to Triton, one of JMI's
two managing general partners, to purchase the Apartments for $26,500,000 ('second
offer'). This letter further stated that any broker's commissions would be paid by Triton.
This letter did not indicate that RWT believed, or had been informed, that petitioners,
individually, had any ownership interest in the Apartments.

In connection with the second offer, on March 26, 1980, an officer of Triton wrote a
letter on behalf of JMI, in Triton's role as a managing general partner of JMI, to a
brokerage company. This letter stated that JMI agreed to pay a real estate brokerage
commission of $250,000 as a result of the sale to RWT and that this commission was the
total commission due. Triton did not mention petitioners' undivided ownership interest in
the Apartments, or of any duty by petitioners to pay a pro rata portion of such
commission.
In preparing to close the sale, an escrow agreement was executed. Under the heading
'seller,' the escrow agreement was signed, on behalf of JMI, by Mr. Chase. The escrow
agreement was not signed by petitioners on behalf of themselves as individual owners of
the Apartments.

On June 12, 1980, when Mr. Chase was certain that the sale to RWT was going to
close, he recorded the deed from JMI, executed in January 1980, for petitioners'
undivided interest in the Apartments.

Petitioners, as with the first offer, attempted to structure the Apartments' disposition so
that it would not be taxable to them. To this end, on June 13, 1980, petitioners entered
into a Real Property Exchange Trust Agreement ('Exchange Agreement') with RWT and
Dudley Ellis ('Mr. Ellis'). Mr. Ellis was a former employee of Mr. Chase who agreed to
serve as trustee of a trust (the 'Ellis Trust'), created under the Exchange Agreement. The
Exchange Agreement was executed in anticipation of the sale of the Apartments to RWT,
and provided that RWT, as purchaser of the Apartments, would transfer to the Ellis Trust
petitioners' share of the proceeds. Pursuant to the Exchange Agreement, Mr. Ellis, in his
capacity as trustee of the Ellis Trust, agreed to transfer to petitioners 'like-kind real
property' which Mr. Ellis was to purchase with such proceeds. Specifically, the Exchange
Agreement provided that petitioners would locate and negotiate the terms for the
purchase of properties to be 'exchanged. ' Petitioners then instructed Marilyn Lamonte,
the escrow officer handling the sale, to pay 46.3527 percent of the 'net proceeds' from the
sale to Mr. Ellis as trustee under the Exchange Agreement.

On July 7, 1980, the John Muir Apartments were sold to Traweek Investment Fund No.
10, Ltd. ('Traweek'), an entity related to, and substituted as buyer by, RWT. The net
proceeds of $9,210,876 received from the sale to Traweek were allocated by Lamonte
between the Ellis Trust and JMI. The actual payments out of escrow were a check for
$3,799,653 to Ellis in his capacity as trustee under the Ellis Trust, and a check for
$4,811,223 paid directly to JMI.

Petitioners' instructions to Lamonte, to the effect that Ellis, as trustee, was to be the
recipient of 46.3527 percent of 'net proceeds' from the sale, were not followed. Rather,
the portion of the proceeds distribute to Ellis in trust for petitioners represented an
allocation of a distributive share of total net proceeds to petitioners in their capacity as
limited partners of JMI in accordance with the terms of the JMI limited partnership
agreement and not as a straight allocation of 46.3527 percent of 'net proceeds.'

From January 1980, until the date of the sale was closed, the expenses of operating the
Apartments were paid with funds that were in JMI's operating bank account. Petitioners
did not pay, with their own money, any of the expenses from January 1980, when they
received a deed to the Apartments through July 7, 1980, the date of sale. Petitioners also
did not receive any of the rental income earned during this period, such rent continued to
be paid to JMI. Petitioners' relationship with respect to the Apartments, after they were
deeded an undivided interest in such, was in all respects unchanged in relation to their
relationship to the Apartments as limited partners of JMI.
On June 30, 1981, Ellis, as trustee of the Ellis Trust, assigned to Creston Corporation
('Creston'), as successor trustee of the Ellis Trust, petitioners' share of the proceeds from
the sale. Creston was, at the time of such assignment, a corporation wholly owned by
Ellis.

By July 23, 1982, Triton, as general partner of entities controlled by petitioner,


completed the acquisition of the following three properties which were later acquired
from Creston by petitioners:

(1) the Snug Harbor Apartments in Dallas, Texas (the 'Snug


Harbor property');
(2) a ground lease to commercial real property in Orange County,
California (the 'Irvine property'); and,
(3) certain commercial real estate in Santa Ana, California (the
'Woodbridge property').

Creston, as trustee under the Ellis Trust, acquired, and immediately transferred to
petitioners, the Snug Harbor property on or about October 27, 1982. Petitioners held the
Snug Harbor property for seven months. Creston acquired and then transferred to
petitioners, the Irvine property on October 29, 1982. Petitioners, in turn, disposed of the
Irvine property on the same date. On October 29, 1982, Creston acquired, and then
transferred the Woodbridge property to petitioners, who disposed of the property on the
same date. In addition to the above properties, Creston, as trustee under the Ellis Trust,
also purchased for petitioners three other properties located in the state of Kentucky.

LIQUIDATION OF THE LOCKWOOD INTEREST

On March 5, 1980, petitioners purchased a 2.92 percent limited partnership interest in


JMI from Albert and Hazel Lockwood for $230,000 and a 8.78 percent limited
partnership interest from Todd and Karen Sue Lockwood for $690,000 (hereinafter
referred to collectively as the 'Lockwood interest'). The Lockwood interest was a limited
partnership interest in addition to the 46.3527 percent interest previously acquired.

On July 9, 1980, two days after the disposition of the Apartments, petitioners received
$929,582 in complete liquidation of their 11.72 percent Lockwood interest. Petitioners
reported a short- term capital loss of $783,762 on their 1980 Federal income tax return as
a result of this distribution. Petitioners computed their adjusted basis and loss as follows:

The $929,582 cash distribution from the liquidation of this 11.72 percent interest
liquidated petitioners' entire LIMITED partnership interest in JMI held as of this date.
Petitioner, however, continued thereafter to hold an interest in JMI as a GENERAL
partner. After this liquidation of the 11.72 percent interest, JMI continued operating as a
partnership for the purpose of investing in other real property.

On December 31, 1980, petitioners acquired a 1.31 percent limited partnership interest
in JMI from Anthony and Carole Cline.
OPINION

The first issue is whether petitioners met the requirements of section 1031. Section
1031(a) provides that no gain or loss is recognized if property held for productive use in a
trade or business or for investment (excluding certain types of property not involved
herein) is exchanged solely for property of like-kind. Since the distinction between 'trade
or business' and 'investment ' in section 1031(a) is immaterial for our purposes, for
convenience, we will use the term 'held for investment.' Based on a number of theories,
respondent contends that petitioners are not entitled to nonrecognition under section
1031(a) or, in the alternative, that petitioners must recognize gain under section 1031(b)
to the extent that certain of the property ultimately received by petitioners was not held
for investment.

Respondent contends that section 1031(a) is inapplicable because the disposition of the
Apartments was, in substance, a sale by JMI, and not an exchange by petitioners of like-
kind property. Petitioners contend that we must respect the form in which they structured
the disposition of the Apartments, and that such form satisfied the requirements of section
1031(a).

To qualify for nonrecognition, a taxpayer must satisfy each of the specific requirements
as well as the underlying purpose of section 1031(a). BOLKER v. Commissioner, 760
F.2d 1039, 1044 (9th Cir. 1985), affg. 81 T.C. 782 (1983). We must determine whether
the 'exchange' requirement of that section was satisfied. Respondent argues that the
substance over form doctrine is applicable to impute the disposition of the Apartments
entirely to JMI and concludes that, in substance, petitioners did not 'exchange' any part of
the Apartments.

The substance over form doctrine applies where the form chosen by the parties is a
fiction that fails to reflect the economic realities of the transaction. Commissioner v.
Court Holding Co., 324 U.S. 331 (1945); United States v. Cumberland Public Service
Co., 338 U.S. 451 (1950). In determining substance, we must look beyond the 'superficial
formalities of a transaction to determine the proper tax treatment.' Blueberry Land Co. v.
Commissioner, 361 F.2d 93, 101 (5th Cir. 1966), affg. 42 T.C. 1137 (1964).
'Transactions, which did not vary, control, or change the flow of economic benefits, are
dismissed from consideration.' Higgins v. Smith, 308 U.S. 473, 476 (1940). We hold that
the substance over form doctrine applies and that, in substance, JMI disposed of the
Apartments.

Although the general partners of JMI caused JMI to prepare a deed conveying an
undivided 46.3527 percent interest in the Apartments to petitioners, at no time did
petitioners act as owners except in their roles as partners of JMI. Petitioners were deeded
an undivided interest at the time of the first offer because it appeared that a sale was
imminent. when this sale failed to close, however, petitioners' deed remained unrecorded
until shortly before the disposition in question. There is no indication that any party to the
sale believed that anyone other than JMI held title at the time of RWT's offer to purchase.
Further, there is no evidence of negotiations by petitioners on behalf of themselves
concerning the terms for the disposition of the Apartments. Also, petitioners never paid
any of the operating costs of the Apartments or their share of the brokerage commission.
Further, petitioners did not receive, or have credited to them, any of the Apartment's
rental income.

Equally important, in apportioning the net sale proceeds, all parties ignored petitioners'
purported interest as direct owners. Rather, petitioners received only their distributive
share of JMI's net proceeds as limited partners. In addition, the JMI limited partnership
agreement provided that no limited partner could demand and receive property other than
cash from the partnership. Further, there is no evidence that petitioners were otherwise
authorized by the other limited partners to receive a share of the Apartments as a
partnership distribution or that the other limited partners were even aware that such a
distribution had occurred. We can only conclude that petitioners' failure to respect the
form in which they cast this transaction by failing to receive their share of proceeds as
direct owners was caused by petitioners' realization that they were not direct owners and
could not be so by virtue of the partnership agreement.

Petitioners final argument regarding the substance issue is that JMI's general partners
acted as petitioners' agents in negotiating the disposition of the John Muir Apartments to
Traweek. This, petitioners argue, explains why they did not appear, individually, as
parties in most of the documents to this transaction. We find petitioners' argument, in this
regard, both self-serving and unsupported by the record.

Having determined that, in substance, JMI disposed of the Apartments, we must


determine whether petitioners are entitled to 'exchange' treatment under section 1031(a),
which treatment would flow through JMI to all partners in accordance with their
distributive share of partnership gain. Sec. 702(a). Petitioners are entitled to
nonrecognition of gain under section 1031(a), as a partner of JMI, if JMI has satisfied the
requirements of section 1031(a) in disposing of the Apartments.

Section 1031(a) requires that like-kind property be both given up and received in the
'exchange.' Here, it is clear that JMI transferred investment property but did not receive
like-kind property in 'exchange.' This is because JMI never held the properties that were
ultimately received by petitioners as part of the purported 'exchange.' Accordingly, JMI
never 'exchanged' like-kind property.

Having concluded that JMI sold the entire interest in the Apartments, and that JMI did
not act as petitioner's agent with respect to an undivided interest in such apartment, we
hold that petitioners failed to 'exchange' like-kind property within the meaning of section
1031(a). Accordingly, petitioners are not entitled to the benefits of that section. [FN2]

Petitioners argue, alternatively, for the first time on brief, that if section 1031(a) is
inapplicable, they now be allowed to elect installment sale treatment under section 453.
Petitioners cite Bayley v. Commissioner, 35 T.C. 288 (1960), wherein we permitted a
taxpayer to elect, in an amended petition, the installment method under section 453,
where the issue of nonrecognition under section 1034 was decided adversely to the
taxpayer. Petitioners' argument fails for two reasons. First, petitioners did not amend their
pleadings or raise such issue at trial, but only raised such issue on brief. See Seligman v.
Commissioner, 84 T.C. 191 (1985) affd. 796 F.2d 116 (5th Cir. 1986); Markwardt v
Commissioner 64 T.C. 989 (1975). Second, since we find that JMI disposed of the
Apartments, the election under section 453 can only be made by the partnership. See sec.
703(b); Rothenberg v. Commissioner, 48 T.C. 369 (1967). Accordingly, we hold
petitioners are not entitled to elect installment sale treatment under section 453.

To reflect the foregoing.


Decision will be entered under Rule 155.

FN1 All section references are to the Internal Revenue Code of 1954, as amended, and in
effect during the year in issue, and all Rule references are to the Tax Court Rules of
Practice and Procedure.

FN2 We do not address respondent's alternative arguments, as those arguments are moot.

PRIVATE LETTER RULING 9252001

This Private Letter Ruling addressed the question as to whether the nonsimultaneous
exchange requirements were met, involving corporations that were utilizing the exchange
process and a trust position to hold monies on a nonsimultaneous exchange.

The Ruling held that such exchange qualified under Code §1031 and the fact that there
were intervening mergers or spin-offs did not prevent the tax-deferred treatment.

The Ruling stated: "These concerns (with exchanges) are equally applicable when the
surviving corporation following a merger receives like-kind property in exchange for
property transferred by a predecessor corporation prior to the merger." (Emphasis
supplied.)

For another example of a nonsimultaneous exchange with regard to corporations, see


Chapter 13, Private Letter Rul. 9252001.

PRIVATE LETTER RULING 9252001


Section 1031 -- Exchange of property held for productive use or investment
September 12, 1992
Publication Date: December 24, 1992
Property A = * * *

ISSUE

Whether the transfer and subsequent receipt of like-kind property qualifies for
nonrecognition treatment under section 1031(a) of the Internal Revenue Code under the
circumstances described below.
FACTS

Taxpayer held all of the stock of Corp P which operated Business A. Taxpayer also
operated, directly or through subsidiaries, Business B. Taxpayer also owned 100% of the
stock of several corporations, including Corp M, that leased to Corp P the real estate used
in Business A, and Corp O. In addition, Taxpayer owned all of the stock of a group of
other corporations, some of which held cash, property and/or property rights while others
were merely shell corporations.

On Date 1, Corp M entered into a contract of sale with respect to real property used in
Business A. The buyer entering into the contract later assigned its interest to Purchaser.
The contract provided that the transfer was intended to be an exchange of properties with
the property to be received by Corp M to be designated later. The proceeds from the
disposition of the property were to be placed in escrow or with trustees pending the
designation of the property to be acquired as part of the exchange. On Date 2, the parties
to the transaction entered into a contract titled Exchange Property Trust Agreement (the
"Agreement"), the stated intention of which was to effect a taxfree, deferred, like-kind
exchange under section 1031 of the Code. Under the terms of the Agreement, the
proceeds from the disposition of the real estate held by Corp M were to be placed in trust
with independent trustees. Corp M was to locate suitable property for the exchange (the
"exchange property") and inform Purchaser of its identity. Purchaser was then to
designate the property to the trustees who would take the steps necessary for its
acquisition. The Agreement provided that if Purchaser failed to designate in writing
within 44 days replacement property to be purchased by the trustee, the trust would
terminate on that day and the funds in the trust would be paid over to Corp M. If
Purchaser did designate replacement property within the 44- day period, the trust would
terminate no later than 179 days after Corp M transferred its property to Purchaser. The
Agreement did not include any provision that would enable Corp M to obtain the funds
held by the trustee prior to the trust's termination.

Corp M's property was transferred on Date 3. On Date 4, Corp M and Corp P were
merged with Corp O. The stock of Corp 0 was distributed in a spin-off by Taxpayer to
Taxpayer's shareholders on Date 5. In a prior letter ruling (PLR 8528083) the Service
ruled that the merger of Corp M with Corp O constituted a reorganization described in
section 368(a)(1)(A) of the Code. The letter ruling also held that the spin-off constituted a
reorganization under section 368(a)(1)(D), and that section 355(a)(1) applied to the
transaction.

Three properties were ultimately identified and acquired pursuant to the Agreement.
The first two properties were identified by Purchaser, and acquired by Corp M before
Date 4. No issue has been raised with respect to these first two properties. Rather, the
disagreement with the Taxpayer involves only the third property, Property A. Property A
was identified by Purchaser prior to Date 4 and acquired on Date 6 (i.e., after Date 4 and
Date 5). Deeds were filed on that date recording the transfers of Property A to the trust,
and from the trust to Corp M (as the nominee or agent of Corp O). This property was also
used in the operation of Business A.
LAW AND ANALYSIS

Section 1031(a)(1) 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 a like kind which is to be held either for
productive use in a trade or business or for investment. Under section 1.1031(a)-1(b) of
the Income Tax Regulations, relating to the meaning of the term "like kind," real property
is generally considered to be of a like kind to all other real property, whether or not any
of the real property is improved. However, under section 1031(a)(3) any property
received by the taxpayer ("replacement property") will be treated as if it is not of a like
kind to the property transferred ("relinquished property") if the replacement property is
(a) not identified within 45 days of the taxpayer's transfer of the relinquished property, or
(b) received after the earlier of (i) 180 days after the taxpayer's transfer of the
relinquished property, or (ii) the due date of the taxpayer's return for the year in which the
taxpayer's transfer of the relinquished property occurred.

Under section 1031(b) of the Code, if an exchange would be within the provisions of
section 1031(a) if it were not for the fact that the property received in the exchange
consists not only of like-kind property, but also of other property or money, then any gain
will be recognized, but in an amount not in excess of the sum of such money and the fair
market value of such other property.

Section 381(a) of the Code provides that, in the case of the acquisition of assets of a
corporation by another corporation in a transfer to which section 361 applies, but only if
the transfer is in connection with a reorganization described in subparagraph (A), (C),
(D), (F) or (G) of section 368(a)(1), the acquiring corporation shall succeed to and take
into account, as of the close of the day of transfer, the items described in subsection
381(c) of the transferor corporation, subject to certain conditions and limitations. For this
purpose a reorganization is treated as meeting the requirements of section 368(a)(1)(D)
only if the requirements of section 354(b)(1) are met. Section 381(c) does not refer to
like-kind exchanges under section 1031.1

Section 1.381(a)-1(b)(3)(i) of the regulations provides that section 381 does not apply
to the carryover of an item or tax attribute not specified in subsection (c) thereof. The
regulation goes on to say, however, that, 11[i]n the case where section 381 does not apply
to a transaction, item, or tax attribute by reason of [the preceding sentence], no inference
is to be drawn from the provisions of section 381 as to whether an item or tax attribute
shall be taken into account by the successor corporation." Thus, no inference should be
drawn from the absence of any reference to section 1031 within section 381(c) for
purposes of determining whether a successor corporation should be treated as the
predecessor corporation in applying section 1031(a). Absent a carryover of tax attributes,
the transaction would not qualify as an exchange since Corp M transferred the
relinquished property and Corp 0 received the replacement property.

The special treatment of like-kind exchanges has been explained primarily on two
grounds. First, a taxpayer making a like-kind exchange has received property similar to
the property relinquished and therefore has not "cashed in" on the investment in the
relinquished property. In addition, administrative problems may arise with respect to
valuing property which is exchanged solely or primarily for similar property. See, e.g.,
Staff of the Joint Committee on Taxation, General Explanation of the Revenue Provisions
of the Deficit Reduction Act of 1984, 98th Cong., 2d Sess. 244-245 (1984); Starker v.
United States, 602 F.2d 1341, 1352 (1979). These concerns are equally applicable when
the surviving corporation following a merger receives like-kind property in exchange for
property transferred by a predecessor corporation prior to the merger. Accordingly, for
purposes of section 1031(a) of the Code, there is a carryover of tax attributes following a
section 368(a)(1)(A) reorganization. For the same reasons, there is a similar carryover for
purposes of section 1031(a) following a section 368(a)(1)(D) reorganization that meets
the requirements of section 355. Thus, the intervening merger and spin-off do not prevent
the receipt of Property A by Corp O on Date 6 from being treated as received in exchange
for Corp M's property transferred on Date 4.

CONCLUSION:

Under these facts,and circumstances the transfer and subsequent receipt of like-kind
property qualifies for nonrecognition treatment under section 1031(a)of the Code.

A copy of this technical advice memorandum is to be given to the taxpayer. Section


6110(j)(3) of the Code provides that it may not be used or cited as precedent. 1 Section
381(c) does refer to other provisions which, like section 1031, provide for the deferral of
income recognition in the context of transactions potentially spanning two or more
taxable years. For example, section 381(c)(13) states that the acquiring corporation will
be considered to be the transferor corporation after the date of transfer for purposes of
applying section 1033 (relating to involuntary conversions, including those in which
taxpayers have over two years in which to reinvest the proceeds in property similar or
related in service or use to the property converted). In addition, section 381(c)(8)
provides that if the acquiring corporation acquires installment obligations, the income
from which the transferor corporation reports on the installment basis under section 453,
the acquiring corporation will be treated as if it were the transferor corporation for
purposes of section 453.

Internal Revenue Service


GREENE V. COMMISSIONER

This case addressed an exchange by the use of what has been labeled as a Starker Trust.
The Court held that even the taxpayers admitted that the Trust in question did not
comport with the requirements under Code §1031. However, they argued that the
substance should control for the tax-deferred treatment.

The Court held that, where in both form and substance the transactions in question fall
short, the Code §1031 treatment would not be allowed. (The taxpayer, Mr. Greene,
controlled the funds an used them for his own benefit.)
JOANNE H. GREENE AND ESTATE OF ROBERT H. GREENE, DECEASED,
JOANNE H. GREENE, EXECUTOR, Petitioners
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

62 T.C.M. (CCH) 512 (1991)


T.C. Memo. 1991-403 (1991)

MEMORANDUM FINDINGS OF FACT AND OPINION

PARR, JUDGE:
Respondent determined a deficiency in Mr. and Mrs. Greene's individual Federal
income tax for the tax year ended December 31, 1981, in the amount of $137,161.

The issue presented is whether the gains on the sale of Mr. Greene's interests in two
separate properties qualify for nonrecognition under section 1031. [FN1]

FINDINGS OF FACT

Some of the facts have been stipulated and are found accordingly. The stipulation of
facts, together with the attached exhibits, are incorporated herein.

Petitioners resided in San Rafael, California, at the time the petition in this case was
filed.

A. BACKGROUND
Mr. and Mrs. Greene filed a joint Federal income tax return for 1981. They did not
report their share of the gain realized on the transfer of two properties. The first was
located at 1925/45 Francisco Boulevard, San Rafael, California (Francisco Boulevard
Property), in which Mr. Greene owned a 40-percent interest. The second was 1.7 acres of
undeveloped real estate in Hayward, California (West Winton Property), in which Mr.
Greene owned an 85- percent interest.

Mr. Greene attempted to structure each transaction to qualify for nonrecognition of the
gain under section 1031, through use of a Starker trust. Accordingly, his share of the
proceeds from each transaction was placed in a separate grantor trust (Francisco
Boulevard Trust or West Winton Trust). Mr. Greene named David J. DeLuca as trustee of
each trust. Mr. DeLuca was also employed by Mr. Greene on an at will basis, as
controller of Mr. Greene's real estate brokerage. Mr. Greene operated the real estate
brokerage as a sole proprietorship.

Mr. Greene died on February 28, 1988.

B. SALE OF FRANCISCO BOULEVARD PROPERTY


1. SALE OF THE PROPERTY AND CREATION OF THE TRUST
Mr. Greene and the other owners of the Francisco Boulevard Property entered into a
purchase agreement with Marin County Employees Retirement Association (MCERA) on
December 22, 1980. MCERA agreed to cooperate with the sellers to "effect an IRS Code
Section 1031 tax deferred exchange," but nevertheless insisted that the "[p]urchase price
[was] to be all cash to Sellers."

On March 10, 1981, Mr. Greene and MCERA entered into an Exchange Agreement
Amendment and Trust Agreement, wherein Mr. Greene and MCERA agreed that Mr.
Greene would transfer his 40-percent interest in the Francisco Boulevard Property to Mr.
DeLuca as trustee of the Francisco Boulevard Trust. If an exchange property was not
located prior to the sale, MCERA would deposit Mr. Greene's 40-percent share of the
proceeds into the Francisco Boulevard Trust.

A suitable exchange property was not located prior to the sale. In contravention of the
Trust Agreement, however, Mr. Greene did not transfer his interest in the Francisco
Boulevard Property to the trustee. Regardless, MCERA paid Mr. Greene's 40-percent
share of the net proceeds, $467,199, to the trustee of the Francisco Boulevard Trust on
March 12, 1981.

The trustee was vested with the following powers:

(1) To invest the funds in money market certificates or equivalent


money fund shares until Mr. Greene located a suitable
exchange property;
(2) to retain all income received by the trust in the trust account;
(3) to acquire the exchange property on Mr. Greene's behalf after
being advised to do so by him; and
(4) to terminate the trust, and pay over the trust corpus to Mr.
Greene "as full consideration for the transfer of [the Francisco
Boulevard Property]," if Mr. Greene did not locate an
exchange property before March 2, 1983.

The trustee was to be paid a fee for providing these services.

2. OPERATION OF THE TRUST


a. ADVANCES TO MR. GREENE
Pursuant to the trust document, the trustee deposited the proceeds of the sale into a
money market account in the name of "David J. DeLuca, Trustee for Robert H. Greene."
During the period April 3, 1981, through April 25, 1983, the trustee made seven advances
from the sale proceeds to Mr. Greene, which totaled $298,044. Mr. Greene executed
unsecured promissory notes for each of the advances, which were payable on demand and
bore interest at rates varying from 8 percent to 15 percent. The trustee continued this
arrangement, in spite of his fiduciary obligations to invest only in money market vehicles,
based on his knowledge of Mr. Greene's financial position. Mr. Greene used most of the
proceeds of the advances for personal purposes.
Mr. Greene repaid six of the advances on October 22, 1986, directly to the trust. One of
the advances was deemed repaid on March 11, 1982, when Mr. Greene made a payment
on behalf of the trust for the purchase of a trust investment property.

The interest due on the advances was not paid on a regular basis, or in amounts which
represented the interest due to date. The trustee neither refused any loan requests made by
Mr. Greene, nor did he enforce the interest payments or make demand for payment on the
promissory notes.

The trustee paid $13,903 to Mr. Greene during 1981, which represented distribution of
the income earned by the trust. No such payments were made after 1981.

b. LOANS TO OTHER PARTIES


The Francisco Boulevard Trust loaned $63,000 to Greene Financial Corporation
between October 1, 1982, and December 15, 1982, at Mr. Greene's direction. Greene
Financial Corporation was owned by Mr. Greene and his family. These loans bore
interest, and were paid in full on October 19, 1983.

On June 30, 1981, the trust loaned $95,000 to the Marin Freeholders, a partnership of
which Mr. Greene owned 50 percent. Again, the advance was made at Mr. Greene's
direction. The loan bore interest, and was repaid in full on July 31, 1981.

On July 21, 1981, the trust loaned $11,510 to Jerry Suyderhood, a real estate broker in
Mr. Greene's real estate firm. The loan was made at Mr. Green's direction. It bore no
interest and was repaid on July 23, 1981.

On July 2, 1981, the trust loaned $20,000 to Harold Holtzinger, friend and business
associate of Mr. Greene. The loan was made at Mr. Greene's direction. It bore interest
and was repaid in full on October 1, 1981.

The trustee did not investigate the creditworthiness of any individual or entity to whom
he loaned or advanced money, but instead relied on Mr. Greene's direction.

c. REAL ESTATE PURCHASES BY THE FRANCISCO BOULEVARD TRUST


1. LINDA VISTA AVENUE
Mr. Greene entered into a joint venture agreement with Richard and Marie Parkinson
(Parkinson) on July 27, 1981, for the development of property at 17 Linda Vista Avenue,
Tiburon, California. Mr. Greene caused the Francisco Boulevard Trust to pay $334,194
for development of the property. Nowhere in the Joint Venture Agreement (the
Agreement), or in the grant deed through which Parkinson contributed the land to the
joint venture, was the Francisco Boulevard Trust mentioned. The Agreement refers to
Mr. Greene as a joint venturer, not the trust.

In spite of this, the trustee considered this property to be a trust investment,


notwithstanding the limitation on the types of trust investments allowed by the trust
agreement (i.e., money market vehicles). When the joint venture was dissolved on
September 17, 1982, Mr. Greene took title to the liquidating distribution in his name, not
that of the trust. Mr. Greene arranged for a loan against the property on September 29,
1982, after the joint venture was dissolved. The proceeds of this loan were deposited into
the trust money market account.

The trust reported the income and expenses (including depreciation) [FN2] of the
property on its annual fiduciary income tax returns. When the property was sold on
December 23, 1986, the trust reported the gain on the transaction.

2. PEBBLE CREEK CONDOMINIUMS


Mr. Greene purchased five condominium units in Pebble Creek Condominiums,
Denver, Colorado, on March 5, 1982. Mr. Greene made an aggregate downpayment of
$10,350 for them, and the seller financed the remainder of the purchase price. The trustee
considered this property to be in exchange for the Francisco Boulevard Property, and
deemed the $10,350 paid by Mr. Greene to be interest expense paid to the trust on
account of the previous advances made to Mr. Greene.

The trustee was not a party to any contract concerning the Pebble Creek
Condominiums. The units were purchased in Mr. Greene's name, and he reported the
income and expenses from the Pebble Creek Condominiums on his individual income tax
return.

3. COLDWATER CANYON PROPERTY


Mr. Greene purchased an additional property at 2155 Coldwater Canyon, Los Angeles,
California, on February 9, 1984. He paid a downpayment of $5,000 from his own funds,
and the trustee paid $49,000 on April 16, 1984. Mr. Greene adjusted his basis in the
Coldwater Canyon property to reflect deferral of the gain on the Francisco Boulevard
Property. The income and expenses for the property were reported on Mr. Greene's
individual income tax return. The trustee was not a party to any contract concerning the
Coldwater Canyon Property, nor did he participate in any of the negotiations.

C. SALE OF WEST WINTON PROPERTY


1. SALE OF THE PROPERTY AND CREATION OF THE TRUST
Mr. Greene and the other owners of the West Winton Property entered into a Real
Estate Purchase Contract with Messrs. Y. C. Yang and E. H. DeWolf (Yang and DeWolf)
on November 21, 1980. The buyers of the property agreed to cooperate with the sellers to
"effect an IRS Code section 1031 tax deferred exchange," but nevertheless insisted that
the "Purchase price [was] to be * * * all cash."

On February 6, 1981, Messrs. Greene, Yang, and DeWolf entered into an Exchange
Agreement Amendment and Trust Agreement, wherein the parties agreed that Mr.
Greene would transfer his 85-percent interest in the West Winton Property to Mr. DeLuca
as trustee of the West Winton Trust. If an exchange property was not located prior to the
sale, the buyers would deposit Mr. Greene's 85-percent share of the proceeds into the
West Winton Trust.
A suitable exchange property was not located prior to the sale. Accordingly, Yang and
DeWolf paid Mr. Greene's 85-percent share of the net proceeds, $145,970, to the trustee
of the West Winton Trust on February 9, 1981.

The trustee was vested with the following powers:

(1) To invest the funds in money market certificates, or equivalent


money fund shares, until a suitable exchange property was
located by Mr. Greene;
(2) to retain all income received by the trust in the trust account;
(3) to acquire the exchange property on Mr. Greene's behalf, after
being advised to do so by him; and
(4) to terminate the trust, and pay over the trust corpus to Mr.
Greene, "as fair consideration for the transfer of [the West
Winton Property]," if Mr. Greene did not locate an exchange
property before February 6, 1983. The trustee was to be paid a
fee for these services.

2. OPERATION OF THE TRUST


a. ADVANCES TO PETITIONER
Pursuant to the Trust Agreement, the trustee deposited the proceeds of the sale into a
money market account in the name of "David J. DeLuca, Trustee for Robert H. Greene."
During the period February 18, 1981, through April 3, 1981, the trustee made three
advances from the sale proceeds to Mr. Greene which totalled $93,500. Mr. Greene
executed unsecured promissory notes for each of the advances, which were payable on
demand and bore interest at rates varying from 13 percent to 18 percent. The trustee
continued with this arrangement, in spite of his fiduciary obligation to invest only in
money market vehicles, based on his knowledge of Mr. Greene's financial position. Mr.
Greene deposited all of the proceeds of these advances into his personal bank accounts.

Mr. Greene repaid $60,000 on February 2, 1982, $1,176 of which was classified as
interest on the loans. On February 3, 1982, he paid $10,000, all of which was deemed to
be interest. The balance of the amount advanced to Mr. Greene by the West Winton Trust
was deemed repaid on March 8, 1983, when he purchased a putative exchange property.

The interest due on the advances was not paid on a regular basis, or in amounts which
represented the interest due to date. The trustee did not refuse any loan requests made by
Mr. Greene, nor did he enforce the interest payments or make demand for payment on the
promissory notes.

The trustee paid $4,289 to Mr. Greene during 1981 and 1982, which represented
distribution of the income earned by the trust.

b. REAL ESTATE PURCHASES BY THE WEST WINTON TRUST


1. BALDWIN AVENUE
Mr. Greene purchased a 42.5-percent interest in a commercial rental property located at
8388-8400 Baldwin Avenue, Oakland, California (Baldwin Property) on February 16,
1982. This property was considered by Mr. Greene and the trustee to be in exchange for
the West Winton Property. The trustee withdrew $125,000 from the Trust money market
account to complete Mr. Greene's purchase. Mr. Greene reported his share of the joint
venture's loss on his individual income tax return. The trustee was not a party to any of
the contracts concerning the Baldwin Property, nor did he participate in any of the
negotiations.

2. 3 GATE 3
Mr. Greene purchased a commercial rental property known as 3 Gate 3, in Sausalito,
California, on March 8, 1983. This property was considered by Mr. Greene and trustee to
be in exchange for the West Winton Property. The purchase was completed in Mr.
Greene's name, with his own funds and a mortgage loan from the sellers of the property.
The trustee was not a party to any of the contracts concerning the 3 Gate 3 property, nor
did he participate in any of the negotiations.

OPINION

The general rule regarding recognition of gain or loss on the sale or exchange of
property is found in section 1001(c), which provides, "Except as otherwise provided in
this subtitle, the entire amount of the gain or loss * * * on the sale or exchange of
property shall be recognized." An exception to the general rule is found in section
1031(a), which provides in relevant part that if property held for investment is exchanged
solely for property of like kind which is also to be held for investment, then no gain or
loss shall be recognized on the exchange.

A. REQUIREMENTS FOR SECTION 1031 NONRECOGNITION


To qualify for nonrecognition, a taxpayer must satisfy (1) the underlying purpose, and
(2) the specific requirements of section 1031(a). Bolker v. Commissioner, 760 F.2d 1039,
1044 (9th Cir. 1985), affg. 81 T.C. 782 (1983); Chase v. Commissioner, 92 T.C. 874, 881
(1989); Magneson v. Commissioner, 81 T.C. 767 (1983), affd. 753 F.2d 1490 (9th Cir.
1985); sec. 1.1002-1(b), Income Tax Regs.

1. UNDERLYING PURPOSE OF SECTION 1031


The underlying purpose of section 1031 is to defer taxation of gains wherein the
taxpayer's economic situation after the exchange is fundamentally the same as it was
before the transaction occurred. "If the taxpayer's money is still tied up in the same kind
of property as that in which it was originally invested, he is not * * * charged with a tax
upon his theoretical profit." H. Rept. No. 704, 73d Cong., 2d Sess. (1934), 1939-1 C.B.
(Part 2) 554, 564. * * * The underlying assumption of section 1031(a) is that the new
property is substantially a continuation of the old investment, still unliquidated.
Commissioner v. P.G. Lake, Inc., 356 U.S. 260, 268 (1958.)

Koch v. Commissioner, 71 T.C. 54, 63-64 (1978).


2. SPECIFIC REQUIREMENTS OF SECTION 1031
To satisfy the specific requirements of section 1031(a), and thereby qualify for
nonrecognition, the transaction must be a reciprocal transfer of property, as distinguished
from a transfer of property for money consideration only. [FN3] Sec. 1.1002-1(d),
Income Tax Regs. "The very essence of an exchange is the transfer of property between
owners, while the mark of a sale is the receipt of cash for the property." Carlton v. United
States, 385 F.2d 238, 242 (5th Cir. 1967). Therefore, a transfer for anything other than
like kind property is excluded from the ambit of section 1031. Biggs v. Commissioner,
632 F.2d 1171, 1176 (5th Cir. 1980), affg. 69 T.C. 905 (1978); Estate of Bowers v.
Commissioner, 94 T.C. 582, 589 (1990).

Mere reinvestment of cash proceeds from the sale of one property into a second like
kind property will not qualify as an exchange under section 1031, even if the
reinvestment is made immediately. Coastal Terminals, Inc. v. United States, 320 F.2d
333, 337 (4th Cir. 1963); Carlton v. United States, 385 F.2d at 242; Estate of Bowers v.
Commissioner, 94 T.C. at 589.

Deductions and exemptions from tax are matters of legislative grace and must be
narrowly construed. Estate of Bowers v. Commissioner, 94 T.C. at 590, and cases cited at
n. 2 therein. However, courts have liberally construed section 1031 and have allowed
multiple-party transactions, Barker v. Commissioner, 74 T.C. 555 (1980); Biggs v.
Commissioner, supra; nonsimultaneous exchanges, Starker v. United States, 602 F.2d
1341 (9th Cir. 1979); deposit of sale proceeds into an escrow account before an exchange
property is located, J.H. Baird Publishing Co. v. Commissioner, 39 T.C. 608 (1962);
transactions in which the intermediary did not acquire legal title to the exchange property,
Biggs v. Commissioner, supra; and change from a sale transaction to an exchange
transaction even though the property to be received on the exchange was not identified as
of the date the original agreement was made. Alderson v. Commissioner, 317 F.2d 790
(9th Cir. 1963), revg. 38 T.C. 215 (1962). On the surface, the transactions at issue in this
case appear to qualify as exchanges under section 1031.

However, courts have recognized that this liberal interpretation of section 1031 should
be limited.

At some point, the confluence of some sufficient number of deviations will bring about
a taxable result. Whether the cause be economic and business reality or poor tax
planning, prior cases make clear that taxpayers who stray too far run the risk of having
their transactions characterized as a sale and reinvestment.

Barker v. Commissioner, 74 T.C. at 563-564. See also Carlton v. United States, supra
(taxpayer received cash, even though the transaction was intended to be an exchange,
simply to avoid unnecessary duplication of titles and related costs -- section 1031 not
applicable); Rogers v. Commissioner, 44 T.C. 126 (1965), affd. per curiam 377 F.2d 534
(9th Cir. 1967) (buyer of property exercised an option to buy the property from taxpayer
just before option was to expire; taxpayer arranged to exchange property with another
party upon expiration of the option -- section 1031 not applicable).
B. TRANSFER OF FRANCISCO BOULEVARD AND WEST WINTON
PROPERTIES WERE NOT LIKE KIND EXCHANGES UNDER SECTION 1031

The transactions at issue do not meet the underlying purpose or specific requirements of
section 1031.

1. UNDERLYING PURPOSE OF SECTION 1031 NOT MET


Mr. Greene's money was not tied up in like kind property within a sufficient time after
the sale of either the Francisco Boulevard or the West Winton properties to assure that
the exchange properties were "a continuation of the old investment." Commissioner v.
P.G. Lake, Inc., 356 U.S. 260, 268 (1958).

Sale of the Francisco Boulevard property was closed on March 12, 1981. In spite of the
fact that the Trust Agreement called for the Francisco Boulevard Trust to be terminated
no later than March 2, 1983, Mr. Greene did not terminate the trust until 1986, more than
five years after the underlying "exchange" which created the trust, and more than three
years after the trust was scheduled to terminate.

Exchange property was not finally located for the West Winton Property until March 8,
1983, more than two years after the underlying "exchange" which created the West
Winton Trust. Even though the trust terminated only one month after it was scheduled to
do so, the totality of the trust's operation, discussed infra, show that the properties
purchased by Mr. Greene were not in exchange.

Arguably, the amount of time that elapses between the sale of one property and the
purchase of another is not the sole determinant of whether the two properties were in
exchange for one another. [FN4] Indeed, the Ninth Circuit has sanctioned
nonsimultaneous exchanges. Starker v. United States, 602 F.2d at 1355; see also Redwing
Carriers, Inc. v. Tomlinson, 399 F.2d 652, 655 (5th Cir. 1968). However, the question is
whether the two transactions were integrated. Biggs v. Commissioner, 632 F.2d at 1178;
Redwing Carriers, Inc. v. Tomlinson, 399 F.2d at 658; Anderson v. Commissioner, T.C.
Memo. 1985-205. If the transactions are not integrated, regardless of the taxpayer's
intent, they will not be eligible for section 1031 treatment. Smith v. Commissioner, 537
F.2d 972 (8th Cir. 1976), affg. a Memorandum Opinion of this Court.

None of the supposed exchanges in either the Francisco Boulevard Trust or the West
Winton Trust were integrated. Neither trust held legal title to any exchange property.
Although this is not strictly required to allow for section 1031 nonrecognition, Biggs v.
Commissioner, 69 T.C. at 916, it would tend to show some connection between the
transactions. The trustee did not negotiate for the purchase of any of the exchange
properties. In fact, the existence of the trusts was not even disclosed when the putative
exchange properties were purchased. Moreover, the buyers of the Francisco Boulevard
and West Winton properties in no way participated in the acquisition by Mr. Greene of
the exchange properties, even though they both agreed to do so. Cf. Biggs v.
Commissioner, 69 T.C. at 917.
2. SPECIFIC REQUIREMENTS OF SECTION 1031 NOT MET
Petitioners have conceded that the operation of the trusts does not comport with the
specific requirements of section 1031. They assert that the substance of the transactions
must be controlling, however, and that mere form is unimportant. Use of this tax law
maxim is almost de rigueur for taxpayers arguing for section 1031 treatment.

The substance over form doctrine applies where the form chosen by the parties is a
fiction that fails to reflect the economic realities of the situation. Commissioner v. Court
Holding Co., 324 U.S. 331 (1945); United States v. Cumberland Public Service Co., 338
U.S. 451 (1950). "Transactions which do not vary, control, or change the flow of
economic benefits, are dismissed from consideration." Higgins v. Smith, 308 U.S. 473,
476 (1940); see also Chase v. Commissioner, 92 T.C. 874, 881 (1989). However, as Mr.
Greene had the freedom to cast the transaction in any manner which he saw fit he should
not be free to cast it aside when he determined, after the fact, that the original form did
not meet his needs. Anderson v. Commissioner, T.C. Memo. 1985-205. "If the exchange
requirement is to have any significance at all, the perhaps formalistic difference between
the two transactions [sale or exchange] must, at least on occasion, engender different
results. Accord Starker v. United States." Barker v. Commissioner, 74 T.C. at 561.
(Citations omitted). See also Swaim v. Commissioner, 651 F.2d 1066, 1070 (5th Cir.
1981). In other words, the form of a transaction cannot be ignored in this analysis. Bell
Lines, Inc. v. United States, 480 F.2d 710, 711 (4th Cir. 1973).

In both form and substance, these transactions fall short of the specific requirements of
exchange treatment. Rather than receiving property in exchange for Francisco Boulevard
and West Winton, we find Mr. Greene had constructive receipt of the proceeds of each
sale. He used each trust account as his personal bank account, withdrawing money as the
need arose.

Constructive receipt of income is defined as income made available so that * * * [the


taxpayer] may draw upon it at any time, or so that he could have drawn upon it during the
taxable year if notice of intention to withdraw had been given. However, income is not
constructively received if the taxpayer's control of its receipt is subject to substantial
limitations or restrictions. * * *

Sec. 1.451-2(a), Income Tax Regs. This doctrine has been applied to section 1031 so
that control by the taxpayer over cash proceeds constitutes constructive receipt. Coupe v.
Commissioner, 52 T.C. 394, 409 (1969).

Mr. Greene "borrowed" $298,044 of the $467,199 initially deposited into the Francisco
Boulevard Trust, and caused an additional $189,510 to be loaned from the Francisco
Boulevard Trust to business entities in which he owned an interest, or to his friends or
business associates. He took outright distributions of $13,903 from the Francisco
Boulevard Trust. Petitioner "borrowed" $93,500 of the $145,970 initially deposited into
the West Winton Trust, and took outright distributions of $4,289 therefrom.
None of Mr. Greene's requests for advances were denied, delayed, or modified by the
trustee. Trustee was employed by Mr. Greene on an at will basis, and therefore did not
pose a substantial limitation to petitioner's access to the money. Even though the
advances were furnished with promissory notes bearing market rates of interest, the
trustee did not enforce payment of the interest on any periodic basis. Instead, whenever
Mr. Greene needed money to purchase a property, he repaid a portion of either the
principal or the interest due to date. No other restrictions were made on Mr. Greene.
Petitioners argue that Mr. Greene could have borrowed the money from a third party,
given his substantial net worth. This does not impact, however, on the fact that he had
unrestrained control over the money. Therefore, we find Mr. Greene had constructive
receipt of the proceeds from the sale of the two properties. [FN5]

In spite of the fact that Mr. Greene intended for these transactions to be exchanges, and
structured the trusts in accordance with the liberal construction afforded to section 1031,
the trusts were not managed to effectuate his intent. Nonetheless, petitioners argue that
section 1031 should be extended so that Mr. Greene's intent to effect a section 1031
transaction will be enough for the transaction to qualify as a nonrecognition event. Courts
have shown sympathy for this position, but only when taxpayers act consistently with
their stated intent. When actions belie intent, "the intention of * * * [the taxpayer] to
effect an exchange does not convert the transfer of the property for cash into an
exchange." Carlton v. United States, 385 F.2d at 243; Anderson v. Commissioner, T.C.
Memo. 1985-205.

Mr. Greene did not adhere to the formalities of the trust agreements. Moreover, he used
the proceeds as if they were his own. He purchased properties up to three years after the
underlying sale, and deemed them to be exchange properties. None of the exchange
properties were listed in the trust agreements. The purchasers of neither the Francisco
Boulevard Property nor the West Winton Property participated in the purchases of the
exchange properties. The existence of the trusts were not disclosed in the purchase of any
exchange property. Mr. Greene borrowed money from the Francisco Boulevard Trust for
his own use, and did not repay it until five years later.

Regardless of Mr. Greene's stated intent, his actions were inconsistent therewith.

To reflect our findings and conclusions herein,

Decision will be entered for the respondent. FN1 Unless otherwise noted, all section
references are to the Internal Revenue Code as amended and in effect for the year in
issue, and all Rule references are to the Tax Court Rules of Practice and Procedure. FN2
The trust determined its basis in the property based on the amount it paid for
development of the property, and after liquidation, the fair market value of the property
distributed. At no time did the trust adjust its basis in the property to account for the
deferral of the gain on the Francisco Boulevard Property. FN3 Sec. 1031(b) allows a
taxpayer to receive other than like kind property in addition to the like kind property
without causing the transaction to be excluded from sec. 1031. However, the taxpayer is
required to recognize his or her gain on the transaction to the extent of this "boot"
received. Sec. 1031(b); sec. 1.1031(b)-1, Income Tax Regs. FN4 In 1984 Congress added
sec. 1031(a)(3), which provides that a transfer will not be treated as a like kind exchange
unless the exchange property is (a) identified within 45 days after the transfer of the
underlying property, and (b) received by the transferor within the earlier of 180 days after
the transfer of the underlying property or the due date for the transferor's tax return on
which the exchange would be reported. Sec. 77(a), Deficit Reduction Act of 1984, Pub.
L. 98-369, 98 Stat. 596.

Sec. 1031(a)(3) applies to transactions after July 18, 1984, or to transactions on or


before July 18, 1984, if the exchange property was not received before January 1, 1987.
Sec. 77(b)(3), Deficit Reduction Act of 1984, Pub. L. 98-369, 98 Stat. 596. Because Mr.
Greene received the putative exchange properties before January 1, 1987, sec. 1031(a)(3)
places no time limit on his purchase of the exchanged properties. FN5 Petitioners cite
Rutland v. Commissioner, T.C. Memo. 1977-8, as standing for the proposition that the
doctrine of constructive receipt should be sparingly used, and then only in a clear case. In
that case, the taxpayer was obligated to pay interest at one half of 1 percent above the
prime lending rate. The Court looked upon this restriction, as well as the forfeiting of
rights that would result from actual receipt, to be sufficient restraint on use of the money
as to deny constructive receipt. No such restrictions existed in this case; Mr. Greene had
complete, unfettered control over the trusts.

DESIGNATION OF PROPERTY IN NONSIMULTANEOUS


EXCHANGE
RAVENSWOOD GROUP

The Ravenswood Group case involved one of the more recent opinions as to a
determination on whether a proper designation of property in a nonsimultaneous
exchange (deferred) exchange took place within the 45-days allowed within Code
§1031(a)(3). The Court held that such designation did not timely take place as a result of
designating a large number of separate properties, along with other deficiencies in the
structure.

The RAVENSWOOD GROUP and Woodland Development Corp., Plaintiffs,


v.
FAIRMONT ASSOCIATES, Defendant.

S.D. New York, --- F.Supp. ---- (1990)

OPINION & ORDER

EDELSTEIN, District Judge.

BACKGROUND
Plaintiff The Ravenswood Group ("Ravenswood") is a New York general partnership
consisting of five individuals: W. Todd Parsons, Jonathan L. Parsons, Nicholas T.
Parsons, Brook Parsons and Nathaniel T. Parsons. Ravenswood owned certain real
property located in Framingham, Massachusetts. On July 9, 1987, Ravenswood entered
into an EXCHANGE agreement with David LaBreque contemplating a like-kind
EXCHANGE under §1031 of the Internal Revenue Code. The transferred property was
sold on October 1, 1987.

In order to effectuate a like-kind EXCHANGE under §1031 Ravenswood had to


designate an EXCHANGE property within 45 days (by November 14, 1987) and close on
the purchase within 180 days (by March 29, 1988). On November 14, 1987, Ravenswood
designated to an escrow agent seven separate properties as potential EXCHANGE
properties. Ravenswood's written designation of the EXCHANGE properties took the
form of seven separate documents, each of which identified one EXCHANGE property.
Each document stated that the particular property would be acceptable as an
EXCHANGE property. In the designation documents, Ravenswood failed to prioritize the
EXCHANGE properties or set forth any factors or contingencies that would dictate which
of the EXCHANGE properties Ravenswood would choose to purchase, maintaining full
discretion to pursue whichever of the seven EXCHANGE properties it chose.

One of the properties designated by Ravenswood was Fairmont Estates ("the


property"), an apartment complex owned by defendant Fairmont Associates.
Subsequently, during December 1987, Ravenswood approached Fairmont concerning a
possible sale of the Property to Ravenswood together with another entity. The parties
engaged in discussions concerning the proposed sale and exchanged various drafts of a
contract of sale. No sale was ever consummated.

Plaintiffs contend that a binding contract of sale was entered with the closing to occur
on March 28, 1988. Fairmont disputes that such a contract was ever formed, and this
issue must ultimately be determined by the trier of fact.

Ravenswood's partners incurred tax liability of approximately $312,000 on the sale of


the transferred property when the contemplated like-kind EXCHANGE could not be
completed, and Ravenswood seeks to recover this amount from Fairmont as
consequential damages. Ravenswood submitted an in limine motion asking the court to
permit the introduction of expert testimony on §1031 at trial to prove the nature and
extent of its tax damages.

On April 23, 1990, a hearing was conducted and the Court heard testimony from
experts with respect to I.R.C. §1031.

THE EXPERTS

Richard Sevin testified as an expert for plaintiffs. A non-practicing attorney, Mr. Sevin
is employed by American Deferred EXCHANGE Corporation in San Francisco,
California, which acts as an accommodating party for like-kind EXCHANGES under
§1031. Mr. Sevin opined that, given the present absence of I.R.S. regulations or rulings,
this Court and taxpayers should adhere solely to the language of §1031, which requires
only identification of properties and imposes no limit on the number of properties that
may be identified. While conceding that the legislative history, as expressed in the
Conference Report, requires identification of priorities among multiple alternative
properties and of contingencies beyond the taxpayer's control that will determine which
of the alternative properties is to be purchased, Mr. Sevin believes that it should be
ignored in interpreting §1031 as it applies to the instant case. He believes that legislative
history was meant merely to provide guidance to the I.R.S. in connection with
promulgating regulations. According to Mr. Sevin, the designation employed by
Ravenswood was consistent with practices he has engaged in and seen, and likely would
be upheld by the I.R.S. on an audit.

Michael Hirschfeld testified as an expert for defendant. Mr. Hirschfeld is a partner in


the New York office of the law firm Winston and Strawn, the author and co-author of
numerous articles and a frequent lecturer in the real estate tax field. Mr. Hirschfeld
testified that, in the absence of regulations promulgated by the I.R.S., the legislative
history of the 1984 amendments to §1031 should be considered binding on taxpayers and
this Court, and that under §1031, identification of multiple alternative properties requires
prioritization, the identification of contingencies beyond the taxpayer's control and
designation of a limited number of EXCHANGE properties. He testified that his view is
consistent with the conclusions reached by the tax periodicals and services he has
reviewed and publications by experts in the area, several of which were identified during
his testimony. Mr. Hirschfeld concluded that the I.R.S. would be likely to disallow a
claim by Ravenswood that it qualified for §1031 treatment given that it had identified
seven properties without prioritizing or identifying any contingencies dictating which
property would be selected.

DISCUSSION

At issue here is whether Ravenswood complied with the requirements of Section


1031(a)(3)(A) of the Internal Revenue Code such that it could have availed itself of the
tax deferral available under that section but for its failure to purchase the Property from
Fairmont. Section 1031(a) of the Internal Revenue Code of 1986 provides that no gain or
loss shall be recognized at the time a property held for productive use in a trade or
business is sold if the seller performs an EXCHANGE of like-kind property. The
taxpayer may transfer property and receive the EXCHANGE property on a subsequent
date only if the requirements set forth in the statute are met.

Under §1031(a)(3)(A) the requirements that must be satisfied to retain eligibility for
§1031 deferral are:

1. The property to be received in the EXCHANGE is to be


identified on or before 45 days after the date on which the
relinquished property is transferred; and
2. The property is received on the earlier of (i) 180 days after the
date on which the taxpayer transferred the relinquished
property, or (ii) the due date of the taxpayer's return from the
taxable year in which the transfer of the relinquished property
occurs, such date to be determined with regard to extensions.

The legislative intent underlying §1031 was that taxpayers should be permitted to avoid
present tax liability when exchanging one property for another of like-kind since taxes
should not be imposed on a realized gain where the taxpayer maintained a continuity of
investment in like-kind property.

In 1984, §1031 was amended to clarify the circumstances under which a deferred
EXCHANGE of like-kind property was permissible. The purpose of the 1984
amendments to §1031 (§77 of the Tax Reform Act of 1984 (P.L. 98-369)) was to provide
guidance for taxpayers performing deferred EXCHANGES and to render significantly
more limited the circumstances in which a deferred EXCHANGE could be performed
from what had been sanctioned by Starker v. United States, 602 F.2d 1341 (9th
Cir.1979). In Starker, the Ninth Circuit Court of Appeals held that an EXCHANGE of
property under §1031 need not be simultaneous. The 1984 amendments permitted
nonsimultaneous EXCHANGES only under certain limited circumstances.

The legislative history from 1984 specifically addresses the mechanics by which the
taxpayer may designate multiple alternative properties. The report of the Conference of
the United States Senate and House of Representatives (H.R.Rep. No. 861, 98th Cong.,
2d Sess. 866 (1984), provides in pertinent part as follows:

It is anticipated that the designation requirement will be satisfied if the contract


between the parties specifies a limited number of properties that may be transferred and
the particular property to be transferred will be determined by contingencies beyond the
control of both parties. For example, if A transferred real estate in EXCHANGE for a
promise by B to transfer Property 1 to A if zoning changes are approved and Property 2 if
they are not, the EXCHANGE would qualify for like-kind treatment.

The General Explanation of the Revenue Provisions of the Deficit Reductions Act of
1984, prepared by the staff of the Congressional Joint Committee on Taxation (U.S.
Government Printing Office 1985), (commonly referred to as the "Blue Book"), is in
accord:

[Property which was not identified as the property to be received by the taxpayer on the
date the transferred property was relinquished or within 45 days after that date will not
qualify as like-kind property ... The designation requirement may be satisfied if the
contract between the parties specifies a limited number of properties that may be
transferred and the particular property to be transferred is to be determined by
contingencies beyond the control of both parties. For example, if A transferred real estate
in EXCHANGE for a promise by B to transfer property 1 to A if zoning EXCHANGES
are approved and property 2 if they are not, the EXCHANGE will qualify for like-kind
treatment.
There have been no reported court decisions or revenue rulings by the Internal Revenue
Service concerning the pertinent sections of 4,6 §1031 addressed to the requirements for
designating multiple alternative properties. As far as the court is aware, this is a case of
first impression.

Before May, 1990, no regulations had been issued by the Commissioner of Internal
Revenue under the pertinent subsections of §1031. On May 6, 1990, the I.R.S. issued
proposed regulations to govern like-kind EXCHANGES under §1031. Although the court
has reviewed and considered the proposed regulations, it should be noted that they are of
no persuasive value in this instance: "It goes without saying that a proposed regulation
does not represent an agency's considered interpretation of its statute and that an agency
is entitled to consider alternative interpretations before settling on the view it considers
most sound." CFTC v. Schor, 478 U.S. 833, 845 (1986). Moreover, these proposed
regulations are prospective only and are subject to change in the rule-making process.

Plaintiff's identification of multiple alternative EXCHANGE properties would not have


complied with the proposed regulations which require a designation of a maximum of
three properties. In reaching its conclusion, however, the court relies on the information
available to the parties at the time the EXCHANGE was contemplated and that which
was presented during the hearing held on April 23, 1990.

The commentators addressing the pertinent subsections of §1031 uniformly have


adhered to the legislative history as controlling authority as to the manner in which
multiple alternative designations may be made and that only a limited number of
alternative properties might be designated, with an outside limit of five properties. See
Levine, Taxfree EXCHANGES Under Section 1031," BNA Tax Management Portfolio
61-5th (1987); CCH Standard Federal Tax Report P 4606.013, Explanation at p. 55,021;
RIA Federal Tax Coordinator 2d P I-2835 (1990); RIA Federal Tax Coordinator 2d,
Special Study "Tax Planning for Like-Kind EXCHANGES," P 702 (April 26, 1990);
Wasserman, "Mr. Mogul's Perpetual Search for Tax Deferral: Techniques and Questions
involving Section 1031 Like-kind EXCHANGES In a World of Changing Tax
Alternatives," 65 Taxes 975 (December 1987); American Bar Association Section on
Taxation, "Proposed Regulations Under Section 1031 Relating to EXCHANGE of
Partnership Interests and Delayed EXCHANGES" (March 17, 1990).

This Court is bound to follow the expressed legislative intention that the 1984
amendments were intended to restrict the flexibility theretofore available under §1031 as
interpreted by the courts. This court concludes that, in this instance, the 1984 legislative
history applies and is controlling as to the manner in which designations of multiple
alternative EXCHANGE properties may be made.

As a result of Ravenswood's designation of seven separate properties as possible


EXCHANGE properties, Ravenswood would not have qualified under §1031(a)(3)(A) for
tax deferral as a like-kind EXCHANGE had it timely closed on its purchase of the
Property because:
1. Ravenswood designated such a large number of separate
EXCHANGE properties.
2. Ravenswood did not set forth the priorities as to which of the
EXCHANGE properties would be purchased in the first
instance and as alternatives if the prior preference proved to be
unavailable.
3. Ravenswood did not bind itself to contingencies beyond its
control that would determine which of the EXCHANGE
properties was to be purchased and did not identify such
contingencies in writing.

Since Ravenswood would not have qualified for tax deferral under §1031 because of its
failure to comply with I.R.C. §1031(a)(3)(A)(a), Ravenswood cannot recover, as
consequential damages, the tax liability incurred by its partners on the sale of the
Transferred Property.

Accordingly, plaintiffs' in limine motion is denied.

SO ORDERED.

JOSEPH KAEMPFER V. COMMISSIONER

This case involved the issue as to whether monies paid would be interest under Code
§163 as a result of an increase in value involving property utilizing Code §1031 for a
nonsimultaneous exchange.

The Court sided with the Government's position that, until the exchange elements were
complete in part, there was no legally enforceable obligation on which interest could be
based. The taxpayers were not unconditionally obligated to pay compensation, and,
therefore, no liability existed for the interest to accrue.

The Court distinguished this transaction from the classic deferred-exchange case under
Starker. Even if there was a legally-enforceable obligation to make payments for each
day of the postponement involved in the exchange, the Court held that the control of the
activity was with the parties. Therefore, the increase in price was not interest within the
meaning of Code §163.

JOSEPH W. KAEMPFER, JR. AND JEAN P. KAEMPFER, Petitioners


v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

T.C. Memo. 1992-19


1992 WL 1415 (Tax Court) (1992)
MEMORANDUM FINDINGS OF FACT AND OPINION
PARKER, JUDGE:
Respondent determined a deficiency of $26,943.59 in petitioners' 1978 Federal income
tax.

Unless otherwise indicated, all section references are to the Internal Revenue Code as
amended and in effect for the period at issue, and all Rule references are to the Tax Court
Rules of Practice and Procedure.

The issue for decision is whether to treat as interest under section 163 the amount
designated as the increase per day in the Assigned Value of property identified for a like-
kind exchange under section 1031.

FINDINGS OF FACT

All of the facts have been stipulated and are so found. The stipulation of facts and the
exhibits attached thereto are incorporated herein by this reference.

Petitioners Joseph W. Kaempfer, Jr., and Jean P. Kaempfer were married, filing a joint
return, during the period at issue. Petitioners have since divorced. At the time they filed
their petition, Joseph W. Kaempfer, Jr., lived in Washington D.C., and Jean P. Kaempfer
lived in Barnesville, Maryland. Jean P. Kaempfer did not participate in the business
transaction that is involved in this lawsuit. All references to petitioner in the singular will
be to Joseph W. Kaempfer, Jr.

Phelps Realty Company, Inc. (hereinafter Phelps Realty) owned a certain parcel of real
property in the Rosslyn section of Arlington, Virginia (hereinafter the Subject Property).
Petitioner wished to acquire the Subject Property in order to grant Arlington County an
easement for public park purposes in exchange for additional development rights (greater
density) relating to construction of an office building on another parcel of land also
located in Rosslyn. Phelps Realty wanted to exchange the Subject Property with
petitioner for another property so that the transfer would qualify for nonrecognition
treatment under section 1031.

On October 29, 1979, petitioner and Phelps Realty entered into a Real Estate Exchange
Agreement (the Initial Agreement). Under this agreement, petitioner was to acquire
property designated by Phelps Realty and thereafter exchange that property (the
Exchange Property) for the Subject Property. In the Initial Agreement the parties agreed
that the fair market value of the Subject Property was $500,000. At the time the
agreement was executed, petitioner deposited $25,000 with Chicago Title Insurance
Company, the escrow agent. The Initial Agreement provided that, in the event of
petitioner's default, the deposit --

shall be paid to Phelps as agreed upon liquidated damages, whereupon this Agreement
shall terminate and the parties hereto shall be released from any further liability or
obligation to each other, it being expressly understood that the payment of Kaempfer's
deposit to Phelps shall be Phelps['] sole and exclusive right and remedy.
In the event of default by Phelps Realty, petitioner "shall have such rights and remedies
as shall be provided by law (including the right to obtain specific performance of this
Agreement)."

The Initial Agreement provided that the closing date would be 240 days after full
contract ratification. Phelps Realty reserved the right to extend the closing date for an
additional 120 days. As a result, the original closing date (without any extension) was
June 25, 1980.

On May 3, 1980, petitioner and Phelps Realty entered into a Real Estate Exchange
Agreement (hereinafter the Modified Agreement), effective as of October 30, 1979,
which restated the Initial Agreement and which modified some of the terms of the Initial
Agreement. Paragraph 4 of the Modified Agreement, for example, provided:

4. ASSIGNED VALUE.
For all purposes under this Agreement the value assigned to the Property (hereinafter
referred to as the "Assigned Value") is the sum of five hundred seventeen thousand five
hundred dollars ($517,500), plus two hundred and fifty dollars ($250.00) per day for each
day that closing is delayed beyond June 29, 1980.

Two hundred fifty dollars per day would approximate an interest rate of 17.5 percent on
$517,500. On October 30, 1979, the prime interest rate was 15.25 percent and on May 2,
1980, it was 18.5 percent.

Upon execution of the Modified Agreement, petitioner deposited an additional $25,000


with the escrow agent, such deposit and any interest thereon to be applied to the purchase
price at closing. Thus, as of May 3, 1980, the aggregate deposit posted by petitioner was
$50,000.

Phelps Realty assumed the risk of all loss or damage to the Subject Property until the
closing date. In the event of condemnation of the Subject Property before the closing
date, all proceeds of condemnation would be the sole property of Phelps Realty and the
entire deposit would be returned to petitioner. At the time the Modified Agreement was
executed, the Subject Property had a tenant operating an open-air parking lot thereon, and
on the closing date Phelps Realty was to assign to petitioner any remaining rights it had
against the tenant. Also, any rental on the Subject Property was to be adjusted between
Phelps Realty and petitioner as of the closing date. Similarly, all property taxes, water
and sewer changes, and similar items, as well as the rent, were to be apportioned between
Phelps Realty and petitioner at closing as of the closing date.

The closing date was set for June 29, 1980, but petitioner rather than Phelps Realty
could "extend the Closing Date for up to three hundred and sixty five (365) days, subject
to the adjustment of Assigned Value * * *" and subject to Phelps Realty's right to require
closing at any time after December 29, 1980, if it had located a suitable Exchange
Property by that time. Either Phelps Realty or petitioner had to provide 30 days' notice of
intent to close.
On May 29, 1980, [FN1] petitioner and Phelps Realty amended the Modified
Agreement to give petitioner the right to extend the closing date for "up to five hundred
forty-seven (547) days, subject to the adjustment of the assigned value, specified in
Section 4 * * *" and subject to Phelps Realty's right to require closing at any time after
December 29, 1980, should it locate a suitable Exchange Property and subject to 30 days'
notice. This amendment also provided that after the tenant's lease expired on June 30,
1981, Phelps Realty could continue to lease the Subject Property to the parking lot
operator, but only on a month-to-month basis. If the tenant was occupying the Subject
Property at closing, any rental was to be adjusted between Phelps Realty and petitioner as
of the closing date. This amendment also added the following paragraph to the Modified
Agreement:

Upon the execution of this Amendment, Kaempfer shall increase the deposit by
delivering to Chicago Title Insurance Company, a promissory note to Phelps, in the form
annexed hereto in the amount of Forty Thousand Dollars ($40,000.). In the event
Kaempfer shall fail to close in accordance with the terms hereof, such note shall be due
and payable, and in the event of a default in payment thereof, such note shall bear interest
at the rate of twelve percent (12%) per annum. At closing, or upon default by Phelps, the
note shall be returned to Kaempfer.

The provisions for default under the Modified Agreement were as follows:

In the event that Phelps makes full tender of performance under this Agreement and
Kaempfer fails to complete Closing as specified hereinabove, the entire deposit aforesaid
and all interest thereon shall be paid to and shall be the property of Phelps and no party
shall have any further claim or right against any other party under this Agreement.

In the event that Kaempfer makes full tender of performance under this Agreement and
Phelps fails to complete Closing as specified hereinabove, Kaempfer shall have the right
to obtain specific performance of this Agreement, but should Kaempfer not initiate legal
proceedings therefor within six (6) months from the Closing Date or the date of
Kaempfer's complete tender of performance, whichever is earlier, then Kaempfer's sole
remedy hereunder shall be return of the deposit aforesaid with all interest thereon to
Kaempfer, and no party shall have any further claim or right against any other party
under this Agreement.

The Modified Agreement further provided for the creation of a trust:

In the event that Phelps is unable by June 1, 1980, to locate and designate acceptable
Exchange Property the total acquisition cost of which is at least equal to the Assigned
Value of the [Subject] Property, or in the event that Kaempfer is unable on the Closing
Date to convey to Phelps title to the designated Exchange Property * * *.

Under the Modified Agreement, petitioner would create the trust (hereinafter "the
Trust") at the request of Phelps Realty at or prior to the closing date to effect the
exchange. Petitioner was to cause the Trustee "as his agent" to arrange for transfer of the
Exchange Property to Phelps Realty. The creation of the Trust was "for the sole purposes
of receiving a deed to the [Subject] Property and delivering it to Kaempfer upon the
Trustee's receipt of a cash payment equal to the Assigned Value of the [Subject]
Property." The Modified Agreement further provided:

On the Closing Date, Phelps shall deliver a deed to the [Subject] Property to the
Trustee, and Kaempfer will deposit with the Trustee the Assigned Value of the [Subject]
Property. The moneys constituting the Assigned Value will constitute the Trust Estate
which will be disbursed by the Trustee to fund the cost of acquiring the Exchange
Property. * * * During the term of this Agreement and the duration of the Trust, Phelps
shall have the right to locate and negotiate the terms of purchase for the Exchange
Property. At the request of Phelps, Kaempfer will then cause the Trustee to arrange for
the transfer of the designated Exchange Property to Phelps on behalf of Kaempfer. * * *
The Assigned Value plus any income earned on the investment thereof shall be held by
the Trustee as part of the Trust Estate. * * *

f. All earnings on the Assigned Value of the [Subject] Property


while held by the Trustee shall be useable for paying acquisition
and conveyancing costs of the Exchange Property, related
expenses, and any proper charges of or levied against the
Trustee or the Trust Estate.
g. Phelps may elect, at any time prior to June 28, 1984, to treat the
conveyance to Kaempfer as a sale and terminate the Trust, in
which event all funds in such Trust shall be immediately paid to
Phelps.

The latest date for the closing on any Exchange Property was June 28, 1984, but at any
time prior to that date Phelps Realty could elect to treat the conveyance to petitioner as a
sale, terminate the Trust, and be paid all funds in the Trust. However, no such Trust was
ever created.

February 14, 1980, was the date of formation of Park Place Associates (hereinafter Park
Place), a limited partnership in which petitioner was a general partner. On that date,
petitioner assigned to Park Place his rights under the Modified Agreement.

The Modified Agreement granted petitioner the right to submit applications for zoning,
planning, site planning, and permit procedures with respect to the Subject Property. The
Modified Agreement further provided that Phelps Realty would cooperate with petitioner
in these applications, but that the "same shall be at the sole cost, expense, and risk of
Kaempfer".

Between January 1, 1981, and October 31, 1981, Park Place spent more than $670,000
in developing the office building in Rosslyn, referred to above. A small portion of the
$670,000 was for legal fees and site plan approval expenses incurred in connection with
the transfer of density rights from the Subject Property to that office building.
On November 2, 1981, pursuant to direction from Phelps Realty, petitioner purchased
real property in Clearwater, Florida (the Exchange Property), for the purpose of
effectuating the like-kind exchange. The purchase price of this property was $620,000.
On the same day, petitioner transferred the Exchange Property to Phelps Realty and,
pursuant to the terms of the Modified Agreement, Phelps Realty transferred its interest in
the Subject Property to Park Place.

The settlement closing sheet indicates that the "contract sales price" for the Subject
Property was $640,250, $614,359.50 of which was the value placed on the Clearwater
Exchange Property, and $25,890.50 were settlement charges to Phelps Realty that were
paid by Park Place. Since the closing date of November 2, 1981, was 491 days after June
29, 1980, the "contract sales price" of the Subject Property was computed by adding
$517,500 plus 491 days times $250 per day ($122,750), as provided in the Modified
Agreement.

The deed recording the transfer of the Subject Property from Phelps Realty to Park
Place showed a consideration of $640,250, and various taxes were based on that amount.
The State tax of $960.45 and the county transfer tax of $320.15, both based on a
consideration of $640,250, were paid by Park Place. The grantor's State recording tax of
$640.50, based upon a consideration of $640,250, was a charge to Phelps Realty, but was
actually paid by Park Place.

Phelps Realty reported the transfer as a like-kind exchange on its corporate tax return.
Phelps Realty recognized no gain or loss and did not treat any portion of the $640,250
consideration as interest income.

Park Place, on its partnership tax return, treated the amount of consideration in excess
of $517,500 as interest expense. Of the $122,750 excess, Park Place allocated $99,250 to
interest and $23,500 to construction period interest subject to amortization. Petitioner's
distributive share of these items was $60,635 for the interest and $1,596 for the
construction period interest.

Petitioner deducted his distributive share of these items on his 1981 Federal income tax
return and applied the excess against his 1978 taxable income as a net operating loss
carryback. In the statutory notice of deficiency, respondent disallowed the $60,635 in
interest and the $1,596 in construction period interest. Respondent made adjustments to
petitioner's income by recalculating his distributive share of (a) Park Place's ordinary loss
for the 1981 interest expense and (b) the allowable portion of constructive period interest
in 1981. Respondent determined a deficiency of $26,943.59 for 1978 based upon this
recalculation.

OPINION

Section 163(a) provides: "There shall be allowed as a deduction all interest paid or
accrued within the taxable year on indebtedness." In order to come within section 163(a),
the following four requirements must be met. There is a genuine indebtedness. Knetsch v.
United States, 364 U.S. 361, 365 (1960); Coleman v. Commissioner, 87 T.C. 178, 209
(1986), affd. without published opinion 833 F.2d 303 (3d Cir. 1987). The indebtedness is
that of the taxpayer. Abdalla v. Commissioner, 69 T.C. 697, 707 (1978). The payment is
of interest. Juda v. Commissioner, 90 T.C. 1263, 1288-1289 (1988), affd. 877 F.2d 1075
(1st Cir. 1989). The interest deduction is claimed in the proper year based on the
taxpayer's method of accounting. Helvering v. Price, 309 U.S. 409, 413 (1940); James
Brothers Coal Co. v. Commissioner, 41 T.C. 917, 922 (1964). See Midkiff v.
Commissioner, 96 T.C. 724, 734 (1991). See also Commissioner v. Philadelphia
Transportation Co., 174 F.2d 255 (3d Cir. 1949), affg. 9 T.C. 1018 (1947), affd. 338 U.S.
883 (1949). Moreover, economic realities, not the form of the transaction, govern the
characterization of the payment or accrual. Titcher v. Commissioner, 57 T.C. 315, 322
(1971).

Although an indebtedness is an obligation, an obligation is not necessarily an


indebtedness within the meaning of section 163(a). Deputy v. Du Pont, 308 U.S. 488, 497
(1940). An indebtedness is "an existing, unconditional, and legally enforceable obligation
for the payment of a principal sum." Midkiff v. Commissioner, 96 T.C. at 734- 735
(citing Howlett v. Commissioner, 56 T.C. 951, 960 (1971)); Jordan v. Commissioner, 60
T.C. 872, 881 (1973), affd. 514 F.2d 1209 (8th Cir. 1975); Williams v. Commissioner, 47
T.C. 689, 692 (1967), affd. 409 F.2d 1361 (6th Cir. 1968). Interest is compensation for
the use or forbearance of money. Deputy v. Du Pont, 308 U.S. at 497; Old Colony
Railroad v. Commissioner, 284 U.S. 552, 560 (1932). In order for interest to be
deductible, it must be on genuine debt. Coleman v. Commissioner, 87 T.C. at 209.

Petitioner argues that the purchase price of the Subject Property was fixed at $517,500
and that "The Agreement established a definitive closing date at which time Phelps was
entitled to be paid the purchase price for the Property."

The parties agreed that the Assigned Value would increase daily if the closing date
were extended beyond June 29, 1980. Petitioner claims that the $250 increase per day
was compensation for the economic loss suffered by Phelps Realty due to its inability to
invest $517,500 at market rates of interest.

The obligation was not for a fixed amount until after Phelps Realty identified suitable
Exchange Property for the exchange. Once the Exchange Property was identified by
Phelps Realty, petitioner had an obligation under the contract to purchase the Exchange
Property for the Assigned Value of the Subject Property and then to exchange it for the
Subject Property.

Respondent's main argument is that there was no existing or legally enforceable


indebtedness on which interest could be based. In support of this, he notes that, in the
event of petitioner's default, Phelps Realty could not enforce petitioner's obligation, but
could only retain the $90,000 deposit. Respondent contends that the per diem increase
was an approximation of the increase in the value of the Subject Property and labels this
increase the "incremental time price differential". Respondent argues that there was no
promise to pay a principal amount, only a promise to exchange property or lose the
deposit.

For the reasons stated below, we find that there was no legally enforceable obligation
on which interest could be based.

In Midkiff v. Commissioner, supra, we elaborated on the factors that give rise to a


legally enforceable obligation. In that case, the taxpayers argued that an obligation arose
as of the date on which the lot they were leasing was designated for acquisition by
eminent domain by the Hawaii Housing Authority (HHA), pursuant to the Hawaii Land
Reform Act of 1967. HHA brought condemnation proceedings against the lessor estate
pursuant to the request of the taxpayers. Midkiff v. Commissioner, 96 T.C. at 726. In
addition to submitting $500 in earnest money to secure their obligation and proof of
financial ability to purchase the leased fee, the taxpayers had to submit a written
commitment to acquire the leased fee upon acquisition by the HHA. In the event that the
taxpayers withdrew their lot from the acquisition process, they were required to pay their
pro rata share of costs and to forfeit their $500 earnest money deposit. Midkiff v.
Commissioner, 96 T.C. at 727.

In April 1986, five years after the condemnation action in Midkiff was brought, the
parties entered into a settlement agreement which provided that the lessor estate would
receive, inter alia, (1) the value of the leased fee as of the date of designation by the HHA
and (2) five percent per year on that value from the date of designation to the date of
closing. Midkiff v. Commissioner, 96 T.C. at 731. Pursuant to the terms of the settlement,
the lessor estate submitted to the taxpayers an offer to sell the fee interest. In August
1986, the taxpayers accepted the lessor estate's offer and, in November 1986, received
legal title to the property. The taxpayers deducted the five percent "interest" payment
from their Federal income taxes for 1986. Midkiff v. Commissioner, 96 T.C. at 733-734.

We found that the taxpayers were not unconditionally obligated to pay just
compensation to the lessor estate until they affirmatively executed the reply to the estate's
offer to sell, indicating their intent to purchase the lot, and escrow closed on the purchase.
That is, * * * [the taxpayers] were not obligated for the payment of a principal sum until
the date that escrow closed on the purchase. Midkiff v. Commissioner, 96 T.C. at 737. As
petitioner does in this case, the taxpayers in Midkiff relied on Dunlap v. Commissioner,
74 T.C. 1377 (1980), revd. on other grounds 670 F.2d 785 (8th Cir. 1982), in support of
their argument that even if the indebtedness did not become unconditional until the date
of closing, it was a "'sufficient obligation upon which deductible interest could ultimately
accrue."' Midkiff v. Commissioner, 96 T.C. at 737.

In Dunlap, we held that the fact that indebtedness was materially conditional during the
period of interest accrual did not preclude a deduction for interest paid with respect to
such period after the debt became unconditional. Dunlap v. Commissioner, 74 T.C. at
1423, 1424. Dunlap involved the purchase of a savings bank. The debt did not become
unconditional unless and until the transaction was approved by the Federal Reserve
Board.
In the case before us, as in Midkiff v. Commissioner, supra, the date that the contract
became unconditional was wholly within the control of the parties to the contract. In
Midkiff, we distinguished Dunlap on the basis that whether and when the debt became
unconditional was within the control of a third party.

In this case, * * * [the taxpayers] had the opportunity to choose not to purchase the
leased fee interest in their lot at any time up to, and until, the date of closing. Thus,
whether * * * [the taxpayers'] obligation to purchase the leased fee interest became
unconditional was wholly within the control of * * * [the taxpayers]. This is a significant
distinction from Dunlap v. Commissioner, supra, and Journal Co. v. Commissioner, [125
F.2d 349 (7th Cir. 1942), revg. 44 B.T.A. 460 (1941)], where the agreements were
subject to the approval of the F.R.B. and a State probate court, respectively, and in each
instance without the control of the taxpayer.

p>
Midkiff v. Commissioner,
96 T.C. at 739.

Here respondent argues that no debtor/creditor relationship was created and that there
was no obligation until closing, at which time the incremental amount merged into the
Assigned Value of the Subject Property. [FN2] Furthermore, respondent argues, there
was no loan of $517,500. The Modified Agreement defined the "Assigned Value" as
$517,500 plus $250 per day. [FN3] We agree that no debtor/creditor relationship existed
prior to closing.

We find that Phelps Realty never had a legally enforceable right to receive $517,500.
Under the provisions of the Modified Agreement, Phelps Realty was not entitled to
receive $517,500. It was at the insistence of Phelps Realty, and for its sole benefit, that
the transaction was structured as an exchange rather than a purchase and sale. Phelps
Realty did, however, have the ability to transform the exchange into a taxable sale of the
Subject Property if it first directed petitioner to create the Trust. In that case, petitioner
would deposit the Assigned Value of the Subject Property with the trustee. If Phelps
Realty elected to treat the transaction as a sale, it would be entitled to all funds in the
Trust -- i.e., the Assigned Value plus any earnings on that amount. In that situation, the
"purchase price" would have been the amount of money deposited by petitioner into the
Trust -- the Assigned Value on the date the Trust was created. That never happened, and
no such Trust was ever created.

In the event of petitioner's default, Phelps Realty could not enforce payment of
$517,500 or any other amount; it was only entitled to liquidated damages in the amount
of the deposit ($90,000) and any interest thereon. Although it might have been an
imprudent business decision for petitioner simply to walk away from the land transaction
and forfeit his $90,000 deposit, that factor alone does not create a legally enforceable
obligation for the payment of any amount.
It is axiomatic that interest is compensation paid for the use or forbearance of money.
Until the actual closing date, however, Phelps Realty had given up neither the use of its
money nor the Subject Property.

Thus, we note that the transaction in the present case is fundamentally distinguishable
from the classic deferred exchange situation addressed in Starker v. United States, 602
F.2d 1341 (9th Cir. 1979), and in the income tax regulations promulgated in 1991.
Starker involved a "land exchange agreement" whereby Starker transferred timberland to
Crown Zellerbach with the agreement that Crown Zellerbach would transfer suitable real
property to Starker within five years or pay any outstanding balance in cash. Crown
Zellerbach agreed to add a six percent annual "growth factor" to the outstanding balance.
Starker v. United States, 602 F.2d at 1342-1343. The United States contended that the
"growth factor" was really compensation for the use or forbearance of money. Starker
argued that the "growth factor" was compensation for timber growth on the property he
had transferred to Crown Zellerbach. The court, agreeing with the United States, stated:

The taxpayer is essentially arguing "that he conveyed $1,502,500 to a stranger for an


indefinite period of time [up to five years] without any interest." The 6 per cent "growth
factor" was "compensation for the use or forbearance of money", that is, for the use of the
unpaid amounts owed to Starker by Crown. Therefore, it was disguised interest.

Starker v. United States,


602 F.2d at 1356 (citations omitted).

In the case before us, we are not faced with a Starker-type deferred exchange. [FN4]
Phelps Realty did not transfer the Subject Property to petitioner and then subsequently
receive other property. The Modified Agreement specifically provided that "On the
Closing Date, * * * Phelps shall exchange the [Subject] Property to and with * * *
[petitioner] for other real property acceptable to Phelps." In both Starker and section
1.1031(k)-1, Income Tax Regs., a party to the exchange has given up property before the
other property in the exchange is transferred. Neither applies to simultaneous exchanges
of property. In this case, the parties to the land transaction contracted for a simultaneous
exchange of property in the future, not a deferred exchange. Because the exchange was to
be simultaneous, Phelps Realty did not give up the Subject Property before receiving the
Exchange Property in return. Phelps Realty assumed the risk of loss of the Subject
Property until the closing date. In fact, all benefits and burdens of ownership of the
Subject Property remained with Phelps Realty until the closing date. The Subject
Property was rented to a parking lot operator which paid the rent to Phelps Realty until
the closing date. Had the Subject Property been condemned before the closing date, all of
the proceeds of condemnation would have belonged to Phelps Realty, and petitioner
would merely have received the return of his deposit. At the closing all items of taxes,
expenses, and rent for the Subject Property were allocated between Phelps Realty and
petitioner as of the closing date. All of this and the transfer of the Subject Property to
petitioner occurred simultaneously with the transfer of the Exchange Property to Phelps
Realty. Thus, Starker v. United States, supra, is not helpful to petitioner in this case.
Although labels given by the parties to the land transaction are not controlling, the
intent of the parties is relevant to the determination of whether an amount is to be treated
as interest. Dunlap v. Commissioner, 74 T.C. at 1421. In the present case, the Modified
Agreement in several instances refers to "interest" on money deposited by petitioner and
"interest" on the funds transferred to any trust. It is, however, silent and does not label the
$250 per diem amount as "interest." The Modified Agreement in fact defined the
Assigned Value of the Subject Property as including this amount. Moreover, we note that
Phelps Realty did not report the $250 per day increase as interest income, [FN5] as would
have been required by section 1031(b) and section 1.1031(b)-1(a)(1), Income Tax Regs.

In conclusion, we find that there was no legally enforceable obligation to which the
$250 per day increase could attach. If there were such an obligation, our holding in
Midkiff v. Commissioner, supra, would preclude its deductibility because whether and
when any such obligation became unconditional was solely within the control of the
parties to the land transaction. The incremental amount was not a payment for the use or
forbearance of money. The actions of the parties to the land transaction indicate that they
did not intend the amount to be interest. We hold that the $250 per day increase is part of
the purchase price of the Subject Property and is included in the basis of the property
acquired by petitioner. We thus hold that no portion of this amount is deductible as
interest under section 163(a).

To reflect the foregoing,

Decision will be entered for respondent. FN1 This amendment states that it was
executed on May 29, 1981, but the parties have stipulated that the date was 1980. Given
the terms of the amendment, 1980 is clearly the correct date. FN2 Respondent contends
that the $250 per day increase was meant to approximate the daily increase in the value of
the Subject Property. We find nothing in the record, however, that indicates what the
actual or projected change in property values for the Arlington, Virginia, area was during
the period in question. It is sufficient to say that the increase was not interest and that it
must be capitalized. FN3 Respondent notes that if the per diem charge were in fact
interest, Phelps Realty would not have been entitled to nonrecognition on this portion.
Sec. 1031(b); sec. 1.1031(b)-1(a)(1), Income Tax Regs. The treatment by Phelps Realty
of the per diem amount may be indicative of the parties' intent, but is not a controlling
factor. FN4 See also section 1.1031(k)-1(h), Income Tax Regs., promulgated in 1991,
which provides:

(1) In general. For purposes of this section, the taxpayer is treated


as being entitled to receive interest or a growth factor with
respect to a deferred exchange if the amount of money or
property the taxpayer is entitled to receive depends upon the
length of time elapsed between transfer of the relinquished
property and receipt of the replacement property.
(2) Treatment as interest. If, as part of a deferred exchange, the
taxpayer receives interest or a growth factor, the interest or
growth factor will be treated as interest, regardless of whether
it is paid to the taxpayer in cash or in property (including
property of a like kind). The taxpayer must include the interest
or growth factor in income according to the taxpayer's method
of accounting.

Section 1.1031(k)-1(a), Income Tax Regs., provides:

For the purposes of section 1031 and this section, a deferred exchange is defined as an
exchange in which, pursuant to an agreement, the taxpayer transfers property held for
productive use in a trade or business or for investment (the "relinquished property") and
subsequently receives property to be held either for productive use in a trade or business
or for investment (the "replacement property").

These regulations only apply to exchanges taking place after June 10, 1991.

FN5 Young v. Commissioner, T.C. Memo. 1978-19, 37 T.C.M. 131, 134, 47 P-H Memo
T.C. par. 78,019 at 140.

NONSIMULTANEOUS EXCHANGES: TIME LIMITS


KUNKEL

In the Kunkel case, a 1995 decision, the Court found that the specific requirements under
the provisions of Code §1031(a)(3), for a nonsimultaneous exchange, were not met
because the taxpayer failed to timely provide for the replacement property.

Kenneth James KUNKEL, Petitioner,


v.
COMMISSIONER OF INTERNAL REVENUE, Respondent.

United States Tax Court.


No. 24705-93.
T.C. Memo. 1995-162
April 10, 1995.

MEMORANDUM FINDINGS OF FACT AND OPINION

WHALEN, Judge:
Respondent determined the following deficiency in, and additions to, petitioner's
income tax:

For each of the years in issue, petitioner filed a joint return with his wife, Mrs. Susan K.
Kunkel. However, Mrs. Kunkel did not join in the filing of the petition in this case.

The issues for decision are: (1) Whether the gain realized during 1990 by petitioner and
his wife from the sale of certain real property held for investment, qualifies for
nonrecognition pursuant to section 1031;
FINDINGS OF FACT

The parties stipulated some of the facts in this case, and the Stipulation of Facts filed by
the parties is incorporated herein by this reference. At the time of trial, petitioner and his
wife resided in North Wales, Pennsylvania.

During 1989 and part of 1990, petitioner and Mrs. Kunkel owned a condominium
located at 5832 Central Avenue, Ocean City, New Jersey (the Central Avenue Property).
On March 24, 1990, petitioner and Mrs. Kunkel executed a Contract For Sale of Real
Estate, dated March 21, 1990, under which they agreed to sell the Central Avenue
Property to Mr. and Mrs. Mervyn Clevenger for $267,500.

On April 6, 1990, petitioner and Mrs. Kunkel entered into a contract to purchase
another property located at 4312 Asbury Avenue, Ocean City, New Jersey (the Asbury
Avenue Property) from Mr. John H. Hornberger for $185,000. On April 16, 1990,
petitioner and Mrs. Kunkel executed an amended contract to purchase the Asbury
Avenue Property from Mr. Hornberger. The closing of the purchase of the Asbury
Avenue Property was scheduled to take place on August 1, 1990.

On May 18, 1990, at the closing of the sale of the Central Avenue Property, petitioner
and his wife executed an addendum to the contract for the sale of that property entitled:

EXCHANGE AGREEMENT ADDENDUM TO AGREEMENT OF SALE DATED


MARCH 21, 1990 BETWEEN KENNETH AND SUSAN KUNKEL, SELLERS, AND
MERVYN CLEVENGER, ET ALS., [sic] BUYER, FOR THE PURCHASE OF
PROPERTY KNOWN AS 5832 CENTRAL AVENUE, A FIRST FLOOR
CONDOMINIUM, OCEAN CITY, NEW JERSEY.

The addendum refers to "Seller's [petitioner's] objective of EXCHANGING the


property for other real estate, pursuant to the provisions of Section 1031 of the Internal
Revenue Code." Under the addendum, petitioner agreed to "identify the EXCHANGE
Property before, at, or not later than 44 days after settlement for the property which is the
subject matter of this agreement". The addendum further provides that the net proceeds of
settlement were to be used to acquire EXCHANGE properties or were to be held by the
title company in escrow pending the acquisition of EXCHANGE properties.

Petitioner also executed an Escrow Agreement with the Title Company of Jersey which
sets forth the following terms and conditions:

THIS IS THE FIRST HALF OF A SECTION 1031 TAX DEFERRED EXCHANGE


BEING CONDUCTED BY SELLER UNDER THE INTERNAL REVENUE CODE.
ALL NET PROCEEDS FROM THE SALE WILL BE ESCROWED UNTIL SUCH
TIME AS YOU ARE PREPARED FOR CLOSING FOR THE ACQUISITION OF A
PROPERTY (NOT TO EXCEED 180 DAYS FROM TODAY) WHICH YOU WILL
IDENTIFY TO THE TITLE COMPANY OF JERSEY WITHIN FORTY FIVE DAYS
OF THE DATE OF THE ESCROW AGREEMENT SO THE SECOND HALF OF A
SECTION 1031 TAX DEFER [sic] EXCHANGE YOU ARE IN THE PROCESS OF
CONDUCTING UNDER THE INTERNAL REVENUE CODE, SELLER MAY ELECT
AT ANY TIME TO REMOVE THE FUNDS FROM THE ESCROW AND
ACKNOWLEDGE THAT BY SO DOING THEY ARE VOIDING ANY CHANCES OF
MAKING USE OF THE TAX DEFERRED EXCHANGE. IF THE FORTY FIVE DAYS
PASS AND THE TITLE COMPANY OF JERSEY HAS NOT BEEN NOTIFIED IN
WRITING OF THE IDENTIFYING PROPERTY THE ESCROW AGREEMENT WILL
BE AUTOMATICALLY TERMINATED AND THE FUNDS RELEASED TO THE
SELLER.

On May 18, 1990, petitioner and Mrs. Kunkel sold the Central Avenue property to the
Clevengers. According to the settlement statement from such sale, petitioner and his wife
were due to receive cash in the amount of $80,950.97 from the sale. That amount was
disbursed as follows: (1) $4,126 was paid to the Clevengers for rents previously collected
by petitioner on the Central Avenue Property; (2) $10,000 was placed in an interest-
bearing account with The Title Company of Jersey, to be used by petitioners as the
deposit on the Asbury Avenue Property; and, (3) $66,804.97 was placed in an escrow
account with The Title Company of Jersey, pursuant to the EXCHANGE Agreement
Addendum described above. We note that the total of the above three amounts is
$80,930.97. The record does not explain how the remaining $20 was disbursed.

On September 10, 1990, petitioner, Mrs. Kunkel, and Mr. Hornberger executed another
contract for the purchase of the Asbury Avenue Property. In a letter dated September 11,
1990, an attorney representing petitioner, Mr. Arnold H. Keehn, informed Mr.
Hornberger and his wife that the September 10, 1990, contract had been "disapproved".
Mr. Keehn's letter also states that the escrow agent, Title Company of Jersey, should
return Mr. Kunkel's deposit of $10,000. Mr. Keehn sent a copy of his letter to the Title
Company of Jersey.

By letter dated September 19, 1990, petitioner requested the Title Company of Jersey to
return the $66,804.97 that the company was holding in escrow. On the following day, the
title company returned the $66,804.97 to petitioner together with $1,105.16 in interest.
On September 26, 1990, the title company also returned petitioner's $10,000 deposit on
the Asbury Avenue Property plus $173.76 in interest, less a $150 cancellation fee.
Sometime after receiving the funds from the title company, petitioner and Mrs. Kunkel
invested the funds in two certificates of deposit.

On August 31, 1991, 470 days after the sale of the Central Avenue Property, petitioner
and Mrs. Kunkel purchased a lot located at 5837-39 Asbury Avenue, Ocean City, New
Jersey (the Second Asbury Avenue Property). Petitioner and Mrs. Kunkel purchased the
Second Asbury Avenue Property with the proceeds from the sale of the Central Avenue
Property. Neither petitioner nor Mrs. Kunkel had identified the Second Asbury Avenue
Property as EXCHANGE property within 45 days after the sale of the Central Avenue
Property, as required by section 1031(a)(3)(A).
On his 1990 return, petitioner reported a capital gain of $12,450 attributable to the sale
of the Central Avenue Property. Petitioner now agrees that the amount of the gain was
$37,583, an increase of $25,133. Respondent determined in the notice of deficiency that
the entire capital gain should be recognized in 1990. The notice states as follows:

It is determined that the sale of your rental property in Ocean City, New Jersey, does
not qualify to be reclassified as a like-kind EXCHANGE per Internal Revenue Code
Section (IRC 1031). The gain from this sale is to be reported as a capital gain and your
taxable income was increased as shown above.

OPINION

The first issue for decision in this case is whether the gain realized by petitioner and
Mrs. Kunkel from the sale of the Central Avenue Property qualifies for non-recognition
under section 1031(a) on the ground that the property was EXCHANGED for other
property of like-kind. Respondent determined that the entire gain from the sale, $37,583,
must be recognized in 1990. Petitioner bears the burden of proving that respondent's
determination is erroneous. Rule 142(a), Tax Court Rules of Practice and Procedure.
Hereinafter, all Rule references are to the Tax Court Rules of Practice and Procedure.

"To qualify for nonrecognition, a taxpayer must satisfy each of the specific
requirements as well as the underlying purpose of section 1031(a)." Chase v.
Commissioner, 92 T.C. 874, 881 (1989) (citing Bolker v. Commissioner, 760 F.2d 1039,
1044 (9th Cir.1985), affg. 81 T.C. 782 (1983)). Among other requirements, section
1031(a) provides that property received by the taxpayer shall be treated as property which
is not like-kind, if it is not identified as EXCHANGE property within 45 days after the
date on which the taxpayer transfers the original property in the EXCHANGE, or if the
property is received more than 180 days after the original property is relinquished or, if
earlier, after the due date of the taxpayer's return. In relevant part, section 1031 provides
as follows:

(a) Nonrecognition Of Gain Or Loss From EXCHANGES Solely In Kind.

(1) In General.--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.
(3) Requirement That Property Be Identified And That
EXCHANGE Be Completed Not More Than 180 Days After
Transfer Of EXCHANGED Property.--For purposes of this
subsection, any property received by the taxpayer shall be
treated as property which is not like-kind property if--
(A) such property is not identified as property to be received in
the EXCHANGE on or before the day which is 45 days
after the date on which the taxpayer transfers the property
relinquished in the EXCHANGE, or
(B) such property is received after the earlier of--
(i) the day which is 180 days after the date on which the
taxpayer transfers the property relinquished in the
EXCHANGE, or
(ii) the due date (determined with regard to extension) for
the transferor's return of the tax imposed by this chapter
for the taxable year in which the transfer of the
relinquished property occurs.

At trial, petitioner admitted that he had not identified the Second Asbury Avenue
Property as EXCHANGE property within 45 days following the transfer of the Central
Avenue Property. Petitioner testified as follows:

THE COURT: Now what property do you claim was


EXCHANGE property?
MR. KUNKEL: 5837-39 Asbury Avenue.
THE COURT: I'm just looking at the trial memoranda. That was
acquired in August of 91?
MR. KUNKEL: Yes.
THE COURT: So was that property identified as EXCHANGE
property within 45 days of the time you sold the
first property?
MR. KUNKEL: No, sir.

It is also clear that petitioner did not obtain ownership of the Second Asbury Avenue
Property until August 31, 1991, 470 days after the sale of the Central Avenue Property.
Thus, in accordance with the express requirements of the statute, the Second Asbury
Avenue Property "shall be treated as property which is not like-kind property". Sec.
1031(a)(3). Therefore, petitioners have failed to satisfy the statutory requirements of
section 1031, and the gain attributable to the Central Avenue Property must be
recognized in petitioner's income for 1990.

NONSIMULTANEOUS EXCHANGE: TIME FRAME:


GOOD FAITH: KNIGHT

In the Knight case, the taxpayers attempted a nonsimultaneous exchange. Unfortunately


for the taxpayers, one day before the scheduled closing, the transaction was delayed by
the seller of the replacement property. The taxpayers argued that in essence they met the
requirements and they were in good faith.

However, the Court responded that: "Although we are sympathetic to petitioners' plight,
we do not have jurisdiction to do what the petitioners' request." The Court concluded that
the taxpayers did not comply within Code §1031.
David A. and Marilyn P. KNIGHT, Petitioners
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 16522-96.
United States Tax Court.
T.C. Memo. 1998-107, 1998 WL 113928 (U.S.Tax Ct.),
75 T.C.M. (CCH) 1992, T.C.M. (RIA) 98,107
March 16, 1998.

MEMORANDUM FINDINGS OF FACT AND OPINION

JACOBS, Judge:

Respondent determined a $27,412 deficiency in petitioners' 1993 Federal income tax.


The sole issue for decision is whether petitioners may defer recognition of gain realized
on the sale of two residential rental properties pursuant to section 1031(a).

Unless otherwise indicated, all section references are to the Internal Revenue Code in
effect for the taxable year in issue.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The stipulations of facts and
the attached exhibits are incorporated herein by this reference. Petitioners resided in
Franklin, Tennessee, at the time they filed their petition and amended petition. At all
relevant times, petitioners were realtors.

Before the year under consideration, petitioners resided in Milwaukee, Wisconsin.


There, they owned two residential rental properties: 3460 North 99th Street (99th Street
property) and 7643 West Center Street (West Center Street property). Petitioners had
purchased the 99th Street property for $126,000 in July 1991 and the West Center Street
property for $118,500 in 1986.

In 1993, petitioners moved to Franklin, Tennessee. They decided to dispose of these


two residential rental properties by exchanging them for like-kind property pursuant to
section 1031. Accordingly, petitioners entered into two accommodation agreements with
Heritage Title Services, Inc. (accommodation agreements), pursuant to which they agreed
to sell the two residential rental properties and purchase other qualifying like-kind
property in Tennessee as part of a tax-free exchange. The accommodation agreements
required petitioners to identify replacement properties within 45 days after the date of the
closing on the two rental properties and to receive the qualifying like-kind property
within 180 days after the date of the closing on the two rental properties.

On February 17, 1993, petitioners sold their 99th Street property for $135,000. On
February 19, 1993, they sold the West Center Street property for $136,000.
On April 2, 1993, petitioners identified the following three potential replacement
properties: (1) A 100-by 300-foot parcel in Franklin, Tennessee; (2) 2902 Campbellsville
Pike, Columbia, Tennessee (Campbellsville Pike property); and (3) 2711 Murfreesboro
Road, Antioch, Tennessee (Murfreesboro Road property)

Petitioners immediately began negotiations to acquire the 100-by 300-foot parcel in


Franklin, Tennessee, but these negotiations ended without an agreement. Then,
petitioners attempted to acquire the Campbellsville Pike property. An agreement to
purchase that property was reached, but on August 16, 1993, the sellers of the property
canceled the sale.

On December 23, 1993, petitioners purchased the Murfreesboro Road property for
$321,750. The acquisition of the property was more than 180 days from the respective
dates the 99th Street and West Center Street properties were sold.

Federal Income Tax Returns

On Forms 8824, Like-Kind Exchanges, attached to their 1993 Federal income tax and
amended returns, petitioners elected to defer the gain realized on the sale of their two
residential rental properties.

Notice of Deficiency

In the notice of deficiency, respondent determined that petitioners' like-kind exchange


of properties in Wisconsin for property in Tennessee did not qualify as a section 1031
nontaxable exchange because the statutory time requirement for completion of the
exchange was not met. Accordingly, respondent determined that petitioners had ordinary
income of $16,266 and capital gain of $82,288 for 1993 arising from this exchange.

OPINION

Petitioners contend that although they attempted to adhere to the section 1031
requirements, an event beyond their control (i.e., the seller of one of the replacement
properties--Campbellsville Pike property--canceled the sale 1 day prior to the date set for
closing) prevented them from receiving the replacement property within the prescribed
180-day period for receiving like- kind property. Respondent argues that because
petitioners received the replacement property beyond the prescribed 180-day period,
petitioners' exchange does not qualify for the like-kind treatment; and, as a consequence,
petitioners must recognize as income the gain attributable to the sale of the 99th Street
and West Center Street properties.

Section 1001 generally requires recognition of the entire amount of gain or loss on the
sale or exchange of property. Section 1031(a)(1), however, provides for the
nonrecognition of such gain or loss 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." For transfers after July 18, 1984, section 1031(a)(3), enacted as part of the
Deficit Reduction Act of 1984, Pub.L. 98-369, sec. 77(a), 98 Stat. 494, 595, governs
deferred like-kind exchanges.

Section 1031(a) (3)(A) requires deferred replacement property to be identified within


45 days after the date the taxpayer transfers the property relinquished in the exchange.
The parties agree that petitioners satisfy this requirement.

Section 1031(a) (3)(B) provides that the property received by the taxpayer (the
exchanged property) will not qualify for tax-free treatment if the exchanged property is
received after the earlier of 180 days from the date the taxpayer transfers the property
relinquished in the exchange or "the due date (determined with regard to extension) for
the transferor's return of the tax imposed by this chapter for the taxable year in which the
transfer of the relinquished property occurs". Petitioners admit that the transfer of the
replacement property (Murfreesboro Road property) to petitioners occurred more than
180 days after they transferred their interest in the two residential rental properties.
Hence, it is obvious that petitioners failed to satisfy the 180 day requirement of section
1031(a)(3)(B)(i). See St. Laurent v. Commissioner, T.C. Memo.1996-150. (We note that
section 1031(a)(3)(B)(ii) does not apply herein because the due date for petitioners' 1993
Federal income tax return was April 15, 1994, which is later than the 180 day
requirement.) Thus, the Murfreesboro Road property is property which is not like-kind.

Petitioners assert they should not have to recognize gain on the exchange because they
made a good faith attempt to adhere to the statute. In essence, petitioners request that the
Court ignore the plain language of the statute and essentially rewrite it to achieve what
would be an equitable result. See Hildebrand v. Commissioner, 683 F.2d 57, 58-59 (3d
Cir.1982), affg. T.C. Memo.1980-532. Although we are sympathetic to petitioners' plight,
we do not have jurisdiction to do as petitioners request. Regrettably for petitioners, this
Court is not a court of equity and does not possess general equitable powers. Stovall v.
Commissioner, 101 T.C. 140, 149-150 (1993) (citing Commissioner v. McCoy, 484 U.S.
3 (1987)); Woods v. Commissioner, 92 T.C. 776, 787 (1989). The Internal Revenue
Code, not general equitable principles, is the mainspring of this Court's jurisdiction.
Commissioner v. Gooch Milling & Elevator Co., 320 U.S. 418, 422 (1943).

Petitioners claim that Internal Revenue Service (IRS) should take a more "citizen-
friendly" position than respondent asserts herein. Petitioners philosophize that if
circumstances beyond their control prevent them from purchasing replacement property
within the 180-day period, then the time for acquiring replacement property pursuant to
section 1031 should be the same as the time for acquiring replacement property where
there is an involuntary conversion; and thus, the 180-day period should be extended to 2
years. Petitioners read IRS Publication 544, Sales and Other Dispositions of Assets, to
support their philosophy. Although we do not read IRS Publication 544 in the way
petitioners do, nonetheless, it is well settled that authoritative tax law is contained in
statutes, regulations, and judicial decisions and not in informal publications. See
Zimmerman v. Commissioner, 71 T.C. 367, 371 (1978), affd. without published opinion
614 F.2d 1294 (2d Cir.1979); Green v. Commissioner, 59 T.C. 456, 458 (1972). Internal
Revenue Service publications, like the one upon which petitioners relied, are merely
guides published by the IRS to aid taxpayers. See Dixon v. United States, 381 U.S. 68, 73
(1965).

Petitioners do not dispute respondent's computations as to the amount of gain realized


from the disposition of the two rental properties in Wisconsin. Accordingly, respondent's
computations are sustained.

To reflect the foregoing,


Decision will be entered for respondent.

NONSIMULTANEOUS EXCHANGE:IDENTIFICATION:
DOBRICH
(1997)

The Dobrich case involved a nonsimultaneous exchange and the identification


requirements under that Rule. The Court held that not only was the identification not
timely and properly made, but there was also evidence of fraud; the taxpayers attempted
to modify the dates of documents to attempt to meet the timing requirements for the
exchange. The taxpayers failed in this regard; they were denied tax-deferred exchange
treatment and suffered a fraud penalty.

FOR EDUCATIONAL USE ONLY


Copr. © West 1997 No Claim to Orig. U.S. Govt. Works

David DOBRICH and Naomi Dobrich, Petitioners


v.
Commissioner of Internal Revenue, Respondent

No. 3832-95, 7382-96.


United States Tax Court.
T.C. Memo. 1997-477
1997 WL 669649 (U.S.Tax Ct.), 74 T.C.M. (CCH) 985
Oct. 20, 1997.

MEMORANDUM FINDINGS OF FACT AND OPINION

GERBER, J.

Respondent determined deficiencies in petitioners' 1989 and 1990 Federal income tax
in the amounts of $1,111,292 and $1,111,320, respectively, and section 6663(a) [FN1]
civil fraud penalties for 1989 and 1990 of $833,469 and $833,490, respectively.
Respondent determined the income tax deficiency and penalty in the alternative for 1989
or 1990.

The issues for our consideration are:


(1) Whether petitioners may defer recognition of gain from the
disposition of certain real property under section 1031,
(2) if the transaction does not qualify for section 1031 exchange,
whether petitioners are entitled to report the gain in 1990 under
the installment sale method, and
(3) whether petitioners are liable for a fraud penalty under section
6663.

FINDINGS OF FACT [FN2]

At the time the petitions in this case were filed, petitioners resided in Danville,
California. Petitioners are married and filed joint Federal income tax returns for each of
the years in issue.

During the years in issue, petitioners engaged in real estate investment and received
rental income from commercial and residential real estate. In 1977, petitioners purchased
137 acres of unimproved real property located in Antioch, California (Antioch property),
for $300,000 and thereafter spent $30,000 in engineering and consulting fees to improve
the property. In 1988, petitioners decided to sell a portion of the Antioch property to an
unrelated third party and granted an option to purchase 117 acres of the property for
$3,969,000, to expire on August 22, 1989. Petitioners intended to dispose of the property
in a section 1031 exchange for like-kind property to obtain nonrecognition treatment of
the gain realized. They knew that they had a limited time period after the sale closed to
replace the Antioch property with like-kind property and had to identify replacement
property within 45 days.

Petitioners entered into an agreement with Clack Brothers, Inc. (Clack Bros.), to act as
an intermediary to facilitate a like-kind exchange of the Antioch property purportedly in
accordance with section 1031 (exchange agreement). Timothy Clack (Mr. Clack), the
president of Clack Bros., is a real estate attorney and had represented petitioners in real
estate transactions since the 1970's. Pursuant to the exchange agreement, petitioners
assigned the right to receive the Antioch option proceeds to Clack Bros. On August 22,
1989, the option holder exercised the option to purchase the Antioch property. Petitioners
transferred the title of the Antioch property to the purchaser without Clack Bros.'
acquiring legal title. The purchaser paid the $3,969,000 purchase price into an escrow
account by August 22, 1989. Clack Bros. thereafter transferred $3,862,339.65 of the
proceeds into an interest-bearing trust account in its name and used the remainder for a
deposit on replacement property chosen by petitioners. Petitioners paid a portion of the
interest earned on the sale proceeds to Clack Bros. as a fee and retained the remainder of
the sale proceeds interest.

The exchange agreement provided that petitioners would be entitled to the sales
proceeds if they did not identify replacement property within 45 days of the transfer of
the Antioch property. If petitioners did identify replacement property, they would have a
right to the sales proceeds if they did not acquire replacement property within 180 days of
the transfer, pursuant to the exchange agreement. A letter attached to the exchange
agreement also informed petitioners of the 45-day identification period. The 45th day
after the transfer was October 6, 1989, and the 180th day was in February 1990.

Petitioners began looking for replacement property in 1988. They considered numerous
potential replacement properties and met with several real estate agents. In connection
with the properties they considered, petitioners examined various information about the
properties, such as building plans, income and expense statements, tenant lists, leases,
rents, service and maintenance contracts on the property, and warranties, in order to
analyze the investment opportunity of the properties. Petitioners expressed an interest in a
number of replacement properties during the identification period. They offered to
purchase several different properties, entered into purchase agreements, and had Clack
Bros. make earnest money deposits using the sales proceeds from the Antioch property.
However, petitioners did not acquire any of these properties. After the identification
period had expired, petitioners continued to search for possible replacement properties
and continued to make unsuccessful offers as late as December 1989. In January 1990,
petitioners made offers to purchase two parcels of real property: 2001 Contra Costa
Boulevard, Pleasant Hill, California, (Pleasant Hill) and 1032 Skyland Drive, Zephyr
Cove, Nevada (Skyland). Petitioners acquired these properties in February 1990 using the
sales proceeds from the Antioch property.

Petitioners purchased the Pleasant Hill property from a partnership in which Daniel
Fivey was a general partner. The partnership began construction of a retail shopping
center on the property in mid-1989 and completed construction in February 1990. The
Pleasant Hill property had not been listed for sale with any real estate brokers. Petitioner
husband had previously discussed another possible replacement property with Mr. Fivey
in mid-1989. During the course of the discussions, Mr. Fivey mentioned the Pleasant Hill
property, which was still under construction and not available for sale. Petitioner husband
did not ask Mr. Fivey for a tour of the property or for any information about the property.
Petitioners did not express any interest in purchasing Pleasant Hill, or otherwise identify
Pleasant Hill as replacement property, at that time or at any time prior to January 1990.

On January 11, 1990, one of petitioners' real estate agents Kevin Van Voorhis (Mr. Van
Voorhis) told petitioner husband that the Pleasant Hill property was for sale. This was the
first time petitioners had discussed Pleasant Hill with Mr. Van Voorhis, and petitioner
husband did not indicate to Mr. Van Voorhis that he was familiar with the property. Mr.
Van Voorhis informed petitioner husband that Pleasant Hill could not be part of a section
1031 exchange for the Antioch property because it was not identified within the 45-day
identification period. On January 26, 1990, petitioners offered to purchase Pleasant Hill
for $3,100,000 and entered into a purchase contract. Petitioners assigned the purchase
contract to Clack Bros., and the purchase closed on February 15, 1990. The purchase
price was paid by Clack Bros. from the Antioch sales proceeds. Petitioners negotiated the
purchase of Pleasant Hills themselves and paid Mr. Van Voorhis a finder's fee of
$31,000.

Petitioners also looked for residential rental property in the Lake Tahoe, Nevada, area
in 1988 and used Sandra Love (Ms. Love) as their real estate agent. On October 12, 1989,
after the identification period had expired, petitioners first expressed an interest in the
Skyland property to Ms. Love. They had toured Skyland that day with another real estate
agent but wanted Ms. Love to handle the purchase. The Skyland property contains a
waterfront, single-family residence. The house was constructed during the summer of
1989 and first advertised for sale in June 1989 while under construction. Ms. Love had
not previously discussed the Skyland property with petitioners or shown the property to
them. Petitioners did not indicate to Ms. Love that they had seen the house prior to
October 12, 1989. The next day, October 13, 1989, petitioners made a verbal offer for the
Skyland property, which they later decided to withdraw. On October 13, 1989, Ms. Love
also contacted Mr. Clack, at petitioners' request, to identify Skyland as replacement
property.

After the initial offer, petitioners did not express any further interest in purchasing
Skyland again until January 24, 1990, when they called Ms. Love to inquire as to whether
the Skyland property was still for sale. On January 26, 1990, petitioners offered to
purchase the Skyland property for $1,200,000 and entered into a purchase contract.
Petitioners assigned the purchase contract to Clack Bros., and the purchase price was paid
by Clack Bros. from the sales proceeds of the Antioch property. The purchase closed on
February 15, 1990.

Petitioners regularly discussed the 45-day identification requirement with Mr. Clack
and with several real estate agents whom petitioners employed. Mr. Clack repeatedly
advised petitioners to obtain documentation to establish that they had identified
replacement property within the 45-day period. Mr. Clack recommended that petitioners
purchase replacement property that had been identified during the 45-day period. Real
estate agents also gave petitioners similar advice, including Mr. Van Voorhis who
recommended that a written identification be furnished to Mr. Clack as the exchange
intermediary. In September 1989, Mr. Van Voorhis offered to write a letter to Mr. Clack
that identified replacement properties that petitioners were considering (Van Voorhis
letter). Mr. Van Voorhis asked petitioners which properties to include in the letter and
also included properties that Mr. Van Voorhis had shown to them. Petitioners did not
inform Mr. Van Voorhis that they were interested in either the Skyland or Pleasant Hill
properties in his preparation of this letter. The letter, dated September 18, 1989, identified
10 potential replacement properties and did not include either the Pleasant Hill or
Skyland properties. Despite this advice, petitioners did not identify either Pleasant Hill or
Skyland in writing or obtain other written documentation. Moreover, petitioners did not
discuss purchasing either the Pleasant Hill or Skyland property with Mr. Clack, any of
their real estate agents, or the prior owners of the properties during the 45-day period.

In January 1990, petitioner husband asked Ms. Love to write a false letter (Skyland
letter) addressed to petitioners purporting to acknowledge that petitioners had expressed
an interest in purchasing the Skyland property to her as of September 1989. The letter
was backdated to September 19, 1989, on petitioner husband's request to misrepresent the
time by which Skyland was identified as replacement property. The letter also incorrectly
stated that petitioners had made a verbal offer to purchase the property on that date. At
petitioners' direction, Ms. Love also changed the date of petitioners' offer for the Skyland
property from January 26, 1990, to a September date. Petitioners and Ms. Love also re-
dated the purchase contract to September 19, 1989. In January 1990, petitioner husband
also asked Mr. Fivey to write a similar letter to fabricate an interest in the Pleasant Hill
property during the identification period Pleasant Hill letter). The letter, backdated to
September 15, 1989, purported to acknowledge petitioner husband's interest in acquiring
Pleasant Hill.

In late October 1989, after the identification period had expired, petitioner husband had
suggested that documents be backdated in connection with another property that
petitioners were considering but did not acquire. Petitioners offered to purchase this
property, and the purchase offer was backdated to be within the identification period. On
January 8, 1990, petitioners received a sample letter from Mr. Clack that was used to
prepare the back dated Pleasant Hill and Skyland letters. The sample letter was dated
September 5, 1989, and addressed to petitioner husband. Petitioners received this sample
letter before they expressed an interest in acquiring either Pleasant Hill or Skyland to Mr.
Clack.

In January 1990, petitioner husband also wrote a letter to Mr. Clack which purported to
identify five possible replacement properties, including the Pleasant Hill and Skyland
properties. Petitioner husband backdated the letter to September 18, 1989, the date of the
Van Voorhis letter identifying potential replacement property.

Petitioners reported the transfer of the Antioch property on their 1990 tax return as a
section 1031 exchange qualifying for nonrecognition of gain and reported that they
identified replacement property on September 18, 1989. Respondent determined that the
transaction did not qualify as a section 1031 exchange because petitioners did not timely
identify the replacement property. Accordingly, respondent determined that petitioners
must report the gain realized on the Antioch property.

Petitioners' accountant relied on the false letters solicited by petitioner husband from
Ms. Love and Mr. Fivey to prepare petitioners' 1989 and 1990 tax returns. Petitioners
indicated to their accountant that they exchanged the Antioch property pursuant to section
1031 and that the replacement properties had been identified within the 45-day
identification period. During the audit of their tax returns, petitioners' accountant
provided to respondent's revenue agent a copy of the backdated letter that petitioner
husband wrote to Mr. Clack identifying the Pleasant Hill and Skyland properties. Mr.
Fivey sent the Pleasant Hill letter to the revenue agent. Pursuant to a written plea
agreement with the U.S. Department of Justice, petitioner husband pleaded guilty to two
counts of violating section 7207 for causing the delivery of false documents to the
Internal Revenue Service (IRS).

Petitioners extended the period of limitations to assess and collect tax for 1989 and
1990 to December 31, 1994, pursuant to section 6501(c)(4). Respondent timely issued a
notice of deficiency for 1989 and issued a notice of deficiency for 1990 on April 12,
1996.
OPINION

Generally a taxpayer must recognize the entire amount of gain or loss on the sale or
exchange of property. Sec. 1001(c). Section 1031(a)(1) allows taxpayers to defer gain or
loss from exchanges of like-kind property held for business or investment purposes, as
distinguished from a cash sale of property followed by a reinvestment of the proceeds in
other property. Barker v. Commissioner, 74 T.C. 555, 561, 1980 WL 4456 (1980).
Section 1031(a)(3) governs nonsimultaneous like-kind exchanges. To qualify as a
nonsimultaneous like-kind exchange, the taxpayer must identify replacement property to
be received in the exchange within 45 days after the date the taxpayer transfers the
property relinquished in the exchange. Sec. 1031(a)(3)(A). In this case, the 45-day period
ended on October 6, 1989.

The parties dispute whether petitioners timely identified either the Pleasant Hill or
Skyland properties as replacement properties. Petitioners contend that they discussed
Pleasant Hill and Skyland with each other during the identification period. Petitioners
further allege that they drove by the properties while under construction and that
petitioner husband toured the construction site and inquired about building plans with
construction workers. Petitioners concede that they never indicated that they were
interested in acquiring Pleasant Hill or Skyland to the prior owners of either property,
their exchange intermediary/attorney, Mr. Clack, or any of their numerous real estate
agents. Petitioners contend that identification of replacement property to each other was
sufficient to meet the identification requirement of section 1031(a)(3)(A). Respondent
contends that petitioners did not consider purchasing Pleasant Hill or Skyland during the
identification period, and even if they did, petitioners did not adequately identify either
property.

Section 1031(a)(3) provides:

For purposes of this subsection, any property received by the taxpayer shall be treated
as property which is not like-kind property if--

(A) such property is not identified as property to be received in the


exchange on or before the day which is 45 days after the date
on which the taxpayer transfers the property relinquished in the
exchange, or
(B) such property is received after the earlier of--
(i) the day which is 180 days after the date on which the
taxpayer transfers the property relinquished in the
exchange, or
(ii) the due date (determined with regard to extension) for the
transferor's return of the tax imposed by this chapter for
the taxable year in which the transfer of the relinquished
property occurs.
The Secretary issued regulations under section 1031 after the years in issue which
require taxpayers to identify replacement property in a written document signed by the
taxpayer and sent to either (1) the person obligated to transfer the replacement property or
(2) any person involved in the exchange (e.g., a party, an intermediary, or an escrow
agent) other than the taxpayer or a disqualified person (the taxpayer's agent or a related
party). Sec. 1.1031(k)- 1(c)(2), Income Tax Regs. The regulations apply to transfers of
property made on or after June 10, 1991, or in limited cases, transfers made on or after
May 16, 1990. Sec. 1.1031(k)-1(o), Income Tax Regs.

As the regulations do not apply in this case, petitioners contend that during the years in
issue, the proper method of identification was ambiguous. They argue that section
1031(a)(3)(A) does not expressly require written identification or specify to whom
identification must be made. Petitioners also argue that the legislative history for section
1031(a)(3) does not clarify the required method of identifying replacement property. The
conference report provides

The conference agreement follows the Senate amendment except that transferors are
permitted 45 days after the transfer to designate the property to be received * * *. The
conferees note that the designation requirement in the conference agreement may be met
by designating the property to be received in the contract between the parties. It is
anticipated that the designation requirement will be satisfied if the contract between the
parties specifies a limited number of properties that may be transferred and the particular
property to be transferred will be determined by contingencies beyond the control of both
parties. * * * [H. Conf. Rept. 98-861, at 866 (1984), 1984-3 C.B. (Vol.2) 1, 120.]

Congress' primary concern in amending section 1031(a)(3) was to prevent long periods
of delay between the exchange of properties, as occurred in Starker v. United States, 602
F.2d 1341 (9th Cir.1979). H. Conf. Rept. 98-861, supra, 1984-3 C.B. at 120. Congress
added the 45- and 180-day requirements for like-kind exchanges to address this concern.

It is not necessary for us to decide whether identification must be in writing. Rather, we


must decide whether the steps taken by petitioners were sufficient. Petitioners have no
credible evidence that they had considered Pleasant Hill or Skyland as replacement
properties during the identification period. During that period, petitioners did not inform
anyone, either verbally or in writing, that they were interested in either property.
Petitioners first expressed an interest in acquiring Pleasant Hill in January 1990 when the
property was brought to their attention by Mr. Van Voorhis. Petitioner husband may have
briefly discussed Pleasant Hill with Mr. Fivey during the identification period. However,
petitioner husband concedes that he did not indicate to Mr. Fivey any intention to acquire
Pleasant Hill as replacement property until after the identification period had expired.
Petitioners first indicated their interest in the Skyland property on October 12, 1989.
Petitioners claim that they drove by the house with a real estate agent in the summer of
1989 while it was under construction. They did not express an interest in purchasing
Skyland at that time. They also contend that they drove by both properties by themselves
on several occasions and that petitioner husband viewed the construction site.
However, there is no evidence, other than their testimony, that petitioners considered
purchasing these properties or expressed an interest in the properties during the
identification period. Throughout the end of 1989, petitioners made a number of offers
and entered into purchase contracts on other properties as replacements for the Antioch
property, including an offer in December 1989. Petitioners claim that by October 6, 1989,
they had decided to purchase Pleasant Hill and Skyland. However, they rely solely on
their own testimony in that regard. Apart from their testimony there is no evidence that
they saw the Skyland property before October 12, 1989 or the Pleasant Hill property
before January of 1990. Even if they had seen either property on the dates alleged, that
would likely not be sufficient to meet the identification requirement.

Although petitioners are not specifically educated in tax matters they are sophisticated
real estate investors. Petitioners repeatedly discussed the identification requirement with
their advisers and were advised as to the adequate measures of identification. We find
that petitioners understood the importance of timely identification. Indeed, they asked
Ms. Love to identify Skyland to Mr. Clack when they made a verbal offer. Nevertheless,
they never disclosed their alleged interest in the Pleasant Hill or Skyland properties
during the identification period to anyone, not to Mr. Clack, their real estate agents, or the
prior owners. Petitioners failed to mention either property to Mr. Van Voorhis in
September 1989 when Mr. Van Voorhis prepared an identification letter to Mr. Clack.
Moreover, petitioner husband did not indicate any prior interest in Pleasant Hill and acted
as if he were unfamiliar with the property when Mr. Van Voorhis first approached him
about it. As petitioners knew and understood the need to timely identify replacement
property, it is highly improbable that petitioners would have kept any actual interest in
these properties to themselves. Under these circumstances, we find to be untrue
petitioners' testimony that their decisions to acquire Pleasant Hill and Skyland as
replacement property were made during the identification period. As further evidence of
the incredible nature of his testimony, petitioner husband repeatedly testified that he was
not familiar with the 45- day identification requirement. Yet, Mr Clack and several real
estate agents testified that they regularly discussed the requirement with petitioners and
that petitioner husband appeared to understand it.

We find that petitioners did not take any steps to identify Pleasant Hill or Skyland as
replacement property during the identification period. Moreover, if taxpayers were
permitted to identify replacement property between themselves without notifying an
unrelated party or another party to the exchange, the identification requirement would be
meaningless. Designation between married taxpayers would also create problems with
the limitation on the number of properties permitted to be identified and would
essentially be the equivalent of permitting taxpayers to identify an unlimited number of
replacement properties. See St. Laurent v. Commissioner, T.C. Memo.1996-150. We
conclude that petitioners did not identify the Pleasant Hill or Skyland properties as
replacement property within the time period required by section 1031(a)(3)(A).
Accordingly, the gain realized from the sale of the Antioch property is recognizable.

In the notices of deficiency, respondent determined the gain realized on the sale of the
Antioch property without regard to petitioners' basis in the property. Section 1001
provides that the gain from the sale of property is the excess of the amount realized over
the adjusted basis. The adjusted basis of property is its basis (cost) as determined under
section 1011 and as adjusted by section 1016. Sec. 1012. The basis is adjusted for the
costs of improvements and betterments made to the property. Sec. 1016(a)(1); sec.
1.1016-2(a), Income Tax Regs.

Petitioners paid $300,000 for 137 acres of the Antioch property and sold 117 acres of
the property in the transaction at issue in this case. Petitioners' original basis in the 117
acres, based on the $300,000 purchase price, is $256,204, as conceded by respondent.
Petitioners also expended approximately $30,000 in engineering and consulting costs to
improve the 137 acres of the Antioch property. We find that petitioners' basis in the 117
acres of the Antioch property is $281,825, and their gain realized is $3,687,175
($3,969,000-$281,825).

Fraud Penalty

Section 6663(a) imposes a penalty equal to 75 percent of any underpayment that is due
to fraud. Fraud is defined as an intentional wrongdoing designed to evade tax believed to
be owing. Edelson v. Commissioner, 829 F.2d 828, 833 (9th Cir.1987), affg. T.C.
Memo.1986-223; Bradford v. Commissioner, 796 F.2d 303, 307 (9th Cir.1986), affg.
T.C. Memo.1984-601. Respondent has the burden of proving fraud by clear and
convincing evidence. Sec. 7454(a); Rule 142(b). [FN3] To satisfy this burden, respondent
must prove that petitioners intended to evade taxes known to be owing by conduct
intended to conceal, mislead, or otherwise prevent the collection of taxes. Rowlee v.
Commissioner, 80 T.C. 1111, 1123, 1983 WL 14844 (1983).

The existence of fraud is a question of fact to be resolved upon consideration of the


entire record. DiLeo v. Commissioner, 96 T.C. 858, 874, 1991 WL 108769 (1991), affd.
959 F.2d 16 (2d Cir.1992); Estate of Pittard v. Commissioner, 69 T.C. 391, 1977 WL
3705 (1977). Fraud is never presumed and must be established by independent evidence
that establishes fraudulent intent. Edelson v. Commissioner, supra; Beaver v.
Commissioner, 55 T.C. 85, 92, 1970 WL 2247 (1970). Fraud may be proven by
circumstantial evidence because direct evidence of the taxpayer's fraudulent intent is
seldom available. Spies v. United States, 317 U.S. 492, 63 S.Ct. 364, 87 L.Ed. 418
(1943); Rowlee v. Commissioner, supra; Gajewski v. Commissioner, 67 T.C. 181, 199,
1976 WL 3591 (1976), affd. without published opinion 578 F.2d 1383 (8th Cir.1978).
The taxpayer's entire course of conduct may establish the requisite fraudulent intent.
Stone v. Commissioner, 56 T.C. 213, 223-224, 1971 WL 2605 (1971); Otsuki v.
Commissioner, 53 T.C. 96, 105-106, 1969 WL 1605 (1969).

Courts have developed several indicia of fraud, or "badges of fraud", which include:

(1) Understatement of income,


(2) inadequate books and records,
(3) failure to file tax returns
(4) implausible or inconsistent explanations of behavior
(5) concealment of assets
(6) failure to cooperate with tax authorities
(7) filing false Forms W-4,
(8) failure to make estimated tax payments,
(9) dealing in cash,
(10) engaging in illegal activity, and
(11) attempting to conceal illegal activity.

Douge v. Commissioner, 899 F.2d 164, 168 (2d Cir.1990); Bradford v. Commissioner,
supra at 307; Recklitis v. Commissioner, 91 T.C. 874, 910, 1988 WL 116976 (1988).
This list is nonexclusive. Miller v. Commissioner, 94 T.C. 316, 334, 1990 WL 20813
(1990).

The strongest evidence of fraud in this case consists of the false documents that
petitioner husband prepared and solicited to make it appear that petitioners expressed an
interest in the Pleasant Hill and Skyland properties within the identification period.
Submitting false documents to the IRS is an indication of fraud. Stephenson v.
Commissioner, 79 T.C. 995, 1007, 1982 WL 11202 (1982), affd. 748 F.2d 331 (6th
Cir.1984); Association Cable TV, Inc. v. Commissioner, T.C. Memo.1995-596

Petitioners contend that their attorney Mr. Clack advised them to obtain the false
documents. Petitioners maintain that they relied on Mr. Clack's advice and that they did
not know that written identification was required and did not realize the significance of
the false, backdated letters. We believe, however, that petitioner husband initiated the
idea of backdating documents and falsifying identification and, more importantly, that
petitioners knew their misrepresentations were fraudulent.

Mr. Clack maintains that it was petitioner husband's idea to falsify documents. In late
October 1989, petitioner husband suggested backdating and falsifying a purchase offer
and contract for another property not ultimately purchased by petitioners in order to
fraudulently obtain section 1031 tax deferral. Mr. Clack denies that he advised petitioners
to falsify documents to establish timely identification but admits that he assisted
petitioners in perpetrating this fraud. Mr. Clack provided a backdated sample letter that
petitioners used in soliciting the Pleasant Hill and Skyland letters. Mr. Clack contends
that he believed that petitioners in fact had expressed an interest in the Pleasant Hill and
Skyland properties during September to Ms. Love and Mr. Fivey and that he did not
know that the letters were false (other than being improperly backdated). Petitioners
received the sample letter from Mr. Clack before they expressed interest in acquiring
Pleasant Hill or Skyland. Most likely, petitioners obtained the letter because they
intended to create a false impression that they had timely identified whatever property
they acquired.

Petitioners had repeated discussions with their real estate agents and Mr. Clack about
the identification requirement and the need to adequately identify replacement property.
Mr. Clack advised petitioners of the need to acquire property that had been identified
during the 45-day period. Mr. Van Voorhis and other real estate agents counseled
petitioners to have written documentation of their identification. When Mr. Van Voorhis
first showed Pleasant Hill to petitioners, he informed them that it could not qualify as
replacement property because it was not timely identified. A letter attached to the
exchange agreement clearly informed petitioners of the need to identify property within
45 days of the sale of the Antioch property.

We find in this setting petitioners cannot rely on Mr. Clack's advice as an excuse for
their fraudulent conduct. They knew their actions were fraudulent because of the repeated
advice they received. Petitioners were not misled into committing fraud by their attorney,
as they contend. See Medieval Attractions N.V. v. Commissioner, T.C. Memo.1996-455.
We consider it probative that petitioner husband pleaded guilty to submitting false
documents to respondent's revenue agent in violation of section 7207. Although this
conviction does not alone establish fraudulent intent to evade taxes, it is evidence of
petitioner husband's intent and propensity to defraud. Petzoldt v. Commissioner, 92 T.C.
661, 701-702, 1989 WL 27845 (1989); Alvarez v. Commissioner, T.C. Memo.1995-414.

Petitioners are highly successful, effective, and sophisticated real estate investors. They
knew that they had not timely identified Pleasant Hill or Skyland as replacement property
and that the transaction did not qualify as a section 1031 exchange. Petitioners reported
the transaction as a section 1031 exchange and knowingly and deceptively deferred tax
on over $3.5 million in taxable gain. Petitioners willfully took steps to disguise the
taxable sale as a section 1031 exchange. Petitioner husband knowingly solicited
fabricated letters from Mr. Fivey and Ms. Love. He also knowingly intended to commit
fraud when he backdated a letter to Mr. Clack in which petitioner husband purported to
identify Pleasant Hill and Skyland. It is likely that petitioner husband intended this letter
to replace the Van Voorhis letter which identified 10 replacement properties, not
including either Pleasant Hill or Skyland. Petitioners were involved in the preparation of
these false documents and presented them to their accountant and to the IRS as part of
their tax returns and in support of their reporting during the audit.

Petitioners argue the false documents were not fraudulent because written identification
was not required under section 1031(a)(3)(A) and the regulations thereunder during the
years in issue. This case involved more than fabricated written identification. We have
found that petitioners did not show any interest in the Pleasant Hill property or the
Skyland property within the identification period, and we do not believe their self-serving
and uncorroborated testimony that, during the identification period, they discussed these
properties with each other and decided to buy them.

Although they knew that they had not identified Pleasant Hill or Skyland even verbally,
petitioners misrepresented to the IRS that they had in fact identified the replacement
property and reported the transaction as a section 1031 exchange. Petitioners knew that
they would owe a substantial amount of tax if they did not timely identify replacement
property. The law is clear with respect to this issue. Petitioners fabricated timely
identification and obtained false documents to substantiate their claim. Petitioners knew
that the letters were false and that their tax returns were false. The false letters, even if
not required for adequate identification, are evidence of fraud. See Association Cable TV,
Inc. v. Commissioner, T.C. Memo.1995-596.

Petitioners' conduct presents clear and convincing evidence of their intent to defraud.
Accordingly, petitioners are liable for a section 6663 fraud penalty for 1990.

To reflect the foregoing,

Decisions will be entered under Rule 155 in docket No. 3832-95 and for petitioners in
docket No. 7382-96.

FN1. Unless otherwise indicated, all section references are to the Internal Revenue Code
for the years in issue, and all Rule references are to the Tax Court Rules of Practice and
Procedure.

FN2. The stipulation of facts and the attached exhibits are incorporated herein by this
reference.

FN3. Petitioners had raised the defense that the period for assessment had expired when
respondent issued the notice of deficiency for the 1990 year. The 1990 year comes into
play in the context of this case if petitioners are entitled to installment sale treatment. In
that event respondent would also have the burden of proving that an exception to the
general period of limitations applies. Stratton v. Commissioner, 54 T.C. 255, 289, 1970
WL 2376 (1970). That question is mooted by our holding that petitioners are not entitled
to installment reporting. Even if petitioners had been successful on the installment
reporting issue, respondent has carried the burden of showing a fraudulent return, and,
therefore, the period for assessment would not have expired prior to issuance of the
deficiency notice. Sec. 6501(c)(1).

NONSIMULTANEOUS EXCHANGE: IDENTIFICATION:


DOBRICH(1998)

In the Dobrich case for 1998, the Tax Court was requested to review and provide a
Supplemental Memorandum Opinion involving the deficiencies in the earlier case at T.C.
Memo 1977-477. In that case, the Tax Court held that the taxpayers did not meet Code
§1031, the gain was recognizable, the taxpayers did not qualify for installment sale
treatment, and that taxpayers were liable for broad penalties under Code §6663. This case
essentially reaffirms the position that if the taxpayer does not meet the requirements
under Code §1031, there can be disastrous tax implications.

David DOBRICH and Naomi Dobrich, Petitioners


v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
No. 3832-95, 7382-96.
United States Tax Court.
T.C. Memo. 1998-39
1998 WL 30665 (U.S.Tax Ct.), 75 T.C.M. (CCH) 1687,
T.C.M. (RIA) 98,039
Jan. 29, 1998.

SUPPLEMENTAL MEMORANDUM OPINION

GERBER, Judge:
The Court filed a Memorandum Findings of Fact and Opinion in this case (T.C.
Memo.1997-477) on October 20, 1997, stating that a decision would be entered for
petitioners for 1990 (docket No. 7382-96) and pursuant to Rule 155 [FN1] as to 1989
(docket No. 3832-95). Respondent filed an unagreed computation for the 1989 taxable
year that would result in a $1,032,409 income tax deficiency and a $392,873.13
overpayment after considering payments made after issuance of the notice of deficiency.
Respondent's computation for 1989 would also result in a $774,307 fraud penalty under
section 6663. This opinion addresses the parties' controversy over the computation of the
decision(s) to be entered.

FN1. Unless otherwise indicated, Rule references are to the Tax Court Rules of Practice
and Procedure, and section references are to the Internal Revenue Code for the years in
issue.

Respondent had determined deficiencies in petitioners' 1989 and 1990 Federal income
tax in the amounts of $1,111,292 and $1,111,320, respectively, and section 6663(a) civil
fraud penalties for 1989 and 1990 of $833,469 and $833,490, respectively. Respondent
determined the income tax deficiency and penalty in the alternative for 1989 or 1990.

The issues we considered were: (1) Whether petitioners may defer recognition of gain
from the disposition of certain real property under section 1031, (2) if the transaction
does not qualify for section 1031 exchange, whether petitioners are entitled to report the
gain in 1990 under the installment sale method, and (3) whether petitioners are liable for
a fraud penalty under section 6663.

In T.C. Memo.1997-477, we decided that petitioners were not entitled to defer


recognition of gain under section 1031, the gain was recognizable in 1989, petitioners did
not qualify for installment sales treatment to place income in 1990, and petitioners were
liable for the section 6663 fraud penalty for 1989.

NONSIMULTANEOUS EXCHANGE: IDENTIFICATION:


TERRY D. SMITH

The Smith case illustrated a failure by the taxpayer to properly identify replacement
property within the 45-day rule provided under Code §1031 for a nonsimultaneous
exchange. Therefore, the exchange treatment was denied.
Terry D. SMITH, Petitioner,
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 843-95.
United States Tax Court.
T.C. Memo. 1997-109
1997 WL 87115 (U.S.Tax Ct.),
73 T.C.M. (CCH) 2158, T.C.M. (RIA) 97,109
March 3, 1997.

MEMORANDUM FINDINGS OF FACT AND OPINION

COLVIN, Judge:
Respondent determined a deficiency of $33,242 in petitioner's Federal income tax for
1990.

The issue for decision is whether petitioner may defer recognition of gain realized on
the sale of two properties pursuant to section 1031(a). We hold that he may not because
he failed to establish that he identified replacement property within 45 days after he
transferred the relinquished properties.

Unless otherwise indicated, section references are to the Internal Revenue Code as in
effect for the year in issue. Rule references are to the Tax Court Rules of Practice and
Procedure.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found.

A. Petitioner
Petitioner lived in Charlotte, North Carolina, when he filed the petition in this case.
Petitioner has been a practicing certified public accountant since 1969. Among his clients
are a large number of individuals and small to medium-sized businesses.

In 1989, petitioner and David E. Parrish (Parrish) owned properties at 4938 Monroe
Road, Charlotte, North Carolina (the Monroe Road property), and at 1900 East Seventh
Street, Charlotte, North Carolina (the Seventh Street property).

B. Petitioner's Sale of the Properties


1. The Monroe Road Property
In December 1989, petitioner contracted to sell his interest in the Monroe Road
property to Mr. and Mrs. Thomas Hauch and Mr. and Mrs. Everett Wohlbruck (the
Hauchs and the Wohlbrucks). Petitioner sent a letter dated December 15, 1989, to the
Hauchs' and Wohlbrucks' attorney, Charles O. Dubose (Dubose). Dubose was an attorney
at the law firm of Kennedy, Covington, Lobdell, & Hickman (KCLH). The letter
included the following statement:

This is to confirm our conversation today regarding Monroe property as a tax free
exchange for my one-half interest in the property. Although I have not yet identified the
replacement property, I do intend to perfect an exchange.

Petitioner transferred his one-half interest in the Monroe Road property to the Hauchs
and Wohlbrucks on February 5, 1990. The contract of sale did not specify any
replacement property

KCLH sent an internal memo to Randall W. Lee at KCLH's Southpark Office, which
included the following statement:

With respect to Mr. Smith's one half undivided interest in the Monroe Road property,
he intends to effect a tax free exchange and, therefore, wants us to hold his portion of the
net proceeds from the sale in escrow pending further instructions relative to the tax free
exchange.

2. The Seventh Street Property


On January 9, 1990, petitioner and Parrish contracted to sell the Seventh Street property
to Donald P. McCurdy (McCurdy). Paragraph 6(a) of the contract of sale stated as
follows:

Sellers intend for this transaction to qualify under the tax-free exchange provisions of
the IRS Code and buyer agrees to execute any related documents required to do so.

The contract of sale did not identify any replacement property. Petitioner transferred his
interest in the Seventh Street property to McCurdy on February 14, 1990. Kenneth F.
Essex (Essex) was McCurdy's attorney for the closing of the Seventh Street property
transaction. Essex's law firm was Essex, Richards, Morris, & Jordan, P.A. Essex was also
petitioner's escrow agent for petitioner's portion of the proceeds from the sale of the
Seventh Street property. The record does not show whether the escrow agreement
between petitioner and Essex was oral or written.

3. Handling of the Proceeds From the Sale of Both Properties


In a letter dated March 2, 1990, Essex confirmed that he invested petitioner's share of
the proceeds from the Seventh Street property ($30,072) in a certificate of deposit with
the Bank of Mecklenburg. Around March 20, 1990, KCLH transferred the proceeds from
the sale of petitioner's interest in the Monroe Road property ($9,882), by check drawn on
KCLH's trust account to Essex's law firm. Essex added those proceeds to the certificate of
deposit with the Bank of Mecklenburg.

C. Petitioner's Purchase of the East Boulevard Property


On February 27, 1990, H.P. Smith (Smith), a real estate broker with MECA properties,
took petitioner to tour property at 910 East Boulevard, Charlotte, North Carolina (the
East Boulevard property), and gave him some preliminary information about the
building. The East Boulevard property was well-located for petitioner's accounting
practice. East Boulevard was one of two streets in Charlotte on which petitioner was
considering buying replacement property. It appeared that the property could possibly be
suitable for petitioner, but there were several points that had to be resolved. First, the East
Boulevard property needed to be substantially rehabilitated to make it usable. Second,
petitioner thought the sellers' price was too high. Third, petitioner wanted to structure the
financing with a high debt-to-value ratio. In order to buy the property, petitioner wanted
to obtain some seller financing. Fourth, petitioner could not decide if the property was
acceptable without the approval of Frederick R. Black (Black), his new partner. Black
saw the East Boulevard property in early March 1990. Petitioner did not look at any
properties after February 27, 1990; he was extremely busy because of the tax season.

Smith intended to talk to petitioner on March 26 about making an offer on the East
Boulevard property, but it is unknown whether he did so. Petitioner and Black did not
make an offer to buy the property until May 14, 1990.

On May 25, 1990, petitioner and Black, as SB Properties, a North Carolina general
partnership, contracted with Harold H. and Loretta K. Brown (Mr. and Mrs. Brown) to
buy the East Boulevard property. Paragraph (2) of Addendum "A" of the Offer to
Purchase and Contract states as follows:

Exchange Provision. Buyer may wish to qualify this transaction under Section 1031 of
the Internal Revenue Code; therefore, Buyer shall have the right to cause Seller to accept
suitable property in exchange for all or part of Seller's property hereunder; provided that,
property exchanged to Seller shall be subject to immediate purchase by a third party, and
provided further that the cost to Seller of accepting the exchange property and
transferring it to a third party shall be reimbursed to Seller by Buyer, and provided that
the terms and conditions of such exchange shall in no event be more onerous and
burdensome to Seller.

On June 19, 1990, Mr. and Mrs. Brown transferred the East Boulevard property to
petitioner and Black as tenants in common. Petitioner's share of the cash portion of the
purchase price was $16,000. Of that amount, petitioner paid $2,500 as earnest money
when the contract was signed. Also on June 19, 1990, Essex redeemed the certificate of
deposit, and thereafter disbursed $20,843 to petitioner and bought two certificates of
deposit for $10,000 each. Petitioner deposited the $20,843 he received in his account with
United Carolina Bank. Petitioner used the two certificates of deposit as partial collateral
for a $50,000 loan to renovate the East Boulevard property.

D. Petitioner's 1990 Tax Return


On the Form 8824, Like-Kind Exchanges, attached to petitioner's 1990 income tax
return, petitioner reported that he transferred property as part of a like-kind exchange on
February 21, 1990. In fact, petitioner transferred his interests in the Monroe Road and
Seventh Street properties on February 5 and February 14, 1990, respectively. Also on that
Form 8824, petitioner reported that he identified replacement property on April 1, 1990.
April 1, 1990, is the 46th day after February 14, 1990, and the 55th day after February 5,
1990, the dates that petitioner transferred his interests in the Seventh Street and Monroe
Road properties, respectively.

OPINION

A. Background and Contentions of the Parties


The issue for decision is whether petitioner may defer the gains realized on the sale of
the Monroe Road and Seventh Street properties pursuant to section 1031(a). Generally, a
taxpayer must recognize gain or loss on the sale of real property. Sec. 1001(c). However,
section 1031(a) provides for the deferral of gain or loss when there is an exchange of
like-kind business or investment properties, as distinguished from a cash sale of property
by the taxpayer and a reinvestment of the proceeds in other property. Barker v.
Commissioner, 74 T.C. 555, 561 (1980).

Petitioner contends that his sale of the Monroe Road and Seventh Street properties and
subsequent purchase of the East Boulevard property qualifies as a nontaxable exchange
under section 1031(a). Respondent contends that those transactions do not qualify
because:

(1) petitioner did not identify the replacement property within 45 days of the sale of the
relinquished properties;
(2) petitioner received the proceeds from the sale of the relinquished properties; and
(3) the sales and purchase were not an "exchange" as required by section 1031(a).
Respondent's determinations are presumed correct, and petitioner bears the burden of
proof. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).

Petitioner must rebut all three of respondent's arguments to qualify under section 1031(a).

B. Identification Requirement
Section 1031(a)(3)(A) requires replacement property to be identified within 45 days
after the date the taxpayer transfers the property relinquished in the exchange. [FN1] The
parties dispute whether petitioner identified the East Boulevard property within 45 days
after he transferred the Monroe Road and Seventh Street properties. Petitioner contends
that he orally identified the East Boulevard property within 45 days after he transferred
the relinquished properties and points out that he saw no other property after he saw the
East Boulevard property on February 27, 1990. Respondent argues (1) that an oral
identification is not sufficient under section 1031(a)(3)(A), and (2) that even if an oral
identification is sufficient, petitioner failed to identify replacement property, orally or
otherwise, within 45 days.

We are not convinced that petitioner identified the East Boulevard property within 45
days after February 5 or 14; i.e., by March 22 or 31. This conclusion is supported by
petitioner's 1990 tax return. Petitioner reported on his 1990 tax return that he identified
the replacement property on April 1, 1990. April 1, 1990, is the 55th day after petitioner
sold the Monroe Road property and the 46th day after he sold the Seventh Street
property. Statements in a tax return are admissions and will not be overcome without
cogent evidence that they are wrong. Waring v. Commissioner, 412 F.2d 800, 801 (3d
Cir. 1969), affg. per curiam T.C. Memo. 1968-126; Estate of Hall v. Commissioner, 92
T.C. 312, 337-338 (1989); Lare v. Commissioner, 62 T.C. 739, 750 (1974) ("Statements
made in a tax return signed by a taxpayer may be treated as admissions."), affd. without
published opinion 521 F.2d 1399 (3d Cir. 1975); Rankin v. Commissioner, T.C. Memo.
1996-350; Sirrine Bldg. No. 1 v. Commissioner, T.C. Memo. 1995-185 ("As statements
of a party opponent, the returns are admissions under rule 801(d)(2) of the Federal Rules
of Evidence."); Estate of Ford v. Commissioner, T.C. Memo. 1993-580, affd. 53 F.3d 924
(8th Cir. 1995); Mooneyham v. Commissioner, T.C. Memo. 1991-178; Estate of McGill
v. Commissioner, T.C. Memo. 1984-292; Estate of Kreis v. Commissioner, T.C. Memo.
1954-139, affd. 227 F.2d 753 (6th Cir. 1955); see United States v. Dinnel, 428 F. Supp.
205, 208 (D. Ariz. 1977) ("Statements made in an income tax return constitute
admissions."), affd. without published opinion 568 F.2d 779 (9th Cir. 1978); Kaltreider v.
Commissioner, 28 T.C. 121 (1957), affd. 255 F.2d 833 (3d Cir. 1958). There is no cogent
or persuasive evidence that petitioner identified the replacement property before April 1,
1990. When petitioner saw the East Boulevard property on February 27, 1990, he liked
the location, but he thought the price was too high, he had specific requirements for
financing terms, he knew he would need to make (and arrange financing for) extensive
renovations, and Black had not yet approved the property. According to petitioner, Black
gave his approval in early March.

Petitioner testified that he instructed Smith on February 27, 1990, that "we would like
to pursue" the purchase of that building, but Smith did not corroborate that or act in the
following weeks as if he had been instructed to arrange the purchase. Petitioner did not
begin to negotiate the price with the sellers until May. There is no evidence that his
concerns (other than approval by Black) were satisfied before May. We give more weight
to his statement on his 1990 tax return that he identified the property as replacement
property on April 1, than to his trial testimony that he identified it earlier.

We conclude that petitioner has not shown that he identified the East Boulevard
property as replacement property within the time required by section 1031(a)(3)(A); i.e.,
by late March, 1990. Petitioner may not defer recognition of the gains realized from the
sale of the Monroe Road or Seventh Street properties under section 1031(a)(1) because
he did not identify replacement property within 45 days after the date he relinquished
either property. Sec. 1031(a)(3)(A).

C. Respondent's Other Contentions


Because we find that petitioner did not identify replacement property on or before
March 30, 1990, we need not decide respondent's contention that an oral identification
does not meet the identification requirement under section 1031(a)(3)(A).

Similarly, we need not decide respondent's contentions that petitioner's sale of the
Monroe Road and Seventh Street properties is ineligible for like-kind exchange treatment
under section 1031(a) because petitioner constructively received the proceeds from the
sale of each of those properties and that the sales and purchase were not an exchange as
required by section 1031(a).

Decision will be entered for respondent.

NONSIMULTANEOUS EXCHANGE: REPLACEMENT NOT TIMELY:


ST. LAURENT

The issue in the St. Laurent case examined the question as to whether Code §1031 was
met to allow a tax deferral. This involved a nonsimultaneous exchange and whether
proper identification of the replacement property was accomplished by the taxpayer.

The Court concluded that the taxpayer properly identified the replacement property
within the meaning of Code §1031; therefore, the transaction qualified for exchange
treatment on this issue.

However, going further, the Court said the connected issue was also whether the
replacement property was timely received. The Court concluded that the taxpayer did not
receive the qualified property on a timely basis. (The taxpayer received the replacement
property 194 days after the transfer of the taxpayer's property, not within 180 days.)
Therefore, the Court concluded that the transaction did not meet the requirements, in toto,
of Code §1031. Gain was recognized.

The Court held that, although no Regulations were issued at the time of the case in
question, which involved the year 1988, the Court held that the clear factual position was
that the transfer of the replacement property did not take place until 194 days after the
transfer of the relinquished property. Therefore, Code §1031 was not met as to the 180-
day rule.

Raymond ST. LAURENT, Petitioner,


v.
COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 23048-93.
United States Tax Court.
T.C. Memo. 1996-150
1996 WL 131431 (U.S.Tax Ct.),
71 T.C.M. (CCH) 2566, T.C.M. (P-H) 96,150
March 25, 1996.

MEMORANDUM FINDINGS OF FACT AND OPINION

WELLS, Judge:
Respondent determined a deficiency of $125,887 in petitioner's 1988 Federal income
tax. After concessions, the only issue remaining for decision is whether, pursuant to
section 1031(a), petitioner may defer recognition of gain realized upon the sale of certain
real property. Unless otherwise indicated, all section references are to the Internal
Revenue Code as in effect for the year in issue, and all Rule references are to the Tax
Court Rules of Practice and Procedure.

FINDINGS OF FACT

At the time the petition in the instant case was filed, petitioner resided in Lewiston,
Maine.

During 1988, petitioner and his ex-wife, Phyllis St. Laurent, owned, as tenants in
common, an apartment complex known as RPDS Estates (RPDS) located in Auburn,
Maine. Petitioner decided to sell RPDS and acquire other real property in which Ms. St.
Laurent would not have an interest. Petitioner intended to dispose of his interest in RPDS
by exchanging it for other property in a manner that would entitle him to nonrecognition
treatment of the gain realized pursuant to section 1031(a).

On May 9, 1988, petitioner and Ms. St. Laurent agreed to sell RPDS to Richard and
Barbara Labbe for $1,900,000. The purchase and sale agreement (sale agreement) signed
by them provided that "It is agreed between the parties that Purchasers shall assist Seller
in consummating a Section 1031 Tax Deferred Exchange. Seller shall indemnify
Purchaser of any legal or accounting costs of said exchange."

After the sale agreement was signed, petitioner began looking for property to replace
his interest in RPDS, but he had not selected replacement property by the time the sale of
RPDS closed. The closing was delayed pending regulatory approval of the sale and
performance of certain work on RPDS. The closing took place November 4, 1988, and on
that date petitioner and Ms. St. Laurent transferred RPDS to the Labbes for $1,880,000.
As part of the closing, the sale agreement was amended (amendment) to provide
procedures by which an exchange of properties would be effected. The amendment
provided in pertinent part:

In lieu of the terms of sale described above in this Agreement, the Sellers may, at their
exclusive option, designate one or more properties (the "Exchange Property") to be
acquired by Buyer and exchanged with the Sellers for the Property to be transferred
hereunder in a manner intended to qualify as a tax free exchange of properties under
Section 1031 of the United States Internal Revenue Code of 1986, as amended (the
"Exchange"). Buyer makes no representation that the Exchange will qualify under
Section 1031 of the U.S. Internal Revenue Code of 1986, as amended. Buyer agrees to
cooperate with the Sellers in the purchase of the Exchange Property designated by the
Sellers, including negotiation for the purchase of the Exchange Property; to execute, but
not otherwise prepare, contracts, documents and instruments as requested in writing by
the Sellers; to purchase the Exchange Property designated by the Sellers; and to execute
all other documents necessary to consummate the Exchange as reasonably requested in
writing by the * * * Sellers. Buyer shall have no obligation to find or select the Exchange
Property; shall not be responsible for the negotiation of the terms of such acquisition or
the preparation of the documents containing such terms; shall not be responsible for the
failure of such purchase of the Exchange Property to be fully closed or settled; shall not
be required to advance any funds on behalf of the Exchange prior to the settlement
hereunder; and shall not be required to advance any funds above the purchase price of the
Property and other sums otherwise payable by Purchaser hereunder for the Property, as a
result of any such Exchange. The Exchange shall be accomplished by any of the
following methods, at the sole option of the Sellers:

(B)
A delayed like kind exchange, whereby the purchase price shall be paid by Buyer to
Coastal Savings Bank of Portland, Maine (the "Escrow Agent"), as escrow holder, for a
term of one hundred eighty (180) days after settlement (the "Exchange Period") and the
deed conveyed to Buyer and the settlement otherwise consummated as elsewhere herein
provided. The entire purchase price shall be held by the Escrow Agent in an interest-
bearing account. Within forty- five (45) days of the settlement (the "Designation
Period"), the Sellers may designate in writing the Exchange Property to be acquired by
Buyer with the escrowed money, the costs of which are to be paid from the escrowed
money. If the Sellers fail to designate an Exchange Property within the Designation
Period, then upon the expiration of the Designation Period, the Escrow Agent shall pay to
the Sellers the escrowed money and all interest accrued thereon. If the Sellers designate
the Exchange Property during the Designation Period, but the Exchange Property is not
transferred to the Sellers before the end of the Exchange Period, then upon termination of
the Exchange Period, the Escrow Agent shall pay to the Sellers the escrowed money and
all interest accrued thereon. The Sellers shall have no right to receive the escrowed
money or interest accrued thereon prior to the earlier of (i) settlement on the Exchange
Property, (ii) termination of the Designation Period without the Sellers having designated
the Exchange Property, or (iii) termination of the Exchange Period. All funds remaining
in the escrow upon termination of the Exchange Period or after settlement on the
Exchange shall, after paying the Exchange Price, be paid to the Sellers.

(C)
Any other arrangement mutually satisfactory to the Sellers and Buyer whereby the
Exchange Property is conveyed to the Sellers and the Property is conveyed to Buyer.

Two checks in the amount of $390,500.30, made payable to the order of Coastal
Savings Bank-Escrow Agent (escrow agent), were received by petitioner and Ms. St.
Laurent at the closing. Petitioner delivered his check to the escrow agent on November 4,
1988, and it was deposited in an escrow account that was opened for the benefit of
petitioner on November 14, 1988. A bank officer assisted petitioner in establishing the
escrow account, and thereafter, the officer's function was as a signatory on the account.
The officer was not an agent of petitioner.

Petitioner continued to search for suitable exchange properties subsequent to the


closing on RPDS, viewing 40 to 50 properties. The Labbes did not search for the
properties, and petitioner did not discuss with them the properties he was considering.
Petitioner was advised to furnish a list of replacement properties to the escrow agent
because it was required under the law governing like-kind exchanges. Pursuant to that
advice, petitioner sent a letter dated December 16, 1988, to the escrow agent in which he
listed 20 properties that were identified pursuant to section 1031 as like-kind property to
be received in exchange for his interest in RPDS. The letter was received by the escrow
agent on or before December 19, 1988. The properties designated included Hillview
Estates (Hillview), a 40-unit trailer park in Turner, Maine, and a lot on Sheffield Street in
Lewiston, Maine (Sheffield lot).

Petitioner subsequently negotiated for the purchase of Hillview, and, on January 30,
1989, petitioner signed an agreement to buy Hillview. The Labbes were not parties to the
agreement. The agreed purchase price was $500,000, consisting of $390,000 to be paid
from the escrow account and a $110,000 seller-financed mortgage. By letter dated March
20, 1989, petitioner requested the escrow agent to release the funds in the escrow account
to the law firm handling the closing for Hillview. On March 22, 1989, petitioner closed
on Hillview. The Labbes did not participate in, nor were they present at, the closing.

Petitioner and Ms. St. Laurent timely filed a joint Federal income tax return for 1988 on
April 15, 1989. They did not request an extension of time to file such return.

On May 17, 1989, petitioner closed on the Sheffield lot.

OPINION

Section 1001 generally requires recognition of the entire amount of gain or loss on the
sale or exchange of property. Section 1031(a)(1), however, provides for the
nonrecognition of such gain or loss 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." For transfers after July 18, 1984, section 1031(a)(3), enacted as part of the
Deficit Reduction Act of 1984 (DEFRA), Pub. L. 98-369, sec. 77(a), 98 Stat. 494, 595,
governs deferred like-kind exchanges. Section 1031(a)(3) provides:

(3) Requirement that property be identified and that exchange be


completed not more than 180 days after transfer of exchanged
property.--For purposes of this subsection, any property
received by the taxpayer shall be treated as property which is
not like-kind property if--
(A) such property is not identified as property to be received in
the exchange on or before the day which is 45 days after
the date on which the taxpayer transfers the property
relinquished in the exchange, or
(B) such property is received after the earlier of--
(i) the day which is 180 days after the date on which the
taxpayer transfers the property relinquished in the
exchange, or
(ii) the due date (determined with regard to extension) for
the transferor's return of the tax imposed by this
chapter for the taxable year in which the transfer of
the relinquished property occurs.

Although the transactions in issue are deferred like-kind exchanges the tax
consequences of which are governed by section 1031(a)(3), we precede our consideration
of the statute by looking to certain pre-DEFRA case law that continues to be generally
applicable to like-kind exchanges. In structuring their transactions as tax-deferred like-
kind exchanges, taxpayers have been allowed great latitude. Biggs v. Commissioner, 69
T.C. 905, 913 (1978), affd. 632 F.2d 1171 (5th Cir. 1980). For instance, an agreement to
sell property for cash may be converted into a like-kind exchange before substantial
implementation of the transaction occurs. Coupe v. Commissioner, 52 T.C. 394, 405
(1969). Multiple parties may be involved in an exchange where the potential buyer of the
taxpayer's property does not own any property at the time that the agreement to exchange
is signed. Biggs v. Commissioner, supra at 913-914. Exchange property need not be
identified at the time an agreement to effect an exchange is made. Alderson v.
Commissioner, 317 F.2d 790 (9th Cir. 1963), revg. 38 T.C. 215 (1962). Proceeds of the
sale of property to be exchanged may be placed in escrow and, provided the taxpayer
does not constructively receive the proceeds, an exchange involving property acquired
with the proceeds will qualify for the benefits of section 1031(a). Garcia v.
Commissioner, 80 T.C. 491, 499-500 (1983). The taxpayer may locate and negotiate for
the property to be exchanged. Biggs v. Commissioner, supra at 915. The buyer need not
hold title to the exchange property received by the taxpayer. Biggs v. Commissioner, 632
F.2d at 1177. Where a preference for exchange is manifest, and an exchange actually
occurs, courts generally ignore the possibility that a sale of the taxpayer's property may
occur if the exchange does not actually take place. Mercantile Trust Co. v.
Commissioner, 32 B.T.A. 82, 87 (1935).

Although considerable latitude has been allowed by the courts with respect to the
structure of like-kind exchanges, that latitude is not open ended. Estate of Bowers v.
Commissioner, 94 T.C. 582, 590 (1990). A taxpayer's intent to effect a section 1031(a)
transaction is not determinative of the transaction's tax treatment, although intent is given
deference where the parties to the transaction have acted consistently therewith. Garcia v.
Commissioner, supra at 498.

In the instant case, respondent makes two principal arguments that the RPDS/Hillview
exchange transaction fails to qualify for tax-deferred treatment pursuant to section
1031(a). Respondent's first objection is that, in acquiring Hillview himself, petitioner
failed to observe the terms of the amendment to the sale agreement that provided that the
Labbes would purchase the property to be exchanged for his interest in RPDS. Secondly,
respondent contends that petitioner's identification of 20 replacement properties exceeds
the limitation on the number of replacement properties that may be designated pursuant
to section 1031(a)(3), and that the particular replacement property received in the
exchange was not subject to determination by contingencies beyond the control of the
parties to the exchange.
As to respondent's first contention, the amendment to the sale agreement makes clear
that the manner in which the exchange transaction was to be effected was almost
exclusively within petitioner's control. We view the Labbes' undertakings in the
amendment with respect to the acquisition of property to be exchanged for petitioner's
interest in RPDS as merely accommodations to petitioner to ensure that the Labbes would
perform whatever acts that might be deemed necessary to cause an exchange to qualify
for like-kind exchange treatment pursuant to section 1031(a). Moreover, the amendment
provides that, in addition to the methods set forth therein, the exchange of petitioner's
interest in RPDS for like-kind property may be effected in any other manner mutually
satisfactory to the parties thereto.

Respondent concedes that it was not necessary for the Labbes to take title to Hillview in
order for the exchange of petitioner's interest in RPDS for such property to meet the
requirements of section 1031(a). See Biggs v. Commissioner, 632 F.2d at 1177.
Consequently, we do not consider it significant, for purposes of section 1031(a), that the
parties to the amendment did not follow the procedure for acquiring the replacement
property (i.e., Hillview). Moreover, by their conduct, we treat petitioner and the Labbes
as having adopted, pursuant to the provisions of the amendment, a mutually satisfactory
alternative method for accomplishing the exchange of petitioner's interest in RPDS for
Hillview.

We next consider respondent's argument concerning the provisions of section


1031(a)(3). As noted above, respondent argues that petitioner's identification of
replacement properties did not satisfy section 1031(a)(3)(A) because (1) petitioner
identified 20 properties as replacement properties, and (2) the particular replacement
properties to be received were not to be determined by contingencies beyond the control
of the parties to the exchange. Respondent relies on the following passage in the
conference report on DEFRA:

The conferees note that the designation requirement in the conference agreement may
be met by designating the property to be received in the contract between the parties. It is
anticipated that the designation requirement will be satisfied if the contract between the
parties specifies a limited number of properties that may be transferred and the particular
property to be transferred will be determined by contingencies beyond the control of both
parties. For example, if A transferred real estate in exchange for a promise by B to
transfer property 1 to A if zoning changes are approved and property 2 if they are not, the
exchange would qualify for like-kind treatment. * * * [H. Conf. Rept. 98-861, at 866
(1984), 1984-3 C.B. (Vol. 2) 1, 120; emphasis supplied.]

After the year in issue, the Commissioner issued regulations providing that, in general,
a taxpayer may identify either (1) a maximum of three properties as replacement
properties, or (2) any number of properties provided the fair market value of the
designated properties does not exceed 200 percent of the fair market value of all
properties relinquished by the taxpayer in the exchange. Sec. 1.1031(k)-1(c)(4), Income
Tax Regs., T.D. 8346, 1991-1 C.B. 150, 157. The regulations, however, are prospective
only, as they apply to transfers of property made on or after June 10, 1991, or in certain
cases, to transfers made on or after May 16, 1990. [FN1] Sec. 1.1031(k)-1(o), Income
Tax Regs., T.D. 8346, 1991-1 C.B. at 165. The Commissioner included no requirement in
the regulations that the particular replacement property to be received by a taxpayer be
determined by contingencies beyond the control of the parties to the exchange. Sec.
1.1031(k)-1(c), Income Tax Regs., T.D. 8346, 1991-1 C.B. at 156.

Petitioner argues that section 1031(a)(3)(A) does not expressly limit to less than 20 the
number of replacement properties that may be designated and that the exchange of
petitioner's interest in RPDS for Hillview complied with the literal language of section
1031(a)(3). We agree.

As the regulations are not before us, the issue presented in the instant case is one of
statutory interpretation. In construing section 1031(a)(3)(A), our task is to give effect to
the intent of Congress, and we must begin with the statutory language, which is the most
persuasive evidence of the statutory purpose.

Nonetheless, we do believe that Congress intended that taxpayers identify only a finite
number of replacement properties. [FN3] To construe the statute otherwise, i.e., as
allowing an unlimited number of replacement properties to be identified, would make the
identification requirement meaningless. The fact that Congress included an identification
requirement suggests that an identification of an unlimited number of properties could
result in none being identified.

In the instant case, however, we need not, and do not, decide the outer limit of how
many replacement properties the statute permits taxpayers to identify. Petitioner's effort
to comply with the statute by identifying 20 specific properties to be received in the
exchange appears to have been made in good faith and does not cause an absurd result,
given the fact that the statute is silent as to the permissible number and the legislative
history is an unreliable indicator of the proper limitation. [FN4] Petitioner sought advice
and, because the regulations were not published, even in proposed form, at the time the
identification was made, [FN5] neither petitioner nor his adviser was on notice that the
Commissioner would take the position that the number of replacement properties that
could be identified pursuant to the statute generally would be limited to three.
Consequently, a trap for unwary taxpayers was set. [FN6]

We also do not accept respondent's contention that petitioner's identification of


replacement properties did not satisfy section 1031(a)(3)(A) because the determination of
the particular replacement property or properties to be received was not based on
contingencies beyond the control of the parties to the exchange. As noted above, the
legislative history relied on by respondent states: "It is anticipated that the designation
requirement will be satisfied if * * * the particular property to be transferred will be
determined by contingencies beyond the control of both parties." H. Conf. Rept. 98-861,
supra at 866, 1984-3 C.B. (Vol. 2) at 120. As we stated above, we believe that Congress
was merely illustrating that a contingent identification would satisfy the statutory
requirement. It does not appear to mean, even by implication, that an identification of
multiple properties without a contingency would not satisfy the identification
requirement. As with the number of replacement properties that may be identified, we
similarly consider the conference report inconclusive as to any contingency requirement.
As noted above, the Commissioner did not see fit to adopt such a requirement in the
regulations. We do not believe that our construction of the statute as not imposing a
contingency requirement would make the identification requirement meaningless.
Accordingly, we are not persuaded that Congress intended that an identification of
replacement properties would satisfy the identification requirement only if the particular
property to be received were to be determined by contingencies beyond the control of the
parties to an exchange.

Consequently, we conclude that petitioner made a valid identification of replacement


properties within the statutorily prescribed period and that Hillview constitutes property
of a like kind received in exchange for petitioner's interest in RPDS pursuant to section
1031(a)(3).

Petitioner's exchange of his interest in RPDS for the Sheffield lot, however, does not
qualify as a like-kind exchange pursuant to the provisions of section 1031(a)(3). As noted
above, section 1031(a)(3)(B) provides that, in order to be considered like-kind property,
replacement property may not be received after the earlier of (1) 180 days after the
transfer of property relinquished in such exchange, or (2) the due date of the return,
including extensions, for the year in which the relinquished property is transferred.
Petitioner's return for 1988, the year in which the transfer of his interest in RPDS
occurred, was due on April 15, 1989. That due date was less than 180 days after the
transfer of his interest in RPDS, and so it marks the end of the time allowed for
completing the exchange of such interest for like-kind property. Petitioner did not receive
the Sheffield lot until May 17, 1989. Consequently, petitioner failed to complete the
exchange of his interest in RPDS for the Sheffield lot within the statutorily prescribed
time limit. Sec. 1031(a)(3)(B)(ii). Furthermore, respondent contends, and petitioner does
not dispute, that the transfer of the Sheffield lot to petitioner occurred 194 days after
petitioner transferred his interest in RPDS. [FN7] Consequently, the exchange of
petitioner's interest in RPDS for the Sheffield lot was not completed within the 180-day
period prescribed by section 1031(a)(3)(B)(i). Accordingly, the Sheffield lot is not
property of a like kind received in exchange for petitioner's interest in RPDS for purposes
of the statutory provisions governing deferred like-kind exchanges. Sec. 1031(a)(3).

In sum, we hold that petitioner must recognize gain realized upon the disposition of his
interest in RPDS only with respect to the exchange of his interest in RPDS for the
Sheffield lot.

THE "FINAL WORD"

The following two articles summarize the current status of nonsimultaneous exchanges,
as evidence by current Regulations.

See the following article that finalizes these Proposed Regulations.


[Changes In Exchanges: Proposed Regulations Affect Nonsimultaneous Exchanges 1]
[Changes In Exchanges: Proposed Regulations Affect Nonsimultaneous Exchanges 2]
[Changes In Exchanges: Proposed Regulations Affect Nonsimultaneous Exchanges 3]
[Changes In Exchanges: Proposed Regulations Affect Nonsimultaneous Exchanges 4]
[Changes In Exchanges: Proposed Regulations Affect Nonsimultaneous Exchanges 5]

EXCHANGES: INTERMEDIARY: RELATED PARTIES:


PRIVATE LETTER RULING 9525002

Under the limited scope of the Ruling, there was a tax-deferred exchange with the use
of an intermediary. However, note the concern with related parties, as mentioned in the
Ruling.

PRIVATE LETTER RULING 9525002


Section 1031 -- EXCHANGE of Property Held for Productive Use or Investment
February 23, 1995
Publication Date: June 23, 1995

The simultaneous transfers of like-kind properties, of approximately equal value


through a qualified intermediary, is treated as an EXCHANGE. In this case, Intermediary
entered into a written agreement with Taxpayer. Pursuant to that agreement, Intermediary
acquired Taxpayer's Relinquished Properties, transferred Relinquished Properties,
acquired Replacement Properties and transferred Replacement Properties to Taxpayer.
Legal title was acquired and transferred by Intermediary. Intermediary also agreed with
the other parties to transfer Taxpayer's Relinquished Properties to them and to transfer
their properties to Taxpayer as Replacement Properties. [FN2]

Therefore, as to Taxpayer, the transaction constitutes a like-kind EXCHANGE that


qualifies for nonrecognition of gain or loss.

However, since related persons are also involved in the entire EXCHANGE transaction,
Taxpayer is also cautioned as to the possible application of section 1031(F) to its case.
Section 1031(F)(1) of the Code provides that if

(A) a taxpayer EXCHANGES property with a related person,


(B) there is nonrecognition of gain or loss to the taxpayer under
this section with respect to the EXCHANGE of such property
(determined without regard to this subsection), and
(C) before the date 2 years after the date of the last transfer which
was part of such EXCHANGE
(i) the related person disposes of such property or
(ii) the taxpayer disposes of the property received in the
EXCHANGE from the related person which was of like
kind to the property transferred by the taxpayer, there
shall be no nonrecognition of gain or loss to the taxpayer
with respect to such EXCHANGE unless one of the
exceptions stated in section 1031(F)(2) applies.

No opinion is expressed as to the tax treatment of this transaction under the provisions
of any other sections of the Code and regulations which may be applicable thereto, or the
tax treatment of any conditions existing at the time of, or effects resulting from, the
transaction which are not specifically covered by this ruling. Specifically, we are not
ruling whether there have been any gifts between the related parties or a distribution from
a trust.

This ruling is directed only to the taxpayer who requested it. Section 6110(j)(3) of the
Code provides that it may not be cited as precedent.
Sincerely yours,
Assistant Chief Counsel (Income Tax & Accounting)
By

BOOT:
PRIVATE LETTER RULING 9413024

Under Private Letter Rul. 9413024, the Service held that a series of transactions over a
number of years, where cash was actually received, constituted boot to the extent that the
cash was received.

The Service tied its position to its prior Revenue Ruling 77-297, arguing that the receipt
of cash in subsequent years was intended to be part of the exchange in question, and,
therefore, the cash was not a separate transaction but rather was boot from the exchange
transaction. The tax-deferred position could nevertheless exist, subject to a partial
transaction that was taxed to the extent of the boot.

In exchange of land used in a productive business for replacement of an apartment


building in a nonsimultaneous exchange, the Ruling held that it did meet the requirements
under Code §1031 and the applicable Regulations.

PRIVATE LETTER RULING 9413024


December 23, 1993
Publication Date: April 1, 1994

Dear _____:
This is in reply to your letter of September 27, 1993, and subsequent correspondence,
requesting rulings under section 1031 of the Internal Revenue Code on the anticipated
exchange of certain real estate (part of Property Z) and the replacement of that property
with Property H, on your behalf.

You have represented that you hold a fee interest in g acres of ranch land, known as
Property Z. Property Z has been used, starting after 1974, for your j operation. In 1989,
you entered into a five year contract with Corp A to develop f acres of the g acre Property
Z, and Corp A and its successors paid you $k from 1989 to date for the option, but Corp
A did not get financing and sold the contract to another developer. The original contract
contains a term allowing the parties to execute a section 1031 exchange instead of a sale
if so agreed. The second developer, Corp B, had other financing problems but is now
planning to sell to Corp C, which soon expects to begin work. Corp C expects to acquire
Property H, a multi-unit apartment building that will be acceptable to you in an exchange
under section 1031 of the Code. Corp C will put $r in escrow with the intermediary, Corp
F, to be used solely to complete the exchange. Corp C has agreed, in accordance with
your letter of November 10, 1993, to make the section 1031 exchange of the f acres of
Property Z. All escrows will be governed by the restriction contained in section
1.1031(k)-1(g)(6) of the Income Tax Regulations.

You acquired Property Z in 1974 for $h. You were compelled to sell an acre of it in
1975 to the state highway department for $e, reducing your basis in the remaining part to
approximately $q. You did not replace the land, but in 1988 you bought 2 more acres
which are not part of the exchange. In 1989 you contracted to sell or exchange the f acres,
and the amount to be realized has been approximately computed as $k in option premium
paid to date, $s in replacement property (H), and $r to be paid as housing units are built
and sold in subsequent years. Your adjusted basis is approximately $q, leaving you with
gain of $u to be deferred. You expect to hold the replacement Property H in the same
manner (fee interest) as the g acres of ranch land and to keep it for productive use as
rental property. You also expect to continue the j operation on the remaining acres of
Property Z which will not be developed.

You have requested that the Service rule that:

The exchange of the f acres of land of Property Z for Property H will qualify as an
exchange of property of a like kind held for productive use in trade or business or for
investment within the meaning of section 1031(a)(1) of the Code.

Section 1031(a)(1) of the Code provides that, in general, 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 a like kind which is to
be held either for productive use in a trade or business or for investment.

Section 1031(a)(3) of the Code provides that for purposes of this subsection, any
property received by the taxpayer shall be treated as property which is not like-kind
property if--

(A) such property is not identified as property to be received in the


exchange on or before the day which is 45 days after the date
on which the taxpayer transfers the property relinquished in
the exchange, or--
(B) such property is received after the earlier of--
(A) such property is not identified as property to be received in the exchange on or before
the day which is 45 days after the date on which the taxpayer transfers the property
relinquished in the exchange, or-- (B) such property is received after the earlier of-- (i)
the day which is 180 days after the date on which the taxpayer transfers the property
relinquished in the exchange, or (ii) the due date (determined with regard to extension)
for the transferor's return of the tax imposed by this chapter for the taxable year in which
the transfer of the relinquished property occurs.

Section 1031(b) of the Code provides that, as to gain from exchanges not solely in kind,
if an exchange would be within the provisions of subsection (a), of section 1035(a), of
section 1036(a), or of section 1037(a), if it were not for the fact that the property received
in the exchange consists not only of property permitted to be received by such provisions
without the recognition of gain or loss, but also of other property or money, then the gain,
if any, to the recipient shall be recognized, but only in an amount not in excess of the sum
of such money and the fair market value of such other property.

Section 1.1031(a)-1(b) of the Income Tax Regulations provides, in part, that the words
"like kind" have reference to the nature or character of property and not to its grade or
quality.

Section 1.1031(k)-1(f)(1) of the regulations provides in part that a transfer of


relinquished property in a deferred exchange is not within the provisions of section
1031(a) if, as part of the consideration, the taxpayer receives money or other property.
However, such a transfer, if otherwise qualified, will be within the provisions of either
section 1031(b) or (c). In addition, in the case of a transfer of relinquished property in a
deferred exchange, gain or loss may be recognized if the taxpayer actually or
constructively receives money or other property before the taxpayer actually receives the
like-kind replacement property.

Section 1.1031(k)-1(g)(6) of the regulations provides additional restrictions on the safe


harbors under paragraphs (g)(3) through (g)(5). An agreement limits the taxpayer's rights
as provided in this paragraph (g)(6) only if the agreement provides that the taxpayer has
no rights, except as provided in paragraphs (g)(6)(ii) and (g)(6)(iii) of this section, to
receive, pledge, borrow, or otherwise obtain the benefits of money or other property
before the end of the exchange period.

Section 1231 of the Code provides, in general, that if section 1231 gains for any taxable
year exceed section 1231 losses for the same taxable year, such gains shall be treated as
long-term capital gains for such year.

Rev.Rul. 77-297, 1977-2 C.B. 304, holds, in part, that a taxpayer agreed to sell a ranch
held for business purposes with the stipulation that the buyer would cooperate in
effectuating an exchange if a suitable property could be found. Pursuant to the agreement,
the buyer purchased another ranch and exchanged it for the taxpayer's ranch. The
exchange qualifies for nonrecognition of gain under section 1031 of the Code with
respect to the taxpayer.
In this case, there is a similar provision for a section 1031 exchange in the original 1989
contract, and the exchange will be made as in Rev.Rul. 77-297. Due to the operation of
section 1031(b), the receipt of the $k in 1989 and subsequent years, always intended as
part of the exchange, though it took several years to complete the exchange, will be
considered part of the exchange transaction for purposes of section 1231 capital gain
characterization. However, it will be treated as boot during the year the exchange is
completed. Therefore, section 1031(b) applies to the exchange, because money also is
received in the exchange. Under section 1031(b) the gain shall be recognized but in an
amount not in excess of the amount of such money. In applying section 1031(b) to your
facts, since the boot is less than $u, the gain realized, the gain recognized at the time of
the exchange is $k. For subsequent years, as payments of $r is received, the $r amount is
also boot and must be treated as proceeds from the exchange. We express no opinion as
to when you must take the $r payments into account as that question is not part of your
ruling request.

You have represented that the g acre parcel has recently been used for direct productive
use in Business j, and that the replacement apartment building, Property H, would be
owned and leased out by you. Accordingly, based on the facts presented and the
representations made, we rule that:

The exchange of the f acres of land of Property Z for Property H will qualify as an
exchange of property of a like kind held for productive use in trade or business or for
investment within the meaning of section 1031(b) of the Code. The treatment of the
transaction is under section 1031(b) of the Code, as money is received in addition to the
property of like kind.

NONSIMULTANEOUS EXCHANGES:

For an excellent examination of many of the issues that were involved in the Proposed
Regulations, addressed in detail in the Final Regulations, see the article by the New York
State Bar Association, Section of Taxation, "Report of Section 1031 Deferred Exchange
Regulations," Tax Notes 1405 (9/10/90).

See Newsom, Jennifer and Reid, John, "Safe Harbors Provide Calmer Waters For
Exchanging," Commercial Investment Real Estate Journal 32 (Fall, 1993).

See also Bogdanski, John, "On Beyond Real Estate: The New Like-Kind Exchange
Regulation," Tax Notes 903 (August 13, 1990).

For a discussion of multi-party deferred exchanges, see Editorial, "Multiparty Deferred


Exchanges," RIA Income Taxes Paragraph 10314.10, RIA (1993).

See article by MacDonald, Stewart, "For Best Results and Like-Kind Exchanges, Use A
Facilitator and A Two-Tier Structure," National Real Estate Investor 94 (June, 1993).
For an overview of current developments in the exchanging real estate field, see
Pattishall, B. Wyckliffe, Jr., "Current Developments and Final Regulations Under IRC
Section 1031," in the Lawyer's Supplement to the Guarantor Newsletter published by
Chicago Title Insurance Company, Part 1 (January/February, 1992).

NONSIMULTANEOUS EXCHANGE: FACTUAL QUESTIONS:


PRIVATE LETTER RULING 9522040
This Private Letter Ruling examined the use of Code §1031(a)(3), nonsimultaneous
exchange, using an unrelated corporation as an intermediary. The requirements for the
nonsimultaneous exchange position were met. However, the Ruling noted that it would
not rule on factual matters, such as whether the property was held for productive use for
an investment and whether the property to acquired would be so held. If this requirement
was met, the exchange requirements under Code §1031 would have been met.

PRIVATE LETTER RULING 9522040


Section 1031 -- EXCHANGE of Property Held for Productive Use or Investment
March 6, 1995
Publication Date: June 2, 1995

Dear ____:
This is in reply to a letter from you dated July 19, 1994 and subsequent correspondence,
requesting rulings under section 1031 of the Internal Revenue Code.

You have requested that you are Individuals A and B, husband and wife. You hold
Property P, a residential investment income property, jointly with Individual C,
Individual A's brother, as tenants in common. Property P was once a family residence but
has been rented to outside tenants since 1969. Individuals A, B, and C have agreed
mutually to dispose of the property, with Individual C to invest his share separately from
Individuals A and B. It is intended to make a tax deferred EXCHANGE of 1/2 of the
proceeds of Property P for like kind property real property under section 1031 of the
Code. It is intended to rent out the replacement property. The replacement property, a
unit in a condominium development designated as Property Q to be acquired has been
chosen, but it may be necessary prior to the end of the identification period to choose
another specific unit within Property Q to be available when Property P is relinquished. It
is intended that there will be a deferred EXCHANGE under section 1031(A)(#) of the
Code with Corp Y, an unrelated corporation, as intermediary.

You have requested that the Service rule as follows:

The transfer by Individuals A and B of their interest in Property P in EXCHANGE for


Property Q constitutes an EXCHANGE eligible for nonrecognition of gain treatment
under section 1031 of the Code by Individuals A and B of properties held by them for
productive use in a trade or business or for investment, for a like kind property which will
be held by Individuals A and B for productive use in a trade or business or for
investment.
Section 1031(A)(1) of the Code provides that, in general, 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 a like kind
which is to be held either for productive use in a trade or business or for investment.

Section 1.1031(A)-1(B) of the Income Tax Regulations provides, in part, that the words
"like kind" have reference to the nature or character of the property and not to its grade or
quality. In subsection (c) examples are provided allowing the EXCHANGE by a taxpayer
who is not a dealer in real estate of a ranch or a farm for city real estate, a leasehold of a
fee with 30 or more years to run for real estate, and improved real estate for unimproved
real estate. It is also possible to EXCHANGE investment property and cash for
investment property of a like kind.

Section 1031(A)(3) of the Code provides that for purposes of this subsection, any
property received by the taxpayer shall be treated as property which is not like-kind
property if--

(A) such property is not identified as property to be received in the


EXCHANGE on or before the day which is 45 days after the
date on which the taxpayer transfers the property relinquished
in the EXCHANGE, or
(B) such property is received after the earlier of--
(i) the day which is 180 days after the date on which the
taxpayer transfers the property relinquished in the
EXCHANGE, or
(ii) the due date (determined with regard to extension) for the
transferor's return of the tax imposed by this chapter for
the taxpayer year in which the transfer of the relinquished
property occurs.

We cannot rule on the fact of whether the Property P currently held constitutes property
held for productive use for investment, an inherently factual matter, or whether the unit in
Property Q is to be held for productive use or for investment. But assuming that they do
so, and that all the requirements of section 1.1031(K)-1 of the regulations are met, based
on the facts presented and the representations made, we rule that:

The transfer by Individuals A and B of heir interest in Property P in EXCHANGE for


Property Q constitutes an EXCHANGE eligible for nonrecognition of gain treatment
under section 1031 of the Code by Individuals A and B of properties held by them for
productive use in a trade or business or for investment, for a like kind property which will
be held by Individuals A and B for productive use in a trade or business or for
investment.

No opinion is expressed as to the tax treatment of the transaction under the provisions
of any other sections of the Code and regulations which may be applicable thereto, or the
tax treatment of any conditions existing at the time of, or effects from, the transaction
which are not specifically covered by the ruling.

A copy of this letter should be attached to the federal income tax return of the taxpayers
for the taxpayer year which the transaction covered by this letter is consummated.

This ruling is directed only to the taxpayers who requested it. Section 6110(j)(3) of the
Code provides that it may not be used or cited as precedent. Sincerely yours, Assistant
Chief Counsel (Income Tax & Accounting)

[Deferred Exchanges Under Code §1031: Is Your Facilitator/Intermediary Solvent? A]


[Deferred Exchanges Under Code §1031: Is Your Facilitator/Intermediary Solvent?" B]
[Deferred Exchanges Under Code §1031: Is Your Facilitator/Intermediary Solvent?" C]
[Deferred Exchanges Under Code §1031: Is Your Facilitator/Intermediary Solvent?" D]
[Deferred Exchanges Under Code §1031: Is Your Facilitator/Intermediary Solvent?" E]
[Deferred Exchanges Under Code §1031: Is Your Facilitator/Intermediary Solvent?" F]
[Deferred Exchanges Under Code §1031: Is Your Facilitator/Intermediary Solvent?" G]
[Deferred Exchanges Under Code §1031: Is Your Facilitator/Intermediary Solvent?" H]
[Deferred Exchanges Under Code §1031: Is Your Facilitator/Intermediary Solvent?" I]
[Deferred Exchanges Under Code §1031: Is Your Facilitator/Intermediary Solvent?" J]
[Deferred Exchanges Under Code §1031: Footnotes 1]
[Deferred Exchanges Under Code §1031: Footnotes 2]
[Deferred EXchanges Under Code §1031: Footnotes 3]
[Deferred Exchanges Under Code §1031: Footnotes 4]
[Deferred Exchanges Under Code §1031: Footnotes 5]
[Deferred Exchanges Under Code §1031: Footnotes 6]

NONSIMULTANEOUS EXCHANGES: SUBSIDIARIES:


TANGIBLE PERSONALTY: SERIES OF EXCHANGES:
PRIVATE LETTER RULING 9812013
In Private Letter Ruling 9812013, the taxpayer requested a Private Letter Rul. involving
a series of exchanges, subsidiaries and regular exchange activities involving rental
tangible personal property.

Because the Regulations under the nonsimultaneous exchange position, that is Code
§1.1031(k) were followed, the rule supported the tax-deferred treatment, notwithstanding
the series of exchanges and the interrelationship of the parent company and subsidiaries
involving a series of exchanges after the property was leased for some period of time.

FOR EDUCATIONAL USE ONLY


Copr. (C) West 1998 No Claim to Orig. U.S. Govt. Works

Internal Revenue Service (I.R.S.)


PRIVATE LETTER RULING 9812013
Issue: March 20, 1998
December 12, 1997
Dear _____:
This letter responds to your request for a private letter ruling, dated June 16, 1997,
submitted on behalf of Taxpayer, requesting rulings on issues arising under §1031 of the
Internal Revenue Code.

Taxpayer is a multi-state *** company, incorporated in State A. Taxpayer uses an


annual accounting period ending December 31 and the overall accrual method of
accounting for maintaining the accounting books and filing the federal income tax return.

Taxpayer is the parent of Subsidiary, which, as of December 31, 1996, operated a


Business offices in States A, B, and C. Subsidiary offers a full range of Business services.

Relinquished Property
Subsidiary is engaged in Property Rental operations. Subsidiary currently maintains a
portfolio of Properties that it leases to individual customers. Typical leases range from b
to c. Subsidiary has legal title to each Property and each Property is depreciated for
federal income tax purposes pursuant to §168. On completion of a lease term, or on early
termination of a lease, the lessee and/or *** can purchase the Property from Subsidiary at
an arm's-length price. At such time, the *** or the individual purchaser of the Property
will contact Subsidiary to obtain the purchase price for the Property (the ***). Only one
department within Subsidiary can provide information.

Under the proposed transaction, upon such call, and before the sale of the Property, a
representative of Subsidiary will quote the *** price for the customer. Subsidiary will
then produce and mail, if to an individual customer, or send by facsimile transmission, if
to a *** a *** statement with a *** containing all relevant *** information to the
customer. The representative will also inform the caller that Subsidiary will be assigning
its right to sell the Property to the Intermediary and that the check for the *** amount
must be made payable to the Intermediary. This notification will also be made in writing
to the purchaser on the *** The assignment language will read as follows:

"[Subsidiary] does hereby transfer, set over and assign all of its rights (but not its
obligations), to sell [the Property] in this *** attached, have been assigned to the
[Intermediary] pursuant to the ... Exchange Contract. Notice is hereby given that all of
[Subsidiary's] rights, (but not its obligations) to sell the [Property] in this *** attached, to
the [Intermediary] pursuant to the ... Exchange Contract."

Upon receiving the call from the customer, Subsidiary will notify the Intermediary, by
transmitting the *** via facsimile transmission to the Intermediary, that Subsidiary will
be assigning to the Intermediary its right to sell the Property. The notification of
assignment will include the *** amount, the description of the Property, and the
purchaser of the Property.

The proposed transaction at issue here involves one of the first five Properties on which
a lease expires in November 1997 that does not involve financing from Subsidiary,
provided the lease did not actually terminate prior to September 15, 1997. In the proposed
transaction at issue here, the purchaser of the Property will not borrow from Subsidiary
any of the funds necessary to purchase the Property. The purchaser will forward a check
made payable to the Intermediary along with the *** to Subsidiary. Subsidiary will then
forward the check to the Intermediary. Subsidiary will then fully process the paperwork
and procedures for the termination of the lease and disposition of the Property including
transfer of title. When the Intermediary cashes the *** check, Subsidiary will arrange to
transfer title to the purchaser.

A portion of the Properties leased by Subsidiary will be returned to Subsidiary either at


the end of the lease term or on early termination. Property that is returned to Subsidiary
by the lessee will be sold *** Upon learning that Subsidiary will receive the Property,
Subsidiary will notify the Intermediary that it is assigning to the Intermediary
Subsidiary's right to sell the Relinquished Property through *** The *** will be notified
that Subsidiary is assigning to the Intermediary Subsidiary's right to sell the Relinquished
Property and that all proceeds from the sale should be made payable to the Intermediary.
At no time will Subsidiary have control of the proceeds from the sale of the Relinquished
Property.

The Intermediary will be an independent third party and will be assigned the right to
sell the Property prior to the sale transaction taking place, regardless of whether the sale
occurs at the end of the lease term or on early termination thereof. All proceeds from the
sale of Relinquished Property will go to the Intermediary. At no time will Subsidiary
have control of such proceeds. The Intermediary will deposit such proceeds in an account
under its name and sole control at a financial institution unrelated to Subsidiary. The
Intermediary will use such funds solely to purchase Replacement Property on
Subsidiary's behalf.

The Exchange Agreement between Subsidiary and Intermediary will expressly limit
Subsidiary's rights to receive, pledge, borrow, or otherwise obtain the benefits of money
or other property held by the Intermediary before the end of the Exchange Period. The
Exchange Period will begin to run on the day of the sale of the Relinquished Property and
will end at midnight on the 45th day following the sale of the Relinquished Property if no
Replacement Property has been identified for the Relinquished Property. If Replacement
Property has been identified within the period stated above, the Exchange Period will end
at midnight on the 180th day following the sale of the Relinquished Property if
Subsidiary has not received the identified Replacement Property. The Exchange Period
will otherwise end on the day that Subsidiary acquires title to the Replacement Property.

Replacement Property
Subsidiary purchases Property from its extensive *** These *** are unrelated to
Subsidiary. Subsidiary currently has contracts with *** in which Subsidiary agrees to
purchase from the *** each Property leased by the *** under Subsidiary terms and
conditions to an individual customer upon Subsidiary approving the *** application
received from the individual customer. Subsidiary purchases such Property from the ***
subject to the lease to the individual customer. Subsidiary is not obligated to purchase the
Property unless and until such time as the *** receives Subsidiary's approval of the ***
application of the individual customer. The Agreement gives Subsidiary the right to
assign its right to purchase Property from the ***

The *** application is completed by the individual customer and *** and describes the
terms of the lease with the customer, the cost of the Property to Subsidiary, and
description of the Property.

Under the proposed transaction, immediately on approval of the individual customer's


*** application, Subsidiary will send by facsimile transmission to the Intermediary notice
that Subsidiary is assigning to the Intermediary Subsidiary's right to purchase the
Property from the *** The notice to the Intermediary will include a description of the
lease with the customer, the cost of the Property to Subsidiary, and a description of the
Property. The assignment language will be similar to the assignment language for the
Relinquished Property quoted above.

After notice of Subsidiary's assignment of its right to purchase the Property is sent to
the Intermediary, Subsidiary will send by facsimile transmission its approval of the ***
to the *** Such approval will include language notifying the *** that Subsidiary is
assigning its right to purchase the Property to the Intermediary.

*** will then *** from the Intermediary the proceeds from the sale of the Property to
the Intermediary. The funds will be transferred directly from the Intermediary's bank
account to *** or the *** bank account. All paperwork completed by the *** will be
mailed to Subsidiary and Subsidiary will record and process the transaction. Title to the
Property will be transferred to and in the name of Subsidiary.

Intermediary will pay the *** out of an account held by the Intermediary (the ***
Proceeds from the sale of the Relinquished Property will go into a separate *** held by
Intermediary (the *** Within 45 days of the sale of the Relinquished Property, Subsidiary
will identify Replacement Property and will assign to the Intermediary Subsidiary's right
to purchase the Replacement Property. The proceeds received by Intermediary from the
sale of Relinquished Property held in the *** will be transferred to the *** and used to
purchase the Replacement Property.

To the extent that the proceeds from the sale of the Relinquished Property are
insufficient to cover the purchase price of the Replacement Property, Subsidiary will
transfer additional funds from *** held by Intermediary (the *** into the *** to cover
such insufficiency. The value of the Replacement Property will equal or exceed the
proceeds from the sale of the Relinquished Property.

If Subsidiary does not identify Replacement Property within 45 days of the date of sale
of the Relinquished Property, the proceeds from the sale of the Relinquished Property
will be transferred from the *** to Subsidiary and Subsidiary will recognize all realized
gain on the sale of the Relinquished Property. All proceeds received on the sale of the
Relinquished Property will be held in the *** until Replacement Property is identified,
which will be at least one day after the sale of the Relinquished Property but not longer
than 45 days after the sale of the Relinquished Property.

Subsidiary will enter into two separate agreements with the Intermediary to perform
services for Subsidiary. The first agreement is the Exchange Agreement. The Exchange
Agreement will facilitate the deferred like-kind exchanges described above. The second
agreement is an agreement that the Intermediary will disburse funds for the purchase of
Property on Subsidiary's behalf that will not be Replacement Property for purposes of a
like-kind exchange transaction. Property purchased on Subsidiary's behalf that is not
Replacement Property will be paid for out of the *** just like the purchase of
Replacement Property. This is necessary because Subsidiary currently acquires
approximately three new Properties for each Property sold at the end of a lease term.
Funds for these purchases will be provided to Intermediary by Subsidiary.

Taxpayer represents that the Property Rental business is highly competitive. As such,
any differentiation or additional burden placed on a *** including confusion over what to
draw on or additional paperwork, may place Subsidiary at a competitive disadvantage to
other Property Rental businesses. Taxpayer represents that, to ease any hardship to
Subsidiary must contract with Intermediary to have *** on the Intermediary account for
all Properties purchased. Taxpayer represents that it would be overly burdensome on to
identify which Properties will be Replacement Properties and which will not be
Replacement Properties. Thus, Intermediary will disburse funds for both Replacement
Properties and non-Replacement Properties on Subsidiary's behalf. Taxpayer represents
that Intermediary's role in purchasing non-Replacement Properties will be nothing more
than as a cash clearinghouse.

Rulings Requested
Under these facts, Taxpayer requests that the Service issue the following rulings:

(1) Each transfer by Subsidiary of a Relinquished Property and the


receipt of an identified Replacement Property in accordance
with the Exchange Agreement will constitute a separate and
distinct like-kind exchange transaction that qualifies for
deferral of gain recognition for federal income tax purposes
pursuant to §1031 of the Internal Revenue Code.
(2) Intermediary, acting in accordance with the Exchange
Agreement, will be treated as acquiring and transferring both
the Relinquished Property and the Replacement Property for
purposes of §1031
(3) Subsidiary will not be in constructive receipt of any money or
other property held by Intermediary pursuant to Treasury
Regulation §1.1031(k)-1(f)(1) unless and until such items are
actually payable to or received by Subsidiary, on the condition
that the requirements of the Exchange Agreement,
representations in this ruling request and other conditions of
the safe harbor test are in fact met.
(4) The exchange pursuant to the Exchange Agreement of each
Relinquished Property for properly identified and received
Replacement Property will constitute a nontaxable exchange to
the extent no cash or other non-like-kind property is received
by Subsidiary, assuming that only Property from the same
general asset class is involved in such exchange. If Subsidiary
does receive cash or other non-like-kind property as defined in
§1031(b) in the exchange, the gain with respect to the
Relinquished Property involved in the exchange will be
recognized in an amount not in excess of such cash or other
property.
(5) The role of the Intermediary in the purchase of Property that is
not Replacement Property, and thus not involved in the like-
kind exchange, constitutes "routine financial or trust services"
for Subsidiary under §1.1031(k)-1(k)(2)(ii) and does not
disqualify the Intermediary from being a qualified
intermediary under §1.1031(k)-1(g)(4)(iii).

Law and Analysis


Section 1031(a)(1) 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 for productive use in a
trade or business or for investment. Section 1031(a)(2) adds that this subsection does not
apply to any exchange of stock in trade or other property held primarily for sale.

Accordingly, when a taxpayer disposes of an asset, there are three general requirements
for nonrecognition treatment under §1031: (1) both the property surrendered and the
property received must be held either for productive use in a trade or business, or for
investment; (2) the property surrendered and the property received must be of "like-
kind"; and (3) there must be an exchange as distinguished from a sale and repurchase.

Productive Use in Trade or Business


The relevant qualified use of the Property owned by Subsidiary and subsequently being
exchanged in the proposed transaction is the leasing of such Property to third parties.
Thus, the Relinquished Property that Subsidiary previously leased to third parties and the
Replacement Property that Subsidiary will be leasing to third parties upon acquisition is
considered property used for productive use in a trade or business in Subsidiary's hands.

Like-kind Property
The requirement that the exchanged properties be of like-kind has reference to the
nature or character of the property and not to its grade or quality. See §1.1031(a)-1(b). To
qualify for like-kind exchange treatment, one kind or class of property may not be
exchanged for property of a different kind or class. Depreciable tangible personal
properties are of a like class if they are either within the same General Asset Class--as
defined in §1.1031(a)-2(b)(2)-- or within the same Product Class--as defined in
§1.1031(a)-2(b)(3).

Section 1.1031(a)-2(b)(3) states that property within a Product Class consists of


depreciable tangible property that is listed in a four-digit product class within Division D
of the Standard Industrial Classification codes, set forth in Executive Office of the
President, Office of Management and Budget, Standard Industrial Classification Manual
(1997) ("SIC Manual"

).

All Properties being exchanged by Subsidiary in the proposed transaction will be


considered Properties and all are classified in the SIC Manual under SIC number d. Thus,
the depreciable tangible personal property being exchanged in the proposed transaction
are within the same Product Class as defined in §1.1031(a)-2(b)(3).

However, when an exchange transaction is deferred, rather than simultaneous, even if


the taxpayer trades property for other property of the same asset or product class, the
exchanged properties will not be of like-kind if the replacement property is not timely
identified or received. Section 1031(a)(3) states that any property received by the
taxpayer shall be treated as property that is not like-kind property if (a) such property is
not identified as property to be received in the exchange on or before the day that is 45
days after the date on which the taxpayer transfers the property relinquished in the
exchange, or (b) such property is received after the earlier of (i) the day that is 180 days
after the date on which the taxpayer transfers the property relinquished in the exchange or
(ii) the due date (determined with regard to extension) for transferor's return of the tax
imposed by this chapter for the taxable year in which the transfer of the relinquished
property occurs.

Section 1.1031(k)-1(c) provides that any replacement property that is received by the
taxpayer before the end of the identification period will in all events be treated as
identified before the end of the identification period. In the instant case, Taxpayer has
represented that Subsidiary will identify the Replacement Property within 45 days of the
sale of the Relinquished Property. However, because Subsidiary, through the
Intermediary, initially may receive more Properties than it will be relinquishing, the issue
arises as to whether Subsidiary will satisfy the "three property" or "200%" rule.

Section 1.1031(k)-1(c)(4)(i) provides that the taxpayer may identify more than one
replacement property. Regardless of the number of relinquished properties transferred by
the taxpayer as part of the same deferred exchange, the maximum number of replacement
properties that the taxpayer may identify is (a) three properties without regard to the fair
market values of the properties (the "three property rule"), or (b) any number of
properties provided that their aggregate fair market value as of the end of the
identification period does not exceed 200% of the aggregate fair market value of all the
relinquished properties as of the date the relinquished properties were transferred by the
taxpayer (the "200% rule"). Section 1.1031(k)- 1(c)(4)(ii) states that, if, as of the end of
the identification period, the taxpayer has identified more properties as replacement
properties than permitted by paragraph (c)(4)(i), the taxpayer is treated as if no
replacement property had been identified.

However, an exchange does not fail for lack of identification due to either the three
property rule or the 200% rule if identification is made by receipt of replacement property
before the end of the identification period. As Subsidiary will receive Replacement
Property within 45 days of the sale of the Relinquished Property, the identification
requirements of §1031(a)(3) will be met by such receipt. Because identification of the
Replacement Property is made by receipt of the Replacement Property within the
identification period, neither the three property rule nor the 200% rule will apply. As
such, the Relinquished Property and the Replacement Property will be of like-kind for
§1031 purposes.

Exchange of Properties
Section 1.1031(k)-1(f)(1) provides that, in the case of a transfer of relinquished
property in a deferred exchange, gain or loss may be recognized if the taxpayer actually
or constructively receives money or other property before the taxpayer actually receives
like-kind replacement property. If the taxpayer actually or constructively receives money
or other property in the full amount of the consideration for the relinquished property
before the taxpayer actually receives like-kind replacement property, the transaction will
constitute a sale and repurchase, and not a deferred exchange, even though the taxpayer
may ultimately receive like-kind replacement property. According to §1.1031(k)- 1(f)(2),
actual or constructive receipt of money or other property by an agent of the taxpayer
(determined without regard to paragraph (k) of this section) is actual or constructive
receipt by the taxpayer.

Section 1.1031(k)-1(g) sets forth four safe harbors, the use of any of which will result
in a determination that the taxpayer is not in actual or constructive receipt of money or
other property for §1031 purposes. Section 1.1031(k)-1(g)(4) provides that, in the case of
a taxpayer's transfer of relinquished property involving a qualified intermediary, the
qualified intermediary is not considered the taxpayer's agent for §1031 purposes. In such
a case, the taxpayer's transfer of relinquished property and subsequent receipt of like-kind
replacement property is treated as an exchange, and the determination of whether the
taxpayer is in actual or constructive receipt of money or other property before the
taxpayer actually receives like-kind replacement property is made as if the qualified
intermediary is not the agent of the taxpayer.

A qualified intermediary is defined in §1.1031(k)-1(g)(4)(iii) as a person who (a) is not


the taxpayer or a disqualified person and (b) enters into a written agreement with the
taxpayer (an "exchange agreement") and, as required by the exchange agreement,
acquires the relinquished property from the taxpayer, transfers the relinquished property,
acquires the replacement property, and transfers the replacement property to the taxpayer.
According to §1.1031(k)-1(k)(2), the term "disqualified person" includes a person who is
the taxpayer's agent at the time of the transaction. For this purpose, a person who has
acted as the taxpayer's employee, attorney, accountant, investment banker or broker, or
real estate agent or broker within the two-year period ending on the date of the transfer of
the first of the relinquished properties is treated as the taxpayer's agent. However,
performance of certain services does not cause an entity to be a "disqualified person".
These services include (a) services for the taxpayer with respect to exchanges of property
intended to qualify for nonrecognition of gain or loss under §1031, and (b) routine
financial, title insurance, escrow, or trust services for the taxpayer by a financial
institution, title insurance company, or escrow company.

In the instant case, Subsidiary will enter a written Exchange Agreement with the
Intermediary. The Intermediary will be an independent, third party financial institution
that will not have previously performed services other than routine financial services for
Subsidiary. As such, Intermediary will not be a "disqualified person" under §1.1031(k)-
1(k).

An intermediary is treated as acquiring and transferring the relinquished property if the


intermediary (either on its own behalf or as the agent of any party to the transaction)
enters into an agreement with a person other than the taxpayer for the transfer of the
relinquished property to that person, and pursuant to that agreement, the relinquished
property is transferred to that person. See §1.1031(k)-1(g)(4)(iv)(B). An intermediary is
treated as acquiring and transferring replacement property if the intermediary (either on
its own behalf or as the agent of any party to the transaction) enters into an agreement
with the owner of the replacement property for the transfer of that property and, pursuant
to that agreement, the replacement property is transferred to the taxpayer. See
§1.1031(k)-1(g)(4)(iv)(C). For these purposes, an intermediary is treated as entering into
an agreement if the rights of a party to the agreement are assigned to the intermediary and
all parties to that agreement are notified in writing of the assignment on or before the date
of the relevant transfer of property. See §1.1031(k)- 1(g)(4)(v).

In the instant case, Subsidiary will assign to the Intermediary Subsidiary's right to sell
Relinquished Property. When *** or individual customer calls Subsidiary to get the ***
amount of the Property, a Subsidiary representative will quote the *** amount to *** or
customer and inform such person that Subsidiary will be assigning to the Intermediary its
right to sell the Property and that such person will soon receive a *** that must be
enclosed with payment of the amount. The *** will inform such person in writing that
Subsidiary has assigned to the Intermediary Subsidiary's right to sell the Property and that
payment of the *** amount must be made payable to the Intermediary. If Relinquished
Property is sold through ***, such *** and individual purchasing from the *** will be
informed in writing that Subsidiary has assigned its right to sell the Property to
Intermediary and that payment must be made payable to Intermediary. Thus, the
Intermediary will be treated as acquiring and transferring the Relinquished Property,
pursuant to §1.1031(k)-1(g)(4)(iv)(B) and (v).

In addition, Subsidiary will assign its right to purchase Replacement Property to


Intermediary. The *** Agreements will state that Subsidiary does not have the obligation
to purchase leased Property from the *** until *** receives an approval of the customer's
*** from Subsidiary in writing. A *** will send by facsimile transmission to Subsidiary a
*** completed by an individual customer seeking to lease a particular Property from the
*** When Subsidiary determines that it will approve the *** Subsidiary will send by
facsimile transmission to the Intermediary the description of the Property and of the deal
and inform the Intermediary that Subsidiary is assigning its right to purchase the Property
to the Intermediary. Also, Subsidiary will send back to the *** by facsimile transmission
its written approval of the *** that will inform the that Subsidiary is assigning to the
Intermediary Subsidiary's right to purchase the Property. The *** will then be paid out of
the *** an account over which Subsidiary has no control. Title to the Property will be
transferred to and in the name of Subsidiary. Thus, the Intermediary will be treated as
acquiring and transferring the Replacement Property, pursuant to §1.1031(k)-
1(g)(4)(iv)(C) and (v).

By using the Intermediary, a qualified intermediary within the meaning of §1.1031(k)-


1(g)(4)(iii), to transact the acquisition and disposition of the Properties, Subsidiary will
not have actual or constructive receipt of money or other property as consideration for an
exchange. The Exchange Agreement will provide that Subsidiary will have no rights to
receive, pledge, borrow, or otherwise obtain the benefits of money or other property
before the end of the Exchange Period as required by §1.1031(k)-1(g)(6)(i). The
Intermediary will pay *** out of the *** Proceeds from the sale of Relinquished Property
will be deposited into the *** Subsidiary will identify Replacement Property by receiving
such Property for the Relinquished Property. The proceeds received by the Intermediary
from the sale of Relinquished Property held in the *** will be transferred to the *** to be
used to purchase the Replacement Property. To the extent that funds in the *** from the
sale of the Relinquished Property are insufficient to cover the purchase of Replacement
Property, Subsidiary will transfer funds to the *** that will subsequently be transferred to
the *** to cover the amount of the purchases. Thus, Subsidiary will never have actual or
constructive receipt of money or other property used as consideration in an exchange. All
proceeds received from the sale of Relinquished Property will be held by the
Intermediary and subsequently used to purchase the Replacement Property.

To preserve its *** in the Property Rental business, Subsidiary will assign its right to
purchase all newly leased Properties to the Intermediary. This allows *** to *** on only
one checking account and prevents the *** from having to determine whether a specific
Property is a Replacement Property or not. Because Subsidiary is currently purchasing
more Properties than it is selling, Intermediary will be assigned the right to purchase
Properties that may not be Replacement Properties for Properties relinquished in a like-
kind exchange. However, the only service being performed by the Intermediary with
respect to non-Replacement Properties is payment for the Properties. Any funds needed
to purchase non-Replacement Properties will flow from Subsidiary to the *** to the ***
and then to the *** This service constitutes "routine financial services" pursuant to
§1.1031(k)-1(k)(2)(ii). Thus, this service will not disqualify the Intermediary from being
a qualified intermediary under §1.1031(k)-1(g)(4)(iii).

Accordingly, based on your representations and the above analysis, and assuming that
Intermediary is a qualified intermediary, we rule as follows:
(1) Each transfer by Subsidiary of Relinquished Property and the
receipt of an identified Replacement Property in accordance
with the Exchange Agreement will constitute a separate and
distinct like-kind exchange transaction that qualifies for
deferral of gain recognition for federal income tax purposes
pursuant to §1031.
(2) Intermediary, acting in accordance with the Exchange
Agreement, will be treated as acquiring and transferring both
the Relinquished Property and the Replacement Property for
purposes of §1031.
(3) Subsidiary will not be in constructive receipt of any money or
other property held by Intermediary unless and until such items
are actually payable to or received by Subsidiary, on the
condition that the requirements of the Exchange Agreement,
representations in this ruling request and other conditions of
the safe harbor test are in fact met.
(4) The exchange pursuant to the Exchange Agreement of each
Relinquished Property for a properly identified and received
Replacement Property will constitute a nontaxable exchange to
the extent no cash or other non-like-kind property is received
by Subsidiary, assuming that only Property from the same
general asset class is involved in such exchange. If Subsidiary
does receive cash or other non-like-kind property as defined in
§1031(b) in the exchange, the gain with respect to the
Relinquished Property involved in the exchange will be
recognized in an amount not in excess of such cash or other
property.
(5) The role of the Intermediary in the purchase of Property that is
not Replacement Property, and thus not involved in the like-
kind exchange, constitutes "routine financial or trust services"
for Subsidiary under §1.1031(k)-1(k)(2)(ii) and does not
disqualify the Intermediary from being a qualified
intermediary under §1.1031(k)-1(g)(4)(iii).

In connection with the fourth ruling, Taxpayer is cautioned that actual or constructive
receipt of any boot by Subsidiary prior to receiving the identified replacement property
could place the entire transaction outside the safe harbor rule. See §1.1031(k)-1(g)(6).
Furthermore, if Subsidiary transfers Relinquished Property to Intermediary and then
identifies Replacement Property that costs less than the proceeds available from the
disposition of the Relinquished Property, Subsidiary should take the excess proceeds into
account as boot. If Subsidiary does not, the validity of the entire transaction as an
exchange may be questioned. To the extent any boot is received in the exchange there
will be recapture of depreciation previously taken with respect to the relinquished
property pursuant to §1245(a)(1) and (b)(4).
With regard to depreciation, Taxpayer is cautioned that no depreciation deduction is
allowable by Subsidiary for an asset Purchased and disposed of in the same taxable year.

No opinion is expressed as to the tax treatment of the proposed transaction under the
provisions of any other section of the Code or regulations that may be applicable or the
tax treatment of any conditions existing at the time of, or effects resulting from, the
transaction described that are not specifically covered in the above ruling. In this
connection, you state that, if a favorable ruling is obtained for this transaction, it will
serve as a model for subsequent exchanges. As previously stated, no opinion is expressed
as to any other transaction that you contemplate.

A copy of this letter should be attached to the federal income tax return for the year in
which the transaction in question occurs. This ruling is directed only to the taxpayer who
requested it. Section 6110(j)(3) of the Code provides that it may not be cited as
precedent.

Sincerely yours,

Assistant Chief Counsel


(Income Tax & Accounting)
By * * * *

TAX-DEFERRED EXCHANGES UNDER CODE §1031:


DO MULTIPLE EXCHANGES CONSTITUTE A SERIES OF
EXCHANGES OR ONE COMPOSITE EXCHANGE?
by: Dr. Mark Lee Levine

I. OVERVIEW OF CODE §1031 AS TO MULTIPLE TRANSFERS:


The issue in this short note focuses on the propriety and requirements to meet a tax-
deferred exchange under 26 U.S.C.A. (the Code) §1031, i.e., the tax-deferred exchange
rule in the Internal Revenue Code, where such exchange involves not the traditional
Property X for Property Y position, but rather a series of properties involving multiple
parties.

The concern is to be certain that one meets the requirements under Code §1031 to allow
the deferral of the gain. To summarize Code §1031, most readers that practice in the
commercial real estate tax area, employing the benefits of deferral of income under Code
§1031, are familiar with the fundamental requirements under that Section. That is, a
taxpayer, to fall within Code §1031 and defer the gain (or loss), must exchange (not sell)
property (not services) that is held in a trade or business or for investment. (This means
that property that is not in the categories of productive use in a "trade or business or for
investment" could not qualify under this rule. Property that is inventory, i.e., property
held primarily for resale, would not qualify.) Such position is provided under Code
§1031(a)(1) and is fairly rudimentary for the requirements under a tax-deferred exchange
for Federal income tax law.
There are many exceptions under Code §1031(a)(2) that automatically disqualify an
exchange. For example, stock-in-trade or inventory, stocks, bonds, notes and other
intangible-type property, including interest in a partnership, certificates in trust and the
like are not qualified property to allow a tax-deferred exchange.

© Copyright by Dr. Mark Lee Levine, Denver, Colorado, l998.


All rights reserved.

However, assuming that the property is qualified property, as noted, the question in this
analysis is: "What are the additional requirements that must be met when the exchange or
exchanges is/are nonsimultaneous, i.e., the transferor (seller) of the property relinquishes
property and expects the transferor to properly receive other like-kind property (real
estate for real estate) that is used in the trade or business or for investment?" (Further,
assume such receipt is not concurrent with the transfer of the transferor's property to a
third party. This area is sometimes referred to as a deferred exchange, or a
nonsimultaneous exchange.)

II. NONSIMULTANEOUS EXCHANGES, WITH A NUMBER OF PROPERTIES:


The nonsimultaneous exchange concept is fairly well ingrained in Code §1031, as a
result of early case law. See, for example, Starker v. U.S., 602 F.2d 1341 (9th Circuit,
1979), and modifications to Code §1031 under Code §1031(a)(3), which statutorily
provided support for some of the case law that allowed for a qualified Code §1031
exchange where the transferor relinquished his property and received the replacement
property of like-kind property at a time subsequent to the transfer of the relinquished
property. In other words, the transferor transferred his or her property, e.g., property X,
and sometime thereafter received Property Y. Such exchange, if the requirements of Code
§1031(a)(3) are met, meets the requirements for deferral.

Code §1031(a)(3) specifically provides for a maximum time frame to complete the
transaction. (It is not the purpose of this short Note to examine those rules, which have
been reviewed in many articles. For more information on this, see the specific Code
Section noted, i.e., Code §1031(a)(3), the Regulations that provide for such position
under Treasury Regs. §1.1031(k) and the text, 3-volumes, Exchanging Real Estate by Dr.
Mark Lee Levine (1997). The concise explanation of this deferral rule under Code
§1031(a)(3) provides that where the property is otherwise qualified, i.e., like-kind
property, that is used in a trade or business or for investment property (qualified property)
that is properly exchanged on a timely basis, it can generally come within the exchange
rules within Code §1031 and the taxpayer can postpone recognition of the gain or loss.
(The time factors generally require that there is a 45-day maximum time frame for the
transferor to identify the replacement property and a 180-day maximum [or the return
date, including extension, whichever is sooner] to complete the exchange. Again, these
rules have been reviewed elsewhere and are not the focus of this material.)

Assuming one has timely met the requirements, as noted, and that additional
requirements are met under the nonsimultaneous rules, including the Regulations cited
earlier under Treasury Reg. §1.1031(k), relative to deferred or nonsimultaneous
exchanges and the use of intermediaries (those companies or people who help facilitate
the exchange transaction, e.g., a title company), one might assume that the requirements
under Code §1031 are met. However, as noted, the focus of this discussion, having
established these fundamental rules for exchanges, looks to the issue as to whether the
exchange would be qualified or nonqualified under Code §1031, where there is a series of
transactions by the transferor and whether that series would be treated as individual
exchanges or one (total) exchange. (If the series of transactions are treated as a composite
of one, the time restrictions, noted earlier, may easily be violated, along with other
requirements under Code §1031. On the other hand, if each of a series of exchanges is
treated independently, as a separate exchange, the exchange, or some of the exchanges,
may qualify for deferral under Code §1031. See the discussion that follows on this issue.

III. NUMBER OF TRANSFERS:


Is a number of exchanges to be treated as a series of exchanges, independent of each
other, or are they a composite and treated as one? The issue raised is the key concern of
this Note. That is, taxpayers who are involved in a number of exchanges, often with the
same parties or a group of parties, must be concerned with the issue as to the series of
transactions. The more transactions that are involved, the more concern that a taxpayer
may have that the entire group of transactions, if treated as an aggregate or composite,
may taint the entire tax-deferral approach.

This type of transaction, or series of transactions, may arise with parties or entities that
are involved in a large number of properties and relatively constant transfers of such
properties. One example might be an airline which owns a number of planes; it
periodically updates those planes by making transfers of those units to third parties, such
as manufacturers of the plane, in exchange for newer planes. (The same could apply with
a number of pieces of equipment that are involved in an activity, e.g., construction or car
rentals. Code §1031 is not limited to real estate, although the focus of this Note is on real
estate.)

Focusing on real estate, if the taxpayer has a number of properties and the taxpayer is
regularly involved in exchange activities, the taxpayer must be concerned with the issues
noted, especially the treatment of a composite number of transfers as one, and issues as to
the propriety of such transfers qualifying in the first place because of an argument that
the taxpayer-transferor might be a dealer (i.e., one who holds property not for use in the
trade or business or for investment, but for resale).

Assuming that the taxpayer can reasonably support his or her position that the activity
involves qualified property, such as a large food franchisee owning real property to house
the outlets for the franchisee, and approximately every 2 years there is a transfer of a
given property for an exchange into a new location, one might qualify within the
exchange rules, notwithstanding the "regularity" of this type of activity.

If it is assumed that the taxpayer does qualify for exchange treatment as noted, one can
then focus on the direction of this note, i.e., whether all the transfers will be included as
one composite transfer, or whether they would be separate, individual exchanges. If all
transfers, say over a number of months or even years, are treated as one transfer, then the
nonsimultaneous transfer would not qualify for the deferral under Code §1031, given the
time restrictions (45 days and 180 days), as indicated earlier.

The argument for treating the transactions as independent transfers would in large part
depend on the facts and circumstances of each case, notwithstanding that the transferor is
the same party involved in the transfers, and notwithstanding that the transferor might
deal with some transferee that are in common over the years, with the series of
exchanges.

It is this issue of composite or individual treatment that has given rise to the concern of
the tax-deferral issue by many taxpayers who are involved in many transfers and as well
as their representatives, whether that be real estate practitioners, CPAs, attorneys or
others.

The Service issued a definitive ruling position on this question as to the propriety and
qualification of such activity of a number of exchanges occurring over a period of time.
This has recently been addressed in Private Letter Ruling 9812013.

IV. RECENT PRIVATE LETTER RULING: MULTIPLE TRANSFERS:


Private Letter Ruling 9812013 is fairly detailed, but the focus is on the issue of this
Note, namely, the question of whether the number of transfers will constitute one
composite exchange (and thereby be disqualified) or whether a number of transfers will
be treated as independent exchanges on each transfer, thereby, assuming they meet the
other requirements of Code §1031, fall within Code §1031, allowing the deferral of the
gain.

The writers of the Ruling took great pains to go through a more detailed analysis of the
requirements under Code §1031, with particular emphasis on the requirements of a
nonsimultaneous (deferred) exchange under the earlier-cited Treasury Reg. §1.1031(k).
The Code Section and the Regulations are very specific as to the earlier-mentioned 45-
day rule and 180-day rule that must be met to qualify under Code §1031.

The Private Letter Ruling examined in detail issues as to the use of qualified
intermediaries, that is, the third party that will receive the transferor's property and also
receive the potential transferee's funds for the acquisition of the property from the
transferor as well as the use of the funds held by the intermediary to invest those funds in
like-kind property, consistent with the nonsimultaneous exchange rules, noted earlier. (As
mentioned, there are numerous articles and cases that have examined this issue as to
nonsimultaneous exchanges. See the Levine text, Exchanging Real Estate, cited earlier.
See also the Starker case, noted earlier, as well as a series of articles on this topic that are
cited in the Levine text.)

Numerous cases have also discussed this issue, although a detailed discussion is outside
the intent of this work. As an example of a few of these cases on nonsimultaneous
exchanges, see Bezdjian, T. C. Memo 1987-140; Swaim, 79-2 USTC 9462 (1979); Red
Wing Carriers, Inc., et. al., 68-2 USTC 9540, 399 F.2d 652 (5th Cir., 1968); and In Re:
Exchanged Titles, et. al., 159 B.R. 303 (1993). See also Private Letter Rulings 9341029
and 9428007.

In Private Letter Ruling 9812013, after taking great pains to review some of the
authorities noted, the Ruling concluded that, on the issue as to whether such exchange or
exchanges would qualify, the use of a number of exchanges will not, in and of itself,
destroy the tax-deferred treatment under Code §1031. That is, the Ruling concluded that
the exchanges would not be treated as a composite, i.e., as one, but rather, they would be
considered independent, separate exchanges, assuming the taxpayer kept them separate in
dealing with the transferee and the intermediary.

The Private Letter Ruling provided that so long as no boot or non-like-kind property
was received, whether in the form of cash, other non-like-kind property or debt relief, and
assuming other requirements were met as noted under Code §1031, the mere fact the
taxpayer was involved in a number of exchanges would not destroy the Code §1031
treatment.

However, the Ruling cautioned that if the taxpayer did receive non-like-kind property,
boot or otherwise failed to qualify within the Section, the taxpayer could not attempt to
correct or alleviate such position by trying to combine other exchanges, given a series of
exchanges that would take place. The Ruling noted, and cited Treasury Reg. §1.1031(k)-
1(g), that where there was boot received and the taxpayer failed to take into account such
boot, all of the exchanges, on a composite basis, may be impacted.

V. CONCLUSION:
In summary, taxpayers have the benefit, theoretically, of the concept of this Private
Letter Ruling, allowing a series of transactions to be treated as independent exchanges, as
opposed to a composite treatment of all of the transactions as one exchange. Thus,
taxpayers have the potential of qualifying these transactions under Code §1031, as
indicated.

The caveat for the taxpayers must be stressed: Be certain to meet the requirements
under Code §1031 in general, and specifically to treat each of the exchanges separately;
do not attempt to avoid gain on one of the exchanges as a result of receiving boot, e.g.,
cash, by attempting to utilize the excess cash position in combination with another in a
series of exchanges. For example, if Taxpayer X, the transferor, transferred Property X-1
to the Intermediary, and received, relative to this exchange, $500,000 in escrow,
ultimately reinvesting through a replacement in Property Y-1, of only $450,000, the
$50,000 difference of cash to X could not be avoided in the exchange of X-1 for Y-1 by
combining a non-related acquisition, by X, of another exchange property, attempting to
utilize the $50,000 difference in such exchange. Such action may result in combining a
number of exchanges into one transaction. In such case, this may defeat all transactions
if, for example, the time periods, mentioned earlier, of 45 days and 180 days, under Code
§1031, are violated.
Another caveat is also worthwhile: A "Private" Letter Ruling is "private;" it is issued to
a given taxpayer. Other taxpayers do not have the right to rely on such Private Letter
Ruling, notwithstanding that such Private Letter Rulings are normally made "public."

mxatdeu.ma
© Copyright by Dr. Mark Lee Levine, Denver, Colorado, l998. All rights reserved.

IN RE EXCHANGED TITLES, INC., Debtor


and DE GROOT, as Trustees
v.
EXCHANGED TITLES, INC. and DAFF,
Chapter 7 Trustee
159 B.R.303 (1993)

This interesting bankruptcy case involved a nonsimultaneous (deferred) exchange that


also was structured as a reverse Starker exchange.

Although the Plaintiffs, DeGroot, had transferred title to their Huntington Beach
property to the Debtor, the intent was to have a tax-deferred exchange. The Plaintiffs had
received like-kind property prior to their transfer of their property at Huntington Beach.

Before the Huntington Beach property could be sold by the Debtor, who was the
facilitator or intermediary, the Debtors filed a Chapter 7 Bankruptcy Petition. As such,
there was a question as to whether the Huntington Beach property could be sold by the
Debtor, or whether that was property of the Estate, which is what the Trustee asserted.

The Court concluded that the Trustee did not have the right to claim the property at
Huntington Beach.

As an aside as to the tax-deferred exchange, although there was a finding by the Court
that there was a clear intent to have a deferred exchange on a reverse Starker approach,
what was not addressed by the Court, as it was not directly reviewing the tax issue is that
the Treasury Regulations specifically provide under Treasury Reg. §1.1031(k) that a
reverse Starker cannot meet the deferred exchange requirements. This point is discussed
in this text.

See also the San Diego Realty Exchange case in this text.

[In Re Exchanged Titles v. Exchanged Titles A]


[In Re Exchanged Titles v. Exchanged Titles B]
[In Re Exchanged Titles v. Exchanged Titles C]
[In Re Exchanged Titles v. Exchanged Titles D]
[In Re Exchanged Titles v. Exchanged Titles E]
SAN DIEGO REALTY EXCHANGE, INC., Debtor;
TAXEL, TRUSTEE
V.
SURNOW

This case might shock anyone dealing with an intermediary and a nonsimultaneous
exchange.

The Taxpayer, Surnow, had hoped to undertake a tax-deferred exchange on a


nonsimultaneous basis. As such, the Plaintiff, San Diego Realty Exchange, Inc.
("SDRE"), was to be the intermediary. When Surnow transferred property to SDRE, to be
held relative to the exchange, part of the question was to determine who had the rights to
that property inasmuch as subsequently SDRE filed for bankruptcy.

Given the bankruptcy, the Trustee in Bankruptcy, Taxel, argued that the approximately
$371,000 that was in Trust in fact should be part of the bankruptcy estate and should not
go to the Transferor, prior property owner, Surnow.

Surnow argued his case to the position that SDRE held the proceeds that they obtained
from the sale of the subject property in Trust for him; therefore, they could not be part of
the bankruptcy estate.

The Lower Court granted a Summary Judgment in favor of Taxel, the Trustee, saying
that the funds were commingled in an account; therefore, the Plaintiff had no claim to the
funds.

On appeal, the 9th Circuit reversed, directing the Bankruptcy Court to determine
whether Surnow created an express trust and whether he was able to trace the funds by
applying a first-in, first-out position to show that the funds were his under a Trust
position.

This case is a paradigm example of the risks that are involved in a nonsimultaneous
exchange when using an intermediary if problems subsequently arise. It also gives some
indication of steps that can be followed to avoid such problems.

1994 WL 161646 (9th Cir.(Cal.))


UNPUBLISHED DISPOSITION
NOTICE:
Ninth Circuit Rule 36-3 provides that dispositions other than opinions or orders
designated for publication are not precedential and should not be cited except when
relevant under the doctrines of law of the case, res judicata, or collateral estoppel.

NOTE: THIS OPINION WILL NOT BE PUBLISHED IN A PRINTED VOLUME.


THE DECISION WILL APPEAR IN TABLES PUBLISHED PERIODICALLY.

In re SAN DIEGO REALTY EXCHANGE, INC., Debtor.


Harold S. TAXEL,
Trustee, Plaintiff-Appellee,
v.
Jack SURNOW,
Defendant-Appellant.

No. 92-56526.
United States Court of Appeals, Ninth Circuit.
Submitted April 5, 1994. Decided May 2, 1994.
Appeal from the United States Bankruptcy Court for the Southern District of California,
No. 90-03752-B7;
S.D.Cal.
REVERSED AND REMANDED.

Before: HALL, LEAVY, and FERNANDEZ, Circuit Judges.

MEMORANDUM [FN**]

Jack Surnow appeals a summary judgment in favor of Harold Taxel, trustee for chapter
7 debtor San Diego Realty EXCHANGE, Inc. Senior District Judge Burns, sitting by
designation on the bankruptcy court, held that Surnow had received a preferential transfer
in violation of 11 U.S.C. §547(b). We exercise jurisdiction over the appeal and reverse.

I.
In the late 1980s, San Diego Realty EXCHANGE, Inc. ("SDRE") facilitated "Starker
EXCHANGES," real estate transactions eligible for tax benefits under 26 U.S.C. §1031.
Generally, SDRE acquired "EXCHANGE property" from a client, transferred title to a
third party, and used the proceeds to purchase "replacement property" for the client.
Seeking to consummate such a deal, Jack Surnow executed an "EXCHANGE
Agreement" with SDRE in 1989. Pursuant to the agreement, Surnow transferred an
EXCHANGE property to SDRE, which then sold the parcel to a third party for
$353,082.11 (plus $2,150.70 from the escrow). At Surnow's insistence, SDRE placed the
sale funds in a segregated account at Michigan National Bank ("MNB") and made
Surnow's son, Michael, a required signatory for all withdrawals.

Surnow was unable to locate suitable replacement property, however, and the
EXCHANGE Agreement ultimately expired without a completed Starker EXCHANGE.
Surnow, therefore, demanded that SDRE authorize MNB to release the funds to him. As
a result, SDRE procured Michael Surnow's signature and closed the account on January
31, 1990. Surnow, however, permitted SDRE to wire transfer the money to its general,
commingled account at Chemical Bank in order to collect a $500 transaction fee. It was
not until thirteen days later, on February 13, 1990, that SDRE wired $370,932.45 (the
sale proceeds plus interest less the transaction fee) to Surnow from a second commingled
account at Union Bank.
On May 4, 1990, less than ninety days later, SDRE's creditors filed an involuntary
petition under chapter 7 of the Bankruptcy Code. Harold Taxel, SDRE's appointed
trustee, subsequently commenced an adversary proceeding against Surnow to recover the
$370,932.45 as a preferential transfer. Senior District Judge Burns, sitting by designation
on the bankruptcy court, granted summary judgment for Taxel and Surnow appealed
directly to the Ninth Circuit.

II.
Although neither party raised the issue, we must first examine whether we have
jurisdiction over Surnow's appeal. E.g., United States v. Stone (In re Stone), 6 F.3d 581,
583 n. 1 (9th Cir.1993) (court of appeals has an independent obligation to determine
jurisdiction). Despite the unusual procedural nature of the case, we conclude that
appellate review in this court is appropriate.

Normally, of course, parties must appeal bankruptcy court orders either to the district
court or the bankruptcy appellate panel in the first instance. See 28 U.S.C. §158(a), (b).
As a result, courts of appeals lack jurisdiction over the direct appeal of any order entered
by a bankruptcy judge. E.g., SEC v. Danning (In re Carter), 759 F.2d 763, 764-66 (9th
Cir.1985); 28 U.S.C. §158(d).

In this case, however, Surnow seeks to appeal an order entered by a district judge
sitting by designation on the bankruptcy court. This fact requires us to exercise
jurisdiction: "It does not make sense to have appeals from a decision of an Article III
judge heard by a panel of Article I judges, or by another judge of that judge's district
court. We accordingly hold that we will treat an appeal from the decision of a district
court judge sitting as a bankruptcy court as an appeal from a final decision appealable
under 28 U.S.C. §1291." Klenske v. Goo (In re Manoa Fin. Co.), 781 F.2d 1370, 1372
(9th Cir.1986), cert. denied, 479 U.S. 1064 (1987). Accord Ryan v. Loui (In re Corey),
892 F.2d 829, 833 n. 1 (9th Cir.1989), cert. denied, 498 U.S. 815 (1990); Graulty v. Bank
of Hawaii (In re Bishop, Baldwin, Rewald, Dillingham & Wong, Inc.), 856 F.2d 78, 79
(9th Cir.1988); Harris v. McCauley (In re McCauley), 814 F.2d 1350, 1351 (9th
Cir.1987); Cannon v. Hawaii Corp. (In re Hawaii Corp.) 796 F.2d 1139, 1141 (9th
Cir.1986). Therefore, because Judge Burns' order is final, see, e.g., Hansen v. MacDonald
Meat Co. (In re Kemp Pac. Fisheries, Inc.), 16 F.3d 313, 315 (9th Cir.1994) (reviewing
grant of summary judgment on preference claim), we may decide this appeal. [FN1]

III.
A bankruptcy trustee may recover property for the benefit of the debtor's estate if:

(1) there was a transfer,


(2) of property of the debtor,
(3) to or for the benefit of a creditor,
(4) for or on account an antecedent debt,
(5) made while the debtor was insolvent,
(6) made on or within ninety days before the date of the
bankruptcy petition,
(7) that enables the creditor to receive more than it would receive
in a chapter 7 liquidation of the estate. E.g., Kemp Pac.
Fisheries, 16 F.3d at 315 n. 1; 11 U.S.C. §547(b).

In the bankruptcy court, Surnow argued that SDRE had held the sale proceeds in trust
for him, thereby excluding the funds from property of the estate. The court, however,
declined to decide that issue, holding that summary judgment was appropriate because,
even if SDRE had held the money in trust, Surnow was unable to trace the funds beyond
the commingled general accounts: "Even under this assumption [that a trust existed],
Surnow would fail to raise an issue of material fact because of the subsequent
commingling of the supposed trust funds with the funds of other creditors. This
commingling is entirely undisputed. Surnow simply cannot trace the supposed corpus of
the trust." Viewing the evidence in the light most favorable to Surnow, as we must when
reviewing a grant of summary judgment, see, e.g., id. at 315, we cannot agree that no
genuine issues of material fact exist.

"Property that the debtor holds in trust at the time the debtor files its bankruptcy
petition is excluded from the bankruptcy estate and thus is not property of the debtor for
purposes of section 547." Kupetz v. United States (In re California Trade Technical Sch.,
Inc.), 923 F.2d 641, 646 (9th Cir.1991). See United States v. Whiting Pools, Inc., 462
U.S. 198, 205 n. 10 (1983); Mitsui Mfrs. Bank v. Unicom Computer Corp. (In re Unicom
Computer Corp.), 13 F.3d 321, 324 (9th Cir.1994); 11 U.S.C. §541(b)(1). However,
"[w]hen property of the estate is alleged to be held in trust, the claimant has the burden of
establishing the original trust relationship. A claimant must prove its title, identify the
trust property, and where the property has been mingled with that of the debtor, the
claimant must adequately trace the property." Altura Partnership v. Breninc, Inc. (In re
B.I. Fin. Servs. Group), 854 F.2d 351, 354 (9th Cir.1988) (emphasis added).

Here, Taxel submitted the declaration of J. Duross O'Bryan, a certified public


accountant, who stated that it was impossible to trace Surnow's money once SDRE
deposited the funds into its general account. Surnow, however, produced SDRE's Union
Bank and Smith Barney account statements. Analyzing these statements under the first-
in, first-out ("FIFO") rule set forth in California Trade Technical, 923 F.2d at 649-50, we
think it likely that at least some of Surnow's alleged trust funds are in fact traceable
through the commingled accounts.

In brief, [FN2] it appears that on January 31, 1990 SDRE wired Surnow's $370,410 to
the Smith Barney account, which contained $1,510,695 ("pre-Surnow funds") prior to the
transfer. [FN3] Between January 31 and February 12, SDRE withdrew a total of
$1,068,900 from the account, [FN4] leaving intact $441,795 of the pre-Surnow funds. On
February 12, SDRE wired $1,181,800 from the Smith Barney account to the Union Bank
account. Under the FIFO rule, that transfer consisted of the $441,795 pre-Surnow funds,
Surnow's $370,410, and $369,595 in subsequently deposited funds.

The Union Bank account had a balance of (-$140,998) prior to the transfer. [FN5] After
the transfer but before SDRE finally wired the money to Surnow, SDRE made an
additional $610,867 withdrawal. Again applying the FIFO rule, $60,340 of Surnow's
original $370,410 appears to remain intact and traceable. [FN6] If so, then Surnow is not
liable for that amount as a preference. See Republic Supply Co. v. Richfield Oil Co., 79
F.2d 375, 377 (9th Cir.1935) ("[N]o change of form can divest a trust fund of its trust
character, ... the cestui may follow and reclaim his funds so long as he is able to trace and
identify them, not as his original dollars or necessarily as any dollars, but through and
into any form into which his dollars may have been converted.").

The fact that SDRE was insolvent throughout the preference period is of no
consequence to Surnow's ability to trace the alleged trust funds. The possibility that
Surnow had created an express trust distinguishes this case from Judge Burns' earlier
ruling in the SDRE bankruptcy, see Taxel v. Vaca (In re San Diego Realty Exch., Inc.),
132 B.R. 424 (Bankr.S.D.Cal.1991), and from the Ponzi scheme described in Danning v.
Bozek (In re Bullion Reserve), 836 F.2d 1214 (9th Cir.), cert. denied, 486 U.S. 1056
(1988).

We therefore reverse and remand in order for the bankruptcy court to determine
whether Surnow had in fact created an express trust and, if so, whether he is able to trace
the trust funds by applying the FIFO rule. Cf. Elliot v. Bumb, 356 F.2d 749, 755 (9th
Cir.) ("The cause is remanded so as to afford [Surnow] the opportunity to attempt to trace
the sources of the commingled funds."), cert. denied, 385 U.S. 829 (1966).

REVERSED and REMANDED.

FN* The panel unanimously finds this case appropriate for decision without oral
argument. Fed.R.App.P. 34(a); 9th Cir.R. 34-4. FN** This disposition is not appropriate
for publication and may not be cited to or by the courts of this circuit except as provided
by 9th Cir.R. 36-3.

FN1. Although Surnow indicated in his timely notice of appeal from Judge Burns' order
that he was invoking jurisdiction of the Ninth Circuit, the clerk of the bankruptcy court
referred his appeal to a bankruptcy appellate panel. After Surnow objected, District Judge
Gilliam entered an order "terminating" the case, thereby permitting a direct appeal to the
circuit. Surnow then filed a second, untimely appeal of Judge Gilliam's order. Surnow's
original notice of appeal was jurisdictionally proper and timely; Judge Gilliam's order
was unnecessary. As a result, Surnow's second, untimely appeal is of no consequence.
We review this case on the basis of the first notice of appeal.

FN2. The following calculations are estimates. The record does not reveal whether the
bank statements are complete and accurate representations of SDRE's financial accounts
and, in any event, the statements themselves are not entirely legible. We undertake this
analysis merely to demonstrate how tracing might be possible. On remand, it will be
Surnow's burden to trace the funds to the satisfaction of the court.

FN3. The opening account balance on January 31 was $1,368,385. Prior to depositing
Surnow's funds later that day, SDRE posted two credits totalling $142,310.
FN4. SDRE posted four debits during that period: $190,000; $300,000; $500,000; and
$78,900.

FN5. The opening balance at the first of the month was $401,679. During the next
twelve days, SDRE posted four credits totaling $1,068,900 ($190,000; $300,000;
$500,000; and $78,900) and eleven debits totalling $1,611,577 ($5,000; $436,858;
$100,000; $22,928; $167,650; $4,400; $76,063; $76,576; $134,781; $94,450; $492,871).
FN6. Deducting the $140,998 debit balance from the total of $441,795 pre-Surnow funds
leaves $300,797 in pre-Surnow funds. Deducting the subsequent $610,867 debit from the
remaining pre-Surnow funds leaves a shortfall of $310,070. Deducting that shortfall from
Surnow's funds leaves $60,340.

THE IMPACT ON A TAX-DEFERRED EXCHANGE UNDER CODE §1031


WHEN THE INTERMEDIARY ENTERS BANKRUPTCY
by
Dr. Mark Lee Levine

I. WHAT HAPPENS WHEN THE INTERMEDIARY IS PLACED INTO


BANKRUPTCY?
It may seem a bit fictitious and irrelevant to even consider the possibility that a
proposed tax-deferred exchange could be destroyed if the intermediary, in a
nonsimultaneous exchange, 1/ is placed into bankruptcy. After all, has it ever occurred?
Yes!

The intent of this Note is not to review in detail the basics of Code §1031 and the
nonsimultaneous exchange (deferred exchange) rules. (For more on the background of
this position, see the authorities cited in the footnote. 2/)

Assuming one would normally meet the requirements under Code §1031(a)(3),
allowing for a qualified nonsimultaneous exchange, 3/ the taxpayer might utilize an
intermediary to facilitate such exchange. Generally speaking, Code §1031 anticipates a
nonsimultaneous exchange by allow the taxpayer, here labeled as Mr. X, to transfer Mr.
X's property, X-1, sometimes referred to as the relinquished property 4/, to a party who
has been labeled, under the Regulations, 5/ as the intermediary. 6/ Thus, the anticipation
is that Mr. X will transfer the X-1 property to the intermediary. The intermediary will,
through the direction of Mr. X, acquire replacement property, "for Mr. X," 7/ that will
meet the requirements of Code §1031. The replacement property desired will be directed
by Mr. X, in which Mr. X identifies the replacement property by communication to the
intermediary, who in turn undertakes the steps to acquire the property.

As mentioned, there are crucial time frames that must be met. If these time frames, the
45-day period to "identify" replacement property and the 180-day rule to close on the
replacement property, referred to in the Code and Regulations (see Footnote 3) for the
nonsimultaneous exchange are not met, the exchange will be destroyed. That is, if the
time elements are not timely met by Mr. X in identifying and replacing with proper
property, qualified under Code §1031, via the intermediary,
© Copyright by Dr. Mark Lee Levine, Denver, Colorado, l998.
All rights reserved.

the tax deferral under Code §1031 is lost. This means that the taxpayer must recognize
the taxable income. 8/ This may prove to be disastrous, from the tax standpoint, for Mr.
X.

Therefore, if the intermediary receives Mr. X's relinquished property, 9/ the taxpayer
expects the intermediary to act on a timely basis to meet the time frames, as indicated. If
the intermediary cannot act timely, possibly because the intermediary is "frozen" as to
any actions because of the intermediary being placed into bankruptcy, this usually means
a very damaging tax result for the taxpayer, Mr. X. (It may mean an even further and
more important adverse result to the taxpayer, Mr. X, if the monies generated from the
relinquished property are potentially in danger of being lost because they are considered,
arguably, to be funds of the bankrupt intermediary and, thus, can be claimed by creditors
of the intermediary and not by Mr. X!)

The purpose of this Note is to recognize the circumstances in which the potential
bankruptcy of the intermediary can destroy the tax-deferred exchange and can imperil the
funds of Mr. X, in the example noted. If one considers this issue as an event that can
"never" occur, the reader need merely consider a series of cases that have been generated
in recent years, one most recently in 1998, in which a bankruptcy occurred and the
intermediary was placed in a bankruptcy, thereby destroying the proposed tax-deferred
exchange and endangering the funds that were those of Mr. X.

Several years ago I raised the issue as to what would happen if an intermediary was
placed in a bankruptcy and the funds were in jeopardy. Having raised the issue, I was
labeled by some commentators as an alarmist; but, in 1994, cases were in fact decided on
this issue. (See the discussion below. 10/) This issue was reignited recently in 1998 with
another case on the same point.

II. RECENT DEVELOPMENTS: WHEN INTERMEDIARIES ARE PLACED


INTO BANKRUPTCY:
As mentioned, the issue of the use of an intermediary is often crucial in a
nonsimultaneous exchanges. Concern with the (intermediary's) timely replacement of
property with qualified replacement property is an absolute requirement under Code
§1031(a)(3). 11/ The concern with this issue was greatly magnified with the advent of
bankruptcies by intermediaries in California.

Historically, the use of intermediaries was generated as a result of legislation in 1984,


which followed the now-famous Starker cases. 12/ Following the Starker cases,
legislation was enacted by Congress to modify Code §1031 and to provide for specific
rules under Code §1031(a)(3) for nonsimultaneous, tax-deferred exchanges. (The use of
an intermediary was also provided for in the Regulations. 13/)
It is this use of the intermediary that gives rise to the concern of what might happen if
the intermediary, holding the money from the Transferor, Mr. X in the example, is placed
into bankruptcy prior to acquiring replacement property and transferring it to the
transferor (Mr. X in the example).

This setting of the intermediary being placed in bankruptcy arose in two (2) cases in
California in the early 1990's. In the case of In re: San Diego, 14/ the intermediary was
undertaking a number of exchanges as intermediary in the San Diego area in the 1980's.
Unfortunately, during the interim of one (1) deferred exchange, where the intermediary
held the funds, the intermediary was placed, by an involuntary petition, into a bankruptcy
status.

The question as to the exchange focused on the issue as to what happens to the funds
that the intermediary held. The Trustee in bankruptcy claimed the funds. On the other
hand, the taxpayer, Mr. Surnow (Mr. X), who had used the intermediary, claimed the
monies were his. However, the bankruptcy judge held, in a summary judgment position,
that the monies would go to the Trustee. In other words, the taxpayer, Mr. Surnow, was
out of luck!

Mr. Surnow appealed. The 9th Circuit of Appeals reversed the bankruptcy court and
held for Mr. Surnow.

Fortunately for Mr. Surnow, the taxpayer, he received the funds. (However, this does
not support a tax-deferred exchange as a result of the time delay!)

Notwithstanding that Mr. Surnow was successful by appealing his case, a key concern
for taxpayers, when using intermediaries is that intermediaries are placed in inconsistent
positions. From a tax standpoint, the taxpayer argues that the funds from the disposition
of the relinquished property are not received by the taxpayer and are not the taxpayer's
funds. On the other hand, from a bankruptcy standpoint, the taxpayer, as with Surnow,
must argue that the funds are the taxpayer's and are being held by the intermediary for the
benefit of the taxpayer. (This position is difficult for the taxpayer to argue, given that the
intermediary, under Treasury Reg. §1.1031(k), cannot be the agent of the taxpayer.
Therefore, it becomes difficult in that setting to argue that the intermediary is holding
funds on behalf of the taxpayer!)

One might consider such case as a fluke, a rare circumstance that will never happen
again. But, consider the case of Exchanged Titles (cited in Footnote 8). Without
examining the details of this case, the essence surrounded the same type of setting as
mentioned in the prior case, with Mr. Surnow. That is, an intermediary was placed into
bankruptcy. The Trustee in bankruptcy argued for the funds that were held by the
intermediary, taking the position that those funds were assets of the debtor/intermediary.
The taxpayer (transferor) that transferred those funds, directly or indirectly, would
arguably be, under the Trustee's position, a general creditor who must wait in line to
receive shared funds that would be available, if any.
Eventually, in the Exchanged Titles case, the plaintiff/taxpayer/transferor prevailed and
received the funds. Nevertheless, again the taxpayer had to battle for such position. In
turn, not only did this risk the funds, caused alarm and attorney fees, but it also normally
destroys the timing ability for meeting the 180-day requirement.

Again, the reaction by many cynical commentators was that these cases were simply
flukes, rare and extraordinary circumstances, for which we should not bother to plan nor
be concerned.

However, consider a recent case, in 1998, Siegel v. Boston. 15/ In the Siegel case, a/k/a
Sale Guaranty Corp., the debtor advised and facilitated Code §1031 exchanges. The
debtor suffered financial setbacks and was placed into bankruptcy. The Bankruptcy Court
was faced with the issue of how to treat funds that were held by the intermediary. Were
the funds to be held as part of the assets of the debtor, to be shared by creditors?
Alternatively, were these funds deemed to be held in a fiduciary/agency-type capacity,
i.e., trust funds held by the facilitator for the transferor?

The Court determined that the ownership of the funds would be controlled by state law.
The California Court held that the funds were in a trust position; therefore, the Court
ruled for the taxpayer/transferor.

Notwithstanding the result of this case, the conflict raised the same concerns as
illustrated earlier in the cases of Exchanged Titles and In re San Diego. Agreed: These
are rare circumstances, compared with the number of exchanges that take place.
However, taxpayers should be cautioned to consider alternatives and take protective steps
to avoid the position of an insolvent intermediary, which could result in not only a
destruction of the time element for an exchange and require litigation, but also, and more
importantly, in circumstances of an insolvent intermediary, it may risk the entirety of the
funds "of the taxpayer/transferor."

III. STEPS THAT COULD BE TAKEN TO AVOID A DEFAULTING


INTERMEDIARY?
I have argued in a prior article 16/ and in my text 17/ that taxpayers/transferors might
consider the following to avoid or lessen the concern with this issue:

1. AVOID AN EXCHANGE:
Obviously this issue only arose where there was a tax-deferred
exchange. Thus, avoid such position. (Of course, the benefits of
the exchange/deferral are lost!)
2. AVOID A NONSIMULTANEOUS EXCHANGE:
The taxpayer could restructure the transaction, and thus avoid
being involved in a nonsimultaneous exchange.
3. AVOID USE OF AN INTERMEDIARY:
The taxpayer could be involved in an exchange, but also avoid the
use of an intermediary in general. (There are other safe harbors
under the Regulations to facilitate the exchange and provide for
security. 18/)
4. PROVIDE FOR A STRONG INTERMEDIARY:
Taxpayers should carefully select an intermediary and avoid the
use of an intermediary that does not have substantial financial
strength. (In most instances, it would be wise to avoid the use of
individual intermediaries, as opposed to strong, financially sound
intermediaries that are usually structured in the form of some
entity.)
6. SEEK A PRIVATE LETTER RULING:
Taxpayers might consider seeking a Private Letter Ruling that
provides the assurance for the transaction to qualify as an
exchange, structured in a way that either: (a) avoids the use of an
intermediary that would expose the funds, as noted in the three
bankruptcy cases above, or, provides for (b) an agreement that the
funds are those of the taxpayer/transferor. (There is no guarantee
that the bankruptcy court would agree with this.)
7. AVOID EXPOSING THE FUNDS:
This is the "generic answer" that focuses on avoiding placing the
taxpayer's funds outside the control of the taxpayer.

IV. CONCLUSION:
Taxpayers should be forewarned as to their exposure when the intermediary defaults
and is forced into a bankruptcy position. However, bankruptcy is not the only setting
where the funds may be at risk. (A failure to secure the funds in a way to make certain
that they are not embezzled, absconded or otherwise lost should also be considered.)

I have argued that often the tax tail wags the economic dog. Taxpayers are very
concerned with the tax implications of their actions. The predisposition to focus on the
tax position has often caused taxpayers to have tunnel vision, thus ignoring other issues,
such as basic exposure for the total loss of the funds in the first place, and not just a
percentage of funds that could be lost by a tax claim. Economic issues, potential liability
and protection of the funds must be viewed on a priority basis, substantially ahead of the
issue of the tax burden.

This entire tax issue could be put to rest by Congress. I have argued in prior articles 19/
and in my text 20/ that Congress should clearly consider the elimination of the hyperbole
that exists in the gyrations that are created to facilitate tax-deferred exchanges. A cursory
examination illustrates the mental gymnastics and distorted structures that exist to contort
a format to comply with Code §1031. This includes the position to argue that the taxpayer
has not received the funds because of the use of a "controlled" intermediary, other
security arrangements, nonsimultaneous exchanges in general, etc.

I am not against tax-deferred exchanges, having worked with them for over 30 years. I
am also not generally in favor of taxing transactions wherein taxpayers dispose of
property and then reinvest the proceeds. Such position would inhibit many transfers and
would in general tend to inhibit the free alienation concept of holding property. The
burden of paying a tax bill encourages many taxpayers to defer the transaction. Code
§1031, on the other hand, encourages transactions to take place. However, in my opinion
there is no valid reason for the government to require the structures that currently exist
under Code §1031, especially under Treasury Reg. §1.1031(k) that provides for the
multiple steps which are necessary to comply with a nonsimultaneous, deferred
exchange.

Congress could pass legislation to eliminate the requirement of the exchange facet
under Code §1031. There is precedent for the position that if the taxpayer disposes of
property and reinvests on a timely basis, the deferral should take place. This latter
approach applied in some instances to the disposition of the principal residence under
Code §1034. (Code §1034 was repealed by the 1997 Taxpayer Relief Act [Tax Reform
Act of 1997]. However, the gain can be excluded, without requiring a reinvestment, if
one complies with Code §121 to meet the requirements as to the principal residence. 21/)

Congress could very quickly provide for the elimination of many cases and problems
that have been raised in this Note by simply passing legislation that, if the
taxpayer/transferor transfers property that is "qualified property," 22/ as that term is used
under Code §1031, and there is a reinvestment on a timely basis, no gain would be taxed.

The argument for Congress to make the change has so far fallen on deaf ears. Rather,
Congress has seen fit to continually expand and enhance the requirements and the
quagmire of the Internal Revenue Code by such provisions as those necessary to provide
for a tax-deferred exchange on a nonsimultaneous basis. Until members of Congress
choose to eliminate the requirements to undertake a deferred exchange, and provide for a
time period to reinvest, taxpayers should be very cognizant of the risks from a defaulting
intermediary that result in a bankruptcy setting. In such event, taxpayers certainly risk the
loss of the tax-deferred exchange, which is almost certain because of the required time
frames. More importantly, taxpayers risk the potential of losing their entire investment
under the arguments noted earlier in the three (3) cases.

© Copyright by Dr. Mark Lee Levine, Denver, Colorado, l998.


All rights reserved.
mxaITDE.ma

FOOTNOTES
1. The use of an intermediary in this setting implies a
nonsimultaneous exchange under 26 U.S.C.A. §1031 of 1986
(hereinafter sometimes referred to as Code §1031). The use of
the intermediary was sanctioned via the 1984 change of Code
§1031 as well as the subsequent development of the Regulations
for nonsimultaneous exchanges, under Treasury Reg.
§1.1031(k).
2. For a legislative history of Code §1031, which had its basis in
1921 and was substantially modified under the Revenue Act of
1924, Chapter 234, Section 203, 43 Stat. 256, passed by the 68th
Congress, see the text by Levine, Mark Lee, Exchanging Real
Estate, Volume 1, pages 1 through 3, Professional Publications
and Education, Inc., Colorado (1998). See also the Bureau of
National Affairs Portfolio No. 61-32, Page B-9, which examines
the legislative history of Code §1031.
3. See Code §1031(a)(3), which examines the detailed
requirements of identifying replacement property within 45 days
of the transfer of the relinquished property and to meet a
generally referred to 180-day rule for replacing the relinquished
property with other like-kind property that is identified as the
replacement property. For more details in this area, see the
authority cited supra, Footnote 2, the Levine text.
4. See Code §1031(a)(3) and Treasury Reg. §1.1031(k).
5. See Treasury Reg. §1.1031(k).
6. See Id.
7. See Id.
8. See In re: San Diego Realty, Inc., Debtor, and Taxel, Trustee, v.
Surnow, 24 F.3d 249, 1994 WL 161646, (9th Cir. California,
1994). See In re: Exchange Titles, Inc., a California Corporation,
Debtor, and DeGroot, Trustee v. Exchange Titles, Inc., a
California Corporation and Daff, a Chapter 7 Trustee, 159 BR
303 (September 15, 1993). See also the article by Levine, Mark
Lee, "Deferred Exchanges Under Code §1031: Is Your
Facilitator/Intermediary Solvent?" contained in the Levine text,
cited supra, Footnote 2.
9. See the Levine article, cited supra, Footnote 8.
10. See also the cases in point in Footnote 8, supra.
11. See also the earlier cited Regulations in Footnote 4, supra.
12. Starker v. U.S., 432 F.Supp. 864 (D.C., Ore., 1977), rev'd and
remanded 602 F.2d 1341 (9th Cir., 1979). For a detailed
discussion of Starker, see the authorities cited in the Levine text,
cited supra, Footnote 2, at Section 577. The Starker case
involved a nonsimultaneous exchange that did not have an
intermediary. Thus, using the earlier example, it would be as
though Starker, Mr. X, transferred property to a potential
"buyer," with an agreement for the buyer to transfer like-kind
property back to Mr. Starker (Mr. X.) Such case ultimately was
approved as a tax-deferred exchange. However, because of the
uncertainty as to the time frame and requirements for a
nonsimultaneous, deferred exchange, in 1984 Congress passed
Amendments to Code §1031. These Amendments under Code
§1031(a)(3) provide for specific time frames for the exchange to
be completed. Treasury Reg. §1.1031(a) further provides for the
safe harbor use of an intermediary to act to receive the property
transferred, property from Mr. X in the example.
13. See Treasury Reg. §1.1031(k).
14. See Footnote 8, supra.
15. In Re Sale Guaranty Corp., Debtor (B.A.P., 9th Circuit, April,
1998).
16. See the article in Footnote 8, supra.
17. See the Levine text, noted supra, Footnote 2.
18. See Treasury Reg. §1.1031(k).
19. See the article in Footnote 8, supra.
20. See Footnote 8, supra.
21. See Code §121. See also Levine, Mark Lee, Real Estate
Transactions, Tax Planning, Chapter 30, West Publishing Co.
(Minnesota, 1998).
22. For a definition of "qualified property," see the Levine text,
Chapter 3, cited supra, Footnote 2.

PRIVATE LETTER RULING 9341029

Given the stated facts, the issue in this Ruling was whether a deferred exchange met the
requirements under Code §1031. It also emphasized the use of a qualified intermediary.

Emphasizing proper compliance with the deferred exchange Regulations under


Treasury Reg. §1.1031-(k), the Ruling holds that the Taxpayer met these requirements
under the stated facts to have a qualified Code §1031 exchange on a deferred basis.

PRIVATE LETTER RULING 9341029


Publication Date: October 15, 1993

Dear _____:

This is in reply to your letter of April 16, 1993, and subsequent correspondence,
requesting a ruling under section 1031 of the Internal Revenue Code upon the exchange
of certain real estate.

You have represented that you are Individual A. You own, as an investment, Property
P, in City Z. This was formerly part of property owned by your brother, who died on date
e and willed half each to you and your sister. The original property consisted of an acre
and slightly more of land with two nearly identical dwelling units side by side, joined on
both floors by doors. The whole appraised value on his death was $q, of which your part
is half, or $r. You propose to exchange Property P (one of the two dwelling units) for
another residential rental real property within a few months of the date of this letter, but
within the times set forth in section 1031(a)(3)(B) of the Code. You propose to identify
the property to be received in the exchange on or before the date which is 45 days after
the date on which you transfer Property P. You represent that you have held Property P
for investment, have never resided in Property P, and have only made brief visits to make
repairs and improvements, never using it as a primary or secondary residence.

You have represented that you have an agreement with a qualified intermediary to
complete a deferred exchange and have sent a copy of that agreement. You also have
represented that you will transfer Property P to the qualified intermediary who will sell
Property P and place funds received upon the intermediary's disposition of Property P in
a qualified escrow. You represent that the qualified intermediary will acquire the property
you identified and transfer the replacement property to you within the exchange period
specified in section 1031(a)(3)(B).

You have requested that the Service rule that:

The exchange of Property P for another investment property of like kind will result in
the deferral of gain from the basis of Individual A in Property P due to the operation of
section 1031 of the Code

Section 1031(a)(1) of the Code provides, in general, 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 a like kind which is to
be held either for productive use in a trade or business or for investment.

Subsection 1031(a)(3) of the Code provides that for purposes of this subsection; any
property received by the taxpayer shall be treated as property which is not like-kind
property if-- (A) such property is not identified as property to be received in the exchange
on or before the date which is 45 days after the date on which the taxpayer transfers the
property relinquished in the exchange, or (B) such property is received after the earlier
of-- (i) the day 180 days after the date on which the taxpayer transfers the property
relinquished in the exchange, or (ii) the due date (determined with regard to extensions)
for the transferor's return of the tax imposed by this chapter for the taxable year in which
the transfer of the relinquished property occurs.

Section 1.1031(k)-1(g)(3)(ii) of the Income Tax Regulations provides that a qualified


escrow account is an escrow account wherein-- (A) The escrow holder is not the taxpayer
or a disqualified person (as defined in paragraph (k) of this section), and (B) The escrow
agreement expressly limits the taxpayer's rights to receive, pledge, borrow, or otherwise
obtain the benefits of the cash or cash equivalent held in the escrow account as provided
in paragraph (g)(6) of this section.

Section 1.1031(k)-1(g)(4)(ii) provides that paragraph (g)(4)(i) of this section applies


only if the agreement between the taxpayer and the qualified intermediary expressly
limits the taxpayer's rights to receive, pledge, borrow, or otherwise obtain the benefits of
money or other property held by the qualified intermediary as provided in paragraph
(g)(6) of his section.
Section 1.1031(k)-1(g)(4)(iii) provides that a qualified intermediary is a person who--
(A) Is not the taxpayer or a disqualified person (as defined in paragraph (k) of this
section), and (B) Enters into a written agreement with the taxpayer (the "exchange
agreement") and, as required by the exchange agreement, acquires the relinquished
property from the taxpayer, transfers the relinquished property, acquires the replacement
property, and transfers the replacement property to the taxpayer.

You have represented that Property A was held for investment before the exchange, and
that rental income would be the purpose of timely acquired like kind replacement
property. It is further stated that the agreement with the intermediary, following
paragraph (g)(6) of section 1.1031(k)-1(g) of the regulations, properly limits Individual
A's rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other
property held by the intermediary to acquire the replacement property before the end of
the exchange period. Accordingly, based on the facts presented and the representations
made, we rule that:

No gain or loss shall be recognized on the exchange of Property P under section 1031 if
such property is exchanged solely for property of a like kind which is to be held either for
productive use in a trade or business or for investment.

This ruling is directed only to the taxpayer who requested it. Section 6110(j)(3) of the
Internal Revenue Code provides that it may not be used or cited as precedent.

No opinion is expressed as to the tax treatment of the transaction under the provisions
of any other sections of the Code and regulations which may be applicable thereto, or the
tax treatment of any conditions existing at the time of, or effects resulting from, the
transaction which are not specifically covered by the above ruling.

Sincerely yours,
Assistant Chief Counsel

PRIVATE LETTER RULING 9428007

This Ruling involved the use of a nonsimultaneous exchange, deferred exchange, under
the now current Regulations. The steps that were to be followed involved the following:

(1) There would be an acquisition of the relinquished property,


Parcel A, from the Taxpayer, and transferred to a qualified
intermediary;
(2) There would be a transfer of Parcel A to a Buyer in exchange
for money.
(3) The monies would be placed into the escrow account and used
to acquire replacement property, labeled as Parcel B;
(4) The qualified intermediary would expend the monies
remaining after acquiring Parcel B to improve Parcel B for a
golf park; and
(5) After the improvements have been made to Parcel B, and
before expiration of the exchange period, the qualified
intermediary would transfer the replacement property with the
improvements to the taxpayer and attempt to meet the
requirements of Code §1031.

The question of the Ruling was: Would these meet the requirements of Code §1031? The
Ruling held, assuming the other requirements of the Regulations were met, that this
would be a qualified tax-deferred exchange.

PRIVATE LETTER RULING 9428007


April 13, 1994
Publication Date: July 15, 1994

Dear _____:

This is in response to your request for a ruling on behalf of Taxpayer. You have
requested that we rule that the transaction described below qualifies as a like-kind
exchange under section 1031 of the Internal Revenue Code.

Taxpayer currently owns an apartment building (Parcel A) that he utilizes for


productive use a trade or business or as investment property. Taxpayer desires to
exchange Parcel A for a vacant tract of land (Parcel B) currently owned by Seller. Buyer
has expressed interest in purchasing Parcel A. Taxpayer desires to use the proceeds from
the sale of Parcel A to acquire Parcel B and build a golf course thereon. These
improvements shall be in the form of, but not limited to, building a pump house and
landscaping, which includes removing trees, shaping fairways, putting in greens and tees,
seeding, and building an irrigation system.

The exchange would be effected by using a qualified escrow account and a qualified
intermediary (QI). The exchange is to be completed within an exchange period that is the
earlier of 180 days after the date on which the taxpayer transfers the property
relinquished in the exchange, or the due date of the return (determined with regard to
extension) for the transferor's return for the tax for the taxable year in which the transfer
of the relinquished property occurs. QI will: (i) acquire the relinquished property, Parcel
A, from Taxpayer; (ii) transfer Parcel A to Buyer in exchange for $325,000; (iii) place
the $325,000 purchase price in escrow and QI will use the funds to acquire the
replacement property, Parcel B, from Seller; (iv) expend the remainder of the purchase
price improving Parcel B within the exchange period; and (v) after improvements have
been made to Parcel B, and on or before the day the exchange period ends, transfer the
replacement property (Parcel B), with improvements to Taxpayer.

During the exchange period, QI has sole authority to control the funds paid to QI in
exchange for Parcel A. Taxpayer will not have the right to the receive, pledge, borrow, or
otherwise obtain the benefits of the cash or cash equivalent of the funds held by the
qualified escrow, other than to select the improvements purchased or constructed.
Taxpayer will be entitled to receive the balance, if any, of the qualified escrow funds (i)
after all of the improvements to Parcel B have been effected and Parcel B is transferred to
Taxpayer or (ii) at the end of the exchange period.

Section 1031(A)(1) 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. Taxpayer represents that Parcel A
is currently used for productive use in a trade or business or for investment and that
Parcel B will be used for productive use in a trade or business.

Section 1031(A)(3)(B) provides that for purposes of this subsection, any property
received by the taxpayer shall be treated as property which is not like-kind property if
such property is received after the earlier of (i) the day which is 180 days after the date on
which the taxpayer transfers the property relinquished in the exchange, or (ii) the due
date (determined with regard to extension) for the transferor's return for the tax imposed
by this chapter for the taxable year in which the transfer of the relinquished property
occurs ("exchange period"). Taxpayer represents that it will receive Parcel B, with
improvements, on the earlier of 180 days after he relinquishes Parcel A or the due day
(determined with regard to extension) for the transferor's return for the taxable year in
which the transfer of Parcel A occurs (that is, prior to the end of the exchange period).

Section 1031(B) provides that if an exchange would be within the provisions of


subsection (a), if it were not for the fact that the property received in exchange consists
not only of property permitted by such provisions to be received without the recognition
of gain, but also of other property or money, then the gain, if any, to the recipient shall be
recognized, but in amount not in excess of the sum of such money and the fair market
value of such other property. Taxpayer does not anticipate receiving any cash in
exchange for Parcel A. However, if the amount received from Buyer for Parcel A exceeds
the cost of Parcel B and improvements, Taxpayer will recognize gain to the extent of the
excess.

Section 1.1031(A)-1(B) of the Income Tax Regulations provides that, as used in section
1031(A), the words "like kind" have reference to the nature or character of the property
and not to its grade or quality. One kind or class of property may not, under that section,
be exchanged for property of a different kind or class. The fact that any real estate is
improved or unimproved is not material, for that fact relates only to the grade or quality
and not to its class. Unproductive real estate held by one other than a dealer for future use
or future realization of the increment in value is held for investment and not primarily for
sale. Taxpayer represents that Parcel A is held, and Parcel B will be held, for productive
use in a trade or business or for investment.

Section 1.1031(K)-1(E)(1) of the regulations provides that a transfer of relinquished


property in a deferred exchange will not fail to qualify for nonrecognition of gain or loss
under section 1031 merely because the replacement property is not in existence or is
being produced at the time the property is being identified as replacement property. For
purposes of this paragraph (e), the terms "produced" and "production" have the same
meanings as provided in section 263A(g)(1) and the regulations thereunder.

Section 1.1031(K)-(E)(2)(I) of the regulations provides that in the case of replacement


property that is to be produced, the replacement property must be identified as provided
in paragraph (c) of this section (relating to identification of replacement property). For
example, if the identified replacement property consists of improved real property where
the improvements are to be constructed, the description of the replacement property
satisfies the requirements of paragraph (c)(3) of this section (relating to the description of
replacement property) if a legal description for the underlying land and as much detail is
provided regarding the construction of the improvements as is practicable at the time the
identification is made. Section 1.1031(K)-1(C)(3) provides that replacement property is
identified only if it is unambiguously described in the written document or agreement.
Real property generally is unambiguously described if it is described by a legal
description, street address, or distinguishable name (e.g., the Mayfair Apartment
Building). Taxpayer has provided an adequate legal description of the real estate and
identified the improvements.

In addition, section 1.1031(K)-1(E)(3)(III) of the regulations provides that if the


identified replacement property is real property to be produced and the production of the
property is not completed on or before the date the taxpayer receives the property, the
property received will be considered to be substantially the same property as identified
only if, had the production been completed on or before the date the taxpayer receives the
replacement property, the property received would have been considered to be
substantially the same property as identified. Even so, the property received is considered
to be substantially the same property as identified only to the extent the property received
is constitutes real property under local law.

Section 1.1031(K)-1(G)(1) of the regulations sets forth four safe harbors the use of
which will result in the determination that the taxpayer is not in actual or constructive
receipt of money or other property for purposes of section 1031 and this section. More
than one safe harbor can be used in the same deferred exchange, but the terms and
conditions of each must be separately satisfied. For purposes of the safe harbor rules, the
term "taxpayer" does not include a person or entity utilized in a safe harbor (e.g., a
qualified intermediary).

Section 1.1031(K)-1(G)(4)(I) of the regulations provides that in the case a taxpayer's


transfer of relinquished property involving a qualified intermediary, the qualified
intermediary is not considered the agent of the taxpayer for purposes of section 1031(A).
In such a case, the taxpayer's transfer of relinquished property and subsequent receipt of
like-kind replacement property is treated as an exchange, and the determination of
whether the taxpayer is in actual or constructive receipt of money or other property
before the taxpayer actually receives like-kind replacement property is made as if the
qualified intermediary is not the agent of the taxpayer.
Section 1.1031(K)-1(G)(4)(II) of the regulations provides that paragraph (g)(4)(i) of
this section applies only if the agreement between the taxpayer and the qualified
intermediary expressly limits that taxpayer's rights to receive, pledge, borrow, or
otherwise obtain the benefits of money or other property held by the qualified
intermediary as provided in paragraph (g)(6) of this section.

Section 1.1031(K)-1(G)(4)(III) of the regulations provides that a qualified intermediary


is a person who (A) is not the taxpayer or a disqualified person (as defined in paragraph
(k) of this section), and (B) enters into a written agreement with the taxpayer (the
"exchange agreement") and, as required by the exchange agreement, acquires the
relinquished property from the taxpayer, transfers the relinquished property, and transfers
the replacement property to the taxpayer. Taxpayer represents that QI is such a person
and has entered into such an agreement.

Section 1.1031(K)-1(K)(1) of the regulations provides that for purposes of this section,
a disqualified person is a person described in paragraph (k)(2), (k)(3), or (k)(4) of this
section. Paragraph (k)(2) provides that if the person is the agent of the taxpayer at the
time of the transaction he is a disqualified person. For this purpose, a person who has
acted as the taxpayer's employee, attorney, accountant, investment banker or broker, or
real estate agent or broker within the 2-year period ending on the date of the transfer of
the first of the relinquished properties is treated as the agent of the taxpayer at the time of
the transaction. Solely for purposes of this paragraph (k)(2), performance of the following
services will not be taken into account: (i) services for the taxpayer with respect to
exchanges of property intended to qualify for nonrecognition of gain or loss under section
1031; and (ii) routine financial, title insurance, escrow, or trust services for the taxpayer
by a financial institution, title insurance company, or escrow company. Taxpayer
represents that QI meets the above requirements and is not related to any of the parties to
the transaction.

Section 1.1031-1(G)(4)(IV) of the regulations provides that regardless of whether an


intermediary acquires and transfers property under general tax principals [principles],
solely for purposes of paragraph (g)(4)(iii)(B) of this section (A) an intermediary is
treated as acquiring and transferring property if the intermediary acquires and transfers
legal title to that property, (B) an intermediary is treated as acquiring and transferring the
relinquished property if the intermediary (either on its own behalf or as the agent of any
party to the transaction) enters into an agreement with a person other than the taxpayer
for the transfer of the relinquished property to that person and, pursuant to that
agreement, the relinquished property is transferred to that person, and (C) an intermediary
is treated as acquiring and transferring replacement property if the intermediary (either on
its own behalf or as the agent of any party to the transaction) enters into an agreement
with the owner of the replacement property for the transfer of that property and, pursuant
to that agreement, the replacement property is transferred to the taxpayer.

Taxpayer has represented that (i) QI shall be assigned the contract to acquire Parcel A
from Taxpayer; (ii) QI shall be assigned the contract to acquire Parcel B from Seller by
general warranty deed; (iii) Buyer will arrange for the purchase price of Parcel A, less
transaction costs (including but not limited to all costs for which Taxpayer is responsible
under the purchase agreement with Buyer), and commission expenses to be paid to QI.
The transaction, as represented, meets this section's requirements.

Section 1.1031(K)-1(G)(4)(V) of the regulations provides that solely for purposes of


paragraphs (g)(4)(iv) of this section, an intermediary is treated as entering into an
agreement if the rights of a party to the agreement are assigned to the intermediary and all
parties are notified in writing of the assignment on or before the date of the relevant
transfer of property. For example, if a taxpayer enters into an agreement for the transfer
of relinquished property and thereafter assigns its rights in that agreement to an
intermediary and all parties to that agreement are notified in writing of the assignment on
or before the date of the transfer of the relinquished property, the intermediary is treated
as entering into that agreement. If the relinquished property is transferred pursuant to that
agreement, the intermediary is treated as having acquired and transferred the relinquished
property.

Upon receipt on (i) the contract to purchase Parcel A from Taxpayer; (ii) the contract to
purchase Parcel B from Seller; (iii) and the purchase price for Parcel A, less transaction
costs and commission expenses, from Buyer, QI shall effect the following transaction. QI
will (i) transfer title of Parcel A to Buyer by general warranty deed under the same terms
and conditions provided in the purchase agreement; (ii) acquire title to Parcel B by
general warranty deed under the same terms and conditions provided in the purchase
agreement assigned to QI for Parcel B; (iii) transfer the title of Parcel B to Taxpayer by
quit- claim deed after improvements are made to Parcel B. The transaction therefore
meets the requirements of section 1.1031(K)-1(G)(4)(V) of the regulations.

Section 1.1031(K)-1(G)(4)(VI) of the regulations provides that paragraph (g)(4)(i) of


this section ceases to apply at the time the taxpayer has an immediate ability or
unrestricted right to receive, pledge, borrow, or otherwise obtain the benefits of money or
other property held by the qualified intermediary. Rights conferred upon the taxpayer
under state law to terminate or dismiss the qualified intermediary are disregarded for this
purpose. Taxpayer has represented that he will not have the right to receive, pledge,
borrow, or otherwise obtain the benefits of money or other property held by QI. Taxpayer
does not have the right to receive any funds until after he receives Parcel B.

Section 1.1031(K)-1(G)(6)(I) of the regulations provides that an agreement limits a


taxpayer's rights as provided in this paragraph (g)(6) only if the agreement provides that
the taxpayer has no rights, except as provided in paragraphs (g)(6)(ii) and (g)(6)(iii) of
this section to receive, pledge, borrow, or otherwise obtain the benefits of money or other
property before the end of the exchange period. Taxpayer has represented that, under the
terms of its agreement with QI, he has no rights, to receive, pledge, borrow, or otherwise
obtain the benefits of money or other property before the end of the exchange period.

Section 1.1031(K)-1(G)(6)(III) of the regulations provides that the agreement may


provide that if the taxpayer has identified the replacement property, the taxpayer may
have rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other
property upon or after the receipt by the taxpayer of all of the replacement property to
which the taxpayer is entitled under the agreement. Taxpayer has represented that he does
not have the right to receive, pledge, borrow, or otherwise obtain the benefits of money or
other property upon or after the receipt by the taxpayer of all of the replacement property
to which the taxpayer is entitled under the agreement.

Based on Taxpayer's representations, we rule that the transaction described above


qualifies for nonrecognition treatment under section 1031 of the Code.

A copy of this letter should be attached to the return for the taxable year in which the
replacement of the converted property is made.

INTERPLAY OF CODE §1031 AND CODE §453:


NONSIMULTANEOUS EXCHANGE WAS NOT TIMELY UNDERTAKEN:
180-DAY RULE:CHRISTENSEN

The major question in the Christensen case was whether the taxpayer met the
requirements under Code §1031, allowing a deferral of the gain. The Court held that,
under the facts of the case, the taxpayer actually sold the property and, therefore, could
not come within the requirements of Code §1031.

This case illustrates the circumstance where the taxpayer failed to comply with the
timing requirements under Code §1031. Therefore, the exchange treatment was denied.

Orville E. CHRISTENSEN and Helen V. Christensen, Petitioners,


v.
COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 12706-94.
United States Tax Court.
T.C. Memo. 1996-254
1996 WL 289977 (U.S.Tax Ct.), 71 T.C.M. (CCH) 3137
June 3, 1996.

MEMORANDUM OPINION
KORNER, Judge:

By timely notice of deficiency, respondent determined deficiencies in petitioners'


Federal income tax in the amounts of $220,039 for 1988 and $240 for 1989. The case was
submitted to the Court on a set of fully stipulated facts and exhibits under Rule 122.
Except as hereinafter noted, all statutory references are to the Internal Revenue Code in
effect for the years in issue, and all Rule references are to the Tax Court Rules of Practice
and Procedure.

After the settlement of other issues in the case, it remains for the Court to decide:
(1) Whether the transfer of a certain property by petitioner
husband in 1988, followed by the receipt by him of certain
other properties in 1989, constituted a tax-free exchange of
like-kind properties within the meaning of section 1031 for the
year 1988; and
(2) whether, if such transfer and receipt of properties does not
qualify for tax-free exchange treatment under section 1031, but
is rather a sale and exchange of properties on which gain or
loss is to be recognized, such transactions constitute sales that
are reportable on the installment method under section 453.

Petitioners, husband and wife, filed joint income tax returns for the years 1988 and
1989, and at the time of filing their petition herein were residents of California.

In 1981, petitioner husband purchased a business property located in Santa Rosa,


California (Tesconi property), which was operated as a trade or business property
producing rental income, and on which petitioners reported income and losses in their
joint income tax returns. On December 22, 1988, petitioner husband entered into an
"agreement of exchange of real property" with Bill and Linda Wilson, Robert and Nina
Klotz, and Gary and Kendra Falconer, under which petitioner husband as "exchanger"
agreed to transfer to Mr. and Mrs. Wilson as "facilitators", for further transfer to Mr. and
Mrs. Klotz and Mr. and Mrs. Falconer as "purchasers", the Tesconi property, as part of a
contemplated tax- free exchange under the provisions of section 1031. In addition, the
exchanger agreed to notify the facilitators of the property that the exchanger desired to
acquire within 45 days after the closing date of the transfer to facilitators of the Tesconi
property in order to complete the projected exchange. Further, the agreement specified
that such property to be received by petitioner husband as exchanger in the projected
exchange would be acquired by him "no later than 180 days after the closing date (but not
later than the due date (taking into account extensions) of Exchanger's Federal income tax
returns for the taxable year in which Exchanger's property was transferred to Facilitator)".

On the same date mentioned above, December 22, 1988, petitioner husband transferred
the Tesconi property to the facilitators, and on that same date the facilitators transferred
said property to the purchasers. No consideration for the transfer was received at that
time.

On February 3, 1989, petitioner husband sent the facilitators a letter listing the
properties that he desired to acquire as part of the projected exchange. Nineteen such
properties were listed, and were identified by the Sonoma County (California) county
assessor's parcel numbers, except for one listed property, which was located in Plumas
County. The first five of these properties were listed in order of preference by petitioner
husband as exchanger.

Thereafter, some of the desired exchange properties listed in the designation letter were
acquired as follows (all such properties were listed in the exchanger's notification letter to
the facilitators, and are referred to herein by their commonly accepted place names).
1. On April 25, 1989, Applesauce Alley was transferred by Golden
Oak Enterprises, Inc., to the facilitators, who on the same day
transferred the property to petitioner husband, who
simultaneously transferred title to petitioners as trustees of the
Christensen trust, a revocable trust created by petitioners for
their benefit, to which they were trustees.
2. On May 1, 1989, the property known as 6691 Sebastopol was
acquired by the facilitators from Don and Betty Mallory, was
transferred by them to petitioner husband, and was
simultaneously transferred by him to petitioners as trustees for
the Christensen trust
3. On June 12, 1989, Thomas and Jean Scally transferred the
property known as Shiloh Road to the facilitators, who
transferred the property to petitioner husband on the same day.
4. On June 20, 1989, David Landrus and William Frye transferred
the property known as Boyd Street to the facilitators, and on the
same day the facilitators transferred the property to petitioner
husband, who in turn transferred the same to petitioners as
trustees for the Christensen trust.
5. On June 16, 1989, the facilitators transferred the property
known as Haystack Landing to petitioner husband, who in turn
transferred the property to petitioners as trustees for the
Christensen trust.
6. On April 26, 1989, Jeffrey and Sandra Bohn transferred the
property known as the Greenville property to petitioners as
trustees for the Christensen trust.

With respect to all these transfers of property, except as section 1031(a)(3) may apply,
petitioners received no money or other nonqualifying property from the facilitators or
otherwise as the result of transferring the Tesconi property.

As part of their 1988 joint income tax return, petitioners included the statement "the
property known as 360 Tesconi Circle is being exchanged in a deferred 'starker'
exchange. The transaction will be completed and reported in 1979". The use of "1979" in
this statement is a typographical error that should read "1989".

No issue is raised by the parties, and they apparently agree that the Tesconi property
relinquished by petitioner husband and the properties received by him were like-kind
properties which would qualify for exchange under section 1031(a)(1). Likewise, the
parties apparently agree that there was no cash boot or other nonqualifying property
received in this set of transactions under section 1031(b). Accordingly, the controversy is
narrowly framed: was the series of transactions involved herein a qualifying nontaxable
exchange within the limitations of section 1031(a)(3); and, if not, does the integrated
transaction qualify for income tax purposes as an installment sale, to be reported under
the provisions of section 453?
Somewhat prophetically, this Court said in Barker v. Commissioner, 74 T.C. 555, 560-
561 (1980):

This case involves another variant of the multiple-party, like-kind exchange by which
the taxpayer, as in this case, seeks to terminate one real estate investment and acquire
another real estate investment without recognizing gain. The statutory provision for
nonrecognition treatment is section 1031. The touchstone of section 1031, at least in this
context, is the requirement that there be an exchange of like-kind business or investment
properties, as distinguished from a cash sale of property by the taxpayer and a
reinvestment of the proceeds in other property.

The "exchange" requirement poses an analytical problem because it runs headlong into
the familiar tax law maxim that the substance of a transaction controls over form. In a
sense, the substance of a transaction in which the taxpayer sells property and immediately
reinvests the proceeds in like-kind property is not much different from the substance of a
transaction in which two parcels are exchanged without cash. Yet, if the exchange
requirement is to have any significance at all, the perhaps formalistic difference between
the two types of transactions must, at least on occasion, engender different results.

The line between an exchange on the one hand and a nonqualifying sale and
reinvestment on the other becomes even less distinct when the person who owns the
property sought by the taxpayer is not the same person who wants to acquire the
taxpayer's property. This means that multiple parties must be involved in the transaction.
* * * [Fn. ref. and citations omitted.]

In Starker v. United States, 602 F.2d 1341 (9th Cir. 1979), the Court of Appeals pointed
out that at the time of an agreement of exchange, the possibility of a cash sale does not
preclude the application of section 1031 if the parties truly intended to have an exchange
of like-kind properties, and if such an exchange is timely consummated; the transfer of
one property and the receipt of another need not be simultaneous. See Brauer v.
Commissioner, 74 T.C. 1134 (1980).

Shortly thereafter, in Biggs v. Commissioner, 632 F.2d 1171 (5th Cir. 1980), affg. 69
T.C. 905 (1978), the Court of Appeals pointed out that the other party of a proposed
nontaxable exchange need not hold title to the property to be exchanged at the time of the
agreement in order to qualify the transaction as an exchange under section 1031. Multiple
transactions leading up to the alleged exchange are not necessarily to be considered as
separate sales and purchases. There must, however, be a true exchange of properties even
though with some taxable boot, not just a sale and a subsequent purchase. The whole
transaction must be shown to be part of an overall plan, which is carried out.

Concurring with Biggs v. Commissioner, supra, this Court in Garcia v. Commissioner,


80 T.C. 491 (1983), opined that the step transaction doctrine is to be included within the
reach of section 1031; the total plan involving a true exchange must be considered.
Nevertheless, the taxpayer's expressed intentions to have a transaction qualify as a section
1031 exchange do not matter; what counts is what was actually done. Carlton v. United
States, 385 F.2d 238 (5th Cir. 1967).

Possibly with the purpose of clarifying some confusion with respect to the limits of
section 1031, and the time that might be allowable in order to complete such a
transaction, which would qualify as tax free, Congress amended, in the Deficit Reduction
Act of 1984, Pub. L. 98-369 (DEFRA), sec. 77(a), 98 Stat. 494, 595, the provisions of
section 1031 by adding a new paragraph (3) to section 1031(a). The new subsection reads
as follows:

(3)
Requirement that property be identified and that exchange be completed not more than
180 days after transfer of exchanged property.--For purposes of this subsection, any
property received by the taxpayer shall be treated as property which is not like-kind
property if:

(A) such property is not identified as property to be received in the


exchange on or before the day which is 45 days after the date
on which the taxpayer transfers the property relinquished in the
exchange, or
(B) such property is received after the earlier of--
(i) the day which is 180 days after the date on which the
taxpayer transfers the property relinquished in the
exchange, or
(ii) the due date (determined with regard to extension) for the
transferor's return of the tax imposed by this chapter for
the taxable year in which the transfer of the relinquished
property occurs.

DEFRA section 77(b)(3), 98 Stat. 596, made the new section 1031(a)(3) effective for
transfers made after July 18, 1984, in tax years ending after that date.

Qualification Under Section 1031(a)(3)(A)

First, we consider whether the projected exchange of properties qualifies under the
restrictions of section 1031(a)(3)(A)--that the desired properties to be received in the
exchange be specifically designated by the exchanger within 45 days. We reject the
suggestion that section 1031(a)(3)(A) was not satisfied in this case because an excessive
number of properties were designated. The statute, which we have quoted above, only
requires that the designated replacement properties be specified within 45 days after the
date on which the taxpayer transfers the property relinquished in the exchange. In the
instant case, that means 45 days after petitioner husband transferred the Tesconi property
to the facilitators, which was December 22, 1988. Forty-five days thereafter was
February 5, 1989, and prior to that date, petitioner husband had designated all the desired
replacement properties. At that time, there was no further limitation on the application of
section 1031(a)(3)(A). In an attempt to limit the number of properties that could be so
designated, section 1.1031(k)-(1)(c), Income Tax Regs., was adopted by T.D. 8346,
1991-1 C.B. 150, 157. The regulations, however, are prospective only as they apply to
transfers of property made on or after June 10, 1991. At the time of the instant
transaction, therefore, there were no regulations in effect, nor were there any
corresponding regulations to limit the number of properties that could be designated. In
the instant case, the letter of designation specified 19 properties, of which 5 were stated
to be preferred by petitioner husband as exchanger and 6 were ultimately received. We do
not find anything excessive or improper in such designation under the law or under the
regulations as they stood at that time. See St. Laurent v. Commissioner, T.C. Memo.
1996-150.

Qualification Under Section 1031(a)(3)(B)

The second requirement of section 1031(a)(3), in subparagraph (B), is that the property
to be received by the taxpayer in exchange will not qualify for tax-free treatment under
section 1031 if it was received after 180 days from the date when the taxpayer transfers
the property relinquished in the exchange, or, alternatively, if such property is received
after "the due date (determined with regard to extension) for the transferor's return of the
tax imposed by this chapter for the taxable year in which the transfer of the relinquished
property occurs".

There are no regulations concerning these provisions of section 1031(a)(3)(B), either at


the time of enactment of this subparagraph or since. We are accordingly left to interpret
the plain language of the statute, which we find to be unambiguous.

Section 6072 provides that a return for an individual on the calendar year basis must be
filed by April 15 following the close of the calendar year. Section 7503 then provides that
if April 15 falls on a Saturday, Sunday, or legal holiday, the due date will be the next day
not a Saturday, Sunday, or legal holiday. The due date for petitioners' 1988 return was on
April 15, 1989, except that such date was a Saturday. Therefore, under section 7503, the
due date for petitioners' income tax return was April 17, 1989. As we have detailed
above, all the transfers to petitioner husband, the exchanger, in this transaction happened
after April 17, 1989: the earliest on April 25, 1989, and the latest on June 20, 1989. Such
transfer dates fall outside the exchange period provided for by the statute, section
1031(a)(3)(B)(ii).

Petitioners nevertheless urge that respondent's argument is just a quibble, that even
though petitioners' joint return was due on April 17, 1989, and in fact was filed on that
date, petitioners nevertheless were entitled to an automatic 4-month extension of time for
the year 1988, which would extend the due date for the return from April 17, 1989, to
August 17, 1989, and that since they were automatically entitled to such an extension, the
permissible period within which a tax-free exchange could be made should be extended
by that period.

We must reject petitioners' argument. The fact is that petitioners' joint return was filed
on April 17, 1989, its due date. The further fact is that no extension of time to file such
return was applied for by petitioners. Furthermore, the "automatic" granting of such
extension of the period for time to file is not as automatic as petitioners urge. Section
6081(a) gives the Secretary power to grant extensions of time for filing returns, generally
for not more than 6 months. Pursuant to that statutory provision, section 1.6081-4,
Income Tax Regs., effective in the years before us, provides an "automatic" extension of
time to file of 4 months, but such extension is to be considered granted only if certain
conditions are met:

(a) An application of extension on Form 4868 must be made and


executed by the taxpayer or other authorized person;
(b) such application must be filed with the appropriate revenue
officer on or before the normal due date of the return (in this
case, April 17, 1989);
(c) such application must show the full estimated amount of the tax
to be due with the return, and the remittance of such estimated
amount with the application is required; and
(d) the automatic extension of time is granted only if the above
conditions are met.

In the instant case, the return for 1988 that petitioners filed showed an overpayment of
tax and a refund due. However, none of the other above-mentioned conditions were met
by petitioners and, in fact, no application for extension for 1988 was filed.

Accordingly, we must hold that the requirements of section 1031(a)(3)(B) are


unambiguous; the transfer of the replacement properties to petitioner husband as
exchanger took place after the required receiving period; no extension of time for filing
the required return for 1988 was applied for or granted; and the transfers involved in this
case do not qualify for tax-free treatment under section 1031.

Qualification of the Transaction for Reporting on the Installment Basis

We have held that the alleged "exchange" of the Tesconi property by petitioner husband
in exchange for various designated properties, all acquired in 1989, are not to be treated
as a tax-free exchange under section 1031; rather, it is a sale by petitioner husband, in
payment of which he received the properties that we have listed herein. The parties have
stipulated that the gain on the disposition of the Tesconi property was $776,441 after
deducting basis, refinancing costs, and expenses of sale. It is true, however, that although
the Tesconi property was conveyed to the facilitators and to the purchasers on December
22, 1988, the compensation to petitioner husband was not received until after April 17,
1989. Petitioners argue that, if the Court should hold that the transaction herein does not
qualify for tax-free exchange treatment under section 1031, nevertheless it should qualify
for installment sale treatment under section 453. [FN1] Section 453(a) provides that
except as otherwise provided, income from an installment sale shall be taken into account
for purposes of taxation under the installment method. An installment sale is defined in
section 453(b) as a "disposition of property where at least 1 payment is to be received
after the close of the taxable year in which the disposition occurs". Section 453(c) defines
the installment method of reporting as "a method under which the income recognized for
any taxable year from a disposition is that proportion of the payments received in that
year which the gross profit (realized or to be realized when payment is completed) bears
to the total contract price". If the facts fulfil the requirements of an installment sale, this
method of tax reporting is to be followed unless the taxpayer elects to have the section
not apply to such a disposition. Sec. 453(d).

In the instant case, the property was conveyed by petitioner husband to the facilitators
and by them to the purchasers on December 22, 1988. Nevertheless, no payment for the
conveyance, in the form of the properties detailed above, was received until various dates
in the year 1989. Accordingly, we agree with petitioner and respondent and hold that
although the Tesconi property was conveyed by petitioner husband to the purchasers in
1988, no payment therefore was received until 1989, so that an installment sale took
place under section 453(b). Since respondent did not determine that any taxable sale took
place in the year 1989, nor any deficiency of tax resulting therefrom, we need to make no
further determinations regarding this matter, but simply hold that respondent's
determination of additional income for 1988 on account of the Tesconi transfer was in
error.

NONSIMULTANEOUS EXCHANGES: TIME LIMIT


CHRISTENSEN (1998)

In the case of Christensen v. Comm., 1998 WL 205787 (9th Circuit, 1998), the taxpayer
attempted a tax-deferred exchange under Code §1031. The Lower Court held that the
taxpayer did not comply with the nonsimultaneous rules, in particular the 180-day
requirement, among other positions. This was affirmed on appeal.

Further, the taxpayer must meet the earlier date of 180 days from the time of transfer of
the relinquished property, or the due dates for the tax return, including extensions. The
taxpayer did not request or receive an extension. This was very important in this case.

The taxpayer argued that, even though they did not request an extension, they
substantially complied by filing their return.

The Court noted an interesting point: ". . . exchange was not reported on the return for
the year in which the taxpayers' property was transferred as contemplated by the
statutes."

Thus, the taxpayers failed in their attempt to meet Code §1031.

Orville E. CHRISTENSEN; Helen V. Christensen, Petitioners-Appellants,


v.
Commissioner of Internal Revenue, Respondent-Appellee.

No. 96-70741.
Tax Ct. No. 12706-94.
United States Court of Appeals,
Ninth Circuit.

Submitted [FN**] Nov. 3, 1997.


Decided April 10, 1998.
Appeal from a Decision of the United States Tax Court.

Before WIGGINS, KLEINFELD, Circuit Judges, and WILSON [FN***] District Judge.

MEMORANDUM [FN*]

FN* This disposition is not appropriate for publication and may not be cited to or by
the courts of this circuit except as provided by 9th Cir. Rule 36-3.

Petitioners-Appellants Orville and Helen Christensen ("taxpayers") appeal the tax


court's decision of deficiency in tax of $218,789 for 1989. The tax court found that the
taxpayers' transfer of a rental property did not qualify as a like-kind exchange under 26
U.S.C. § 1031(a) because the exchange was completed after the due date for their tax
return. We have jurisdiction under 26 U.S.C. § 7482, and we affirm.

I.

In general, the gain or loss on the sale or exchange of property is taxable. See 26 U.S.C.
§ 1001. One notable exception to this rule is § 1031 which provides for the
nonrecognition of gain or loss in the case of like-kind exchanges of property held for
productive use in a trade or business or for investment. See 26 U.S.C. § 1031. Thus, a
taxpayer can avoid recognition of gain when he continues his investment in qualifying
property.

In 1984, Congress amended § 1031 to limit the circumstances in which a deferred


exchange could qualify for nonrecognition. Congress was motivated in part by a concern
that the law did not require that a like-kind exchange be completed within a specified
period. See H.R. Conf. Rep. No. 98-861, at 866 (1984). The amended § 1031(a)(3)
provides: (3) Requirement that property be identified and that exchange be completed not
more than 180 days after transfer of exchanged property. For purposes of this subsection,
any property received by the taxpayer shall be treated as property which is not like-kind
property if-

(A) such property is not identified as property to be received in the


exchange on or before the day which is 45 days after the date
on which the taxpayer transfers the property relinquished in
the exchange, or
(B) such property is received after the earlier of-
(i) the day which is 180 days after the date on which the
taxpayer transfers the property relinquished in the
exchange, or
(ii) the due date (determined with regard to extension) for the
transferor's return of the tax imposed by this chapter for
the taxable year in which the transfer of the relinquished
property occurs.

§ 1031(a)(3). This amendment imposed clear time requirements on any proposed like-
kind exchange.

The taxpayers did not acquire the exchange property before the due date of their 1988
tax return, which was earlier than 180 days after they transferred their rental property. In
addition, they did not request or receive an extension of time to file their 1988 return. The
Commissioner of Internal Revenue determined that the taxpayers' exchange did not
qualify as a like-kind exchange because it did not satisfy the time limits prescribed by §
1031(a). As a result, the Commissioner assessed a deficiency. In response, the taxpayers
filed suit in tax court. The tax court agreed with the Commissioner and entered a decision
of deficiency in tax of $218,789 for 1989.

Because it was a question of law, the tax court's determination that the series of
transfers at issue did not qualify as a like-kind exchange exempt from tax under § 1031 is
reviewed de novo. See Vukasovich, Inc. v. Commissioner, 790 F.2d 1409, 1413 (9th
Cir.1986).

II.

The taxpayers' first claim is that the tax court misinterpreted the time limits of §
1031(a). They argue that "the due date (determined with regard to extension)" should
include the extension that is available under § 6081(a) even if the taxpayer did not
actually apply for and receive the extension. The tax court held that the language of §
1031(a)(3)(B)(ii) is unambiguous: the deadline to complete the exchange is the due date
for the transferor's tax return, including any granted extensions. We agree with this
interpretation and reject the taxpayers' argument.

"Canons of statutory construction dictate that if the language of a statute is clear, we


look no further than that language in determining the statute's meaning." United States v.
Lewis, 67 F.3d 225, 228 (9th Cir.1995). The plain meaning of a statute controls if it does
not lead to absurd or impracticable consequences. See Seattle-First Nat'l Bank v.
Conaway, 98 F.3d 1195, 1197 (9th Cir.1996). Section 1031(a)(3)(B)(ii) has a plain
meaning that does not lead to absurd results.

The focus of the section is the due date of the tax return. The deadline for receipt of
exchange property is this actual due date, not a hypothetical due date. The section
indicates that the due date is to be "determined with regard to extension." The logical
meaning of "extension," as it modifies "due date," is actual extension. The statute does
not refer to an "available" or "possible" extension, and the taxpayers have provided no
persuasive basis on which to infer such a reference. "[D]ue date (determined with regard
to extension)" means the actual due date of the tax return, including any extensions
granted. Because the taxpayers failed to complete the exchange by the due date of their
tax return, the transfer was not a like-kind exchange.

III.

In the alternative, the taxpayers contend that they substantially complied with the
requirements of § 1031(a). They argue that, by filing their tax return on its due date
(without an extension), they provided the Commissioner with the same information they
would have provided if they followed the literal requirements of § 1031(a). After
reviewing the statute and the taxpayers' transaction, we conclude that the taxpayers did
not substantially comply with the section.

The doctrine of substantial compliance can be applied only when it would not defeat
the policies of the underlying statutory provisions. See Sawyer v. County of Sonoma, 719
F.2d 1001, 1008 (9th Cir.1983). It is well-established that the doctrine of substantial
compliance is particularly problematic when deadlines are at issue. See, e.g., United
States v. Locke, 471 U.S. 84, 100-01, 105 S.Ct. 1785, 85 L.Ed.2d 64 (1985); Prussner v.
United States, 896 F.2d 218, 223 (7th Cir.1990). As the Supreme Court has recognized,
"[f]iling deadlines, like statutes of limitations, necessarily operate harshly and arbitrarily
with respect to individuals who fall just on the other side of them, but if the concept of a
filing deadline is to have any content, the deadline must be enforced." Locke, 471 U.S. at
100-01. Section 1031(a)(3)(B)(ii) imposes a deadline on the completion of a like-kind
exchange. Consequently, we are chary to assume that anything less than literal
compliance satisfies this Congressionally-mandated deadline.

In this case, the taxpayers did not comply with the section at all. Under §
1031(a)(3)(B)(ii), the exchange must be completed by the earlier of (1) 180 days after the
taxpayer transfers the property or (2) the due date of the transferor's tax return. The
taxpayers failed to complete the exchange by this deadline. Moreover, the exchange was
not reported on the return for the year in which the taxpayers' property was transferred as
contemplated by the statute. Substantial compliance must not be predicated on no
compliance at all. See Walker & Sons, Inc. v. Valentine, 431 F.2d 1235, 1239 (5th
Cir.1970); Johnson v. Does, 950 F.Supp. 632, 635 (D.N.J.1997); Connecticut Gen. Life
Ins. Co. v. Thomas, 910 F.Supp. 297, 302 (S.D.Tex.1995).

The policy underlying § 1031(a)(3)(B)(ii) is to provide strict time and reporting


requirements on the completion of like-kind exchanges. See H.R. Conf. Rep. No. 98-861,
at 866 (1984). Application of the substantial compliance doctrine in this context would
defeat the policy. The doctrine would allow the taxpayers to avoid the very time
requirements that were the reason for the amendment of the section. Accordingly, it
cannot be said that the taxpayers substantially complied with § 1031(a).

IV.

We conclude that the taxpayers did not satisfy the requirements for a like-kind
exchange under 26 U.S.C. § 1031. Thus, the judgment of the tax court is affirmed.
AFFIRMED.

KLEIN V. COMMISSIONER,
T. C. Memo 1993-491 (1993)

The issue in this case is whether a nonsimultaneous exchange met the requirements
under Code §1031 where the Taxpayer had constructive receipt on the funds.

The Court held that since the Taxpayer had control over the funds and any limitations
were only placed on those at the Taxpayer's own request, constructive receipt applied,
and Code §1031 was inapplicable.

Keith K. KLEIN, Petitioner,


v.
COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 8109-92.
United States Tax Court
T.C. Memo. 1993-491 (Oct. 26, 1993).

MEMORANDUM FINDINGS OF FACT AND OPINION

COHEN

Respondent determined a deficiency of $19,876 in petitioner's Federal income tax for


1988. The sole issue remaining for decision is whether the disposition of certain real
property and the acquisition of other real property constituted a nontaxable exchange
under section 1031.

Unless otherwise indicated, all section references are to the Internal Revenue Code in
effect for the year in issue.

FINDINGS OF FACT

Most of the facts have been stipulated, and the stipulated facts are incorporated in our
findings by this reference.

At the time the petition was filed, petitioner resided in South Lake Tahoe, California.

Petitioner owned real property located at 3349 Treehaven Drive, South Lake Tahoe,
California (Treehaven property). Petitioner held the Treehaven property as rental
property from 1976 or 1977 through September 16, 1988. In 1988, petitioner decided to
sell the Treehaven property because a second deed of trust had come due on that
property. Petitioner wanted to continue to invest in real estate to build his retirement
fund. Petitioner also wanted to avoid a taxable event so as to preserve more funds for the
purchase of another property. Therefore, petitioner sought to transfer the Treehaven
property in a section 1031 exchange.

On May 20, 1988, petitioner entered into an exclusive authorization to sell the
Treehaven property with real estate agent Bill Suss of T.I.G.R.R. Realty. This exclusive
authorization included a clause requiring that a section 1031 exchange be accommodated
for petitioner.

On August 4, 1988, petitioner received an offer to purchase the Treehaven property


from Steve and Anna Smith (the Smiths). On August 6, 1988, petitioner made a
counteroffer to the Smiths to sell the Treehaven property for $111,000. This counteroffer
included a provision requiring the Smiths to cooperate with petitioner in transacting a
section 1031 exchange. The smiths accepted petitioner's counteroffer on August 71 1988.
On September 9, 1988, an escrow account was opened with Founders Title Company for
the sale of the Treehaven property. The Smiths, however, did not own property that could
be exchanged for the Treehaven property in a section 1031 transaction. Consequently,
petitioner began to search for exchange property to complete the transaction pursuant to
section 1031.

Petitioner found suitable property located at 325 W. Neilsen, Fresno, California


(Neilsen property). The Neilsen property was owned by Dean Murphy (Murphy) and had
been listed for sale "on and off for a number of years." Petitioner and Murphy had been
acquainted for several years, and Murphy was willing to assist petitioner in completing a
section 1031 exchange. Petitioner orally agreed to acquire the Neilsen property from
Murphy for $150,000, using the proceeds from the sale of the Treehaven property.
Petitioner and Murphy orally agreed that petitioner would forward all moneys from the
Treehaven property escrow directly to Murphy for the downpayment on the purchase of
the Neilsen property. Petitioner and Murphy also orally agreed that petitioner would be
released from his promise to acquire the Neilsen property if petitioner's Treehaven
property deal with the Smiths did not close.

On September 9, 1988, petitioner executed the Treehaven property escrow instructions


with Founders Title Company, providing that any and all proceeds due to petitioner at the
close of the escrow were assigned to Murphy. In these instructions, Founders Title
Company expressly stated that it was not a party to the separate agreement between
petitioner and Murphy. On September 15, 1988, petitioner amended these escrow
instructions to provide for an assignment of $30,000 to Murphy and for the balance of
any proceeds remaining after deductions and disbursements to be paid directly to
petitioner. The $30,000 assignment constituted petitioner's downpayment on the purchase
of the Neilsen property. The Neilsen property transaction between petitioner and Murphy
was not included in the Treehaven property escrow account. Moreover, a separate escrow
account was not opened for the purchase and sale of the Neilsen property.

On September 16, 1988, escrow closed on the Treehaven property, and the following
events occurred: title to the Treehaven property was transferred to the Smiths; the Smiths
paid into the escrow account the purchase price of the Treehaven property; the escrow
company disbursed all funds from the account pursuant to the escrow agreement,
including a $30,000 check made payable to Murphy and a $8,614.87 check made payable
to petitioner, which represented the balance of the escrow account after all deductions
and disbursements. On the same day, petitioner hand-delivered the $30,000 check to
Murphy, and petitioner and Murphy executed a written installment contract for the
purchase of the Neilsen property. This installment contract made no reference to the
Treehaven property sale.

Petitioner reported no gain or loss with respect to the Treehaven property on his 1988
return. In the notice of deficiency, respondent determined that petitioner's disposition of
the Treehaven property was a taxable event.

OPINION

Section 1001(c) requires that gain or loss realized upon the sale or disposition of
property must be recognized for tax purposes. Section 1031(a), however, provides for the
nonrecognition of gain or loss where certain property that is held for productive use in a
trade or business or for investment is exchanged solely for property of a like kind. The
cornerstone of section 1031 is the requirement that there be an exchange of like-kind
business or investment properties, as distinguished from a cash sale by the taxpayer
followed by an immediate reinvestment of the proceeds in other property. Barker v.
Commissioner, 74 T.C. 555, 561 (1980). In Barker, id., we noted that:

The "exchange" requirement poses an analytical problem because it runs headlong into
the familiar tax law maxim that the substance of a transaction controls over form. In a
sense, the substance of a transaction in which the taxpayer sells property and immediately
reinvests the proceeds in like-kind property is not much different from the substance of a
transaction in which two parcels are exchanged without cash. Bell Lines, Inc. v. United
States, 480 F.2d 710, 711 (4th Cir.1973). Yet, if the exchange requirement is to have any
significance at all, the perhaps formalistic difference between the two types of
transactions must, at least on occasion, engender different results. Accord, Starker v.
United States, 602 F.2d 1341, 1352 (9th Cir.1979).

As a result, courts have acknowledged that transactions that take the form of a cash sale
and reinvestment cannot, in substance, constitute an exchange for purposes of section
1031, even though the end result is the same as a reciprocal exchange of properties. Bell
Lines, Inc. v. United States, 480 F.2d 710, 714 (4th Cir.1973); Carlton v. United States,
385 F.2d 238, 241 (5th Cir.1967). Thus, our inquiry here is narrowly focused on whether
petitioner's disposition of the Treehaven property was a sale, as argued by respondent, or
an exchange, as argued by petitioner.

Petitioner contends that the series of transactions here, culminating in the acquisition of
the Neilsen property with the Treehaven property escrow funds, were steps in an
integrated transaction, the substance of which was an exchange of properties. Petitioner
cites several cases involving multiparty transactions that were characterized as
exchanges. Alderson v. Commissioner, 317 F.2d 790 (9th Cir.1963), revg. 38 T.C. 215
(1962); Garcia v. Commissioner, 80 T.C. 491 (1983); Barker v. Commissioner, 74 T.C.
555 (1980); Biggs v. Commissioner, 69 T.C. 905 (1978), affd. 632 F.2d 1171 (5th
Cir.1980). In such multiparty transactions, the taxpayer desires to exchange, rather than
to sell, his property, but the potential buyer owns no property that the taxpayer wishes to
receive in exchange. Thus, these cases involve three or more parties and multiple
conveyances of property in an effort to structure an exchange instead of a sale and
reinvestment. In numerous cases, these multiparty transactions have been held to
constitute an exchange within the meaning of section 1031. In so holding, the courts have
allowed taxpayers great latitude in structuring their transactions and have allowed
nonsimultaneous exchanges, Starker v. United States, 602 F.2d 1341 (9th Cir.1979);
deposit of sale proceeds into a bank account controlled by an independent third party
before an exchange property is located, J. H. Baird Publishing Co. v. Commissioner, 39
T.C. 608 (1962); transactions in which the intermediary did not acquire legal title to the
exchange property, Biggs v. Commissioner, supra; and change from a sale transaction to
an exchange transaction even though the property to be received on the exchange was not
identified as of the date the original agreement was made, Alderson v. Commissioner,
supra.

These multiparty cases have explained that section 1031 "only requires that as the end
result of an agreement, property be received as consideration for property transferred by
the taxpayer without his receipt of, or control over, cash." Coupe v. Commissioner, 52
T.C. 394, 409 (1969). On the other hand, receipt of, or control over, cash proceeds by a
taxpayer will prevent characterization of a multiparty transaction as an exchange.

The end result of the multiparty transaction here was that the Smiths acquired the
Treehaven property and petitioner acquired the Neilsen property. However, respondent
contends that, in the interim, petitioner had constructive receipt of the proceeds from the
sale of the Treehaven property to the Smiths.

Section 1.451-2, Income Tax Regs, relating to the constructive receipt of income,
provides in pertinent part:

(a) General rule. Income although not actually reduced to a taxpayer's possession is
constructively received by him in the taxable year during which it is credited to his
account, set apart for him, or otherwise made available so that he may draw upon it at any
time, or so that he could have drawn upon it during the taxable year if notice of intention
to withdraw had been given. However, income is not constructively received if the
taxpayer's control of its receipt is subject to substantial limitations or restrictions.
[Emphasis added.]

Respondent contends that petitioner maintained control over the funds in the Treehaven
property escrow account because petitioner had and exercised the ability to change the
escrow instructions and because there was no written or binding agreement between
petitioner and Murphy to determine how, and to whom, the escrow funds should be
disbursed. Respondent argues that petitioner thus had constructive receipt of the
Treehaven property sale proceeds and, as a result, the transactions here should be
characterized as a cash sale and a separate reinvestment of the proceeds.

Respondent cites Carlton v. United States, 385 F.2d 238 (5th Cir.1967), and Nixon v.
Commissioner, T.C. Memo.1987-318, in support of her contention that a taxable sale and
purchase have occurred. In those multiparty cases, taxpayers received unrestricted control
over cash proceeds upon the transfer of their property, and no methods were used to
ensure that a portion of such funds would be used to acquire like-kind property. Because
those taxpayers had control of the cash proceeds, the transactions in those cases were
held to be a sale and reinvestment instead of a series of steps constituting an exchange.

Petitioner, however, contends that the transactions here are distinguishable from those
in Carlton and Nixon. Specifically, petitioner argues that his assignment of the Treehaven
property proceeds in the escrow instructions and his oral agreement with Murphy
operated as substantial limitations on his control of the escrow funds.

We recognize that there are factual differences between the structure of the transactions
here and those in Carlton and Nixon. In those cases, cash proceeds from the sale of
property were transferred directly to the taxpayer/sellers. Here, in contrast, the proceeds
from the sale of the Treehaven property were deposited into an escrow account.
However, because we are satisfied that petitioner had unrestricted control over, and thus
constructive receipt of, the funds in the Treehaven property escrow, we believe that this
case is essentially the same as Carlton and Nixon.

We reject petitioner's contention that his $30,000 assignment to Murphy in the escrow
instructions constituted a substantial limitation on his control of the Treehaven property
sale proceeds. A similar constructive receipt of income issue arose in Woodbury v.
Commissioner, 49 T.C. 180 (1967), where a taxpayer selling cattle in 1958 desired to
defer the recognition of income resulting from the sale until 1959. Attempting to obtain a
deferral, the taxpayer/seller arranged with its bank to have the buyer's check, which was
deposited by the buyer at the taxpayer's bank in November 1958, credited to his account
in January 1959. This arrangement was not discussed with the buyer, who had placed no
restrictions on the check and knew.of no such arrangement whereby the taxpayer was not
to receive the funds from the bank until 1959. On those facts, we held that the
arrangement preventing the taxpayer from reaching the funds was made at the taxpayer's
"own behest" and that, at the "critical point in time," when the check was deposited at the
bank, the taxpayer had complete control over the flow of the funds. Id. at 196.

Here, we also believe that the limitation consisting of an assignment of $30,000 to


Murphy in the escrow instructions was made at petitioner's "own behest". The Treehaven
property deal between petitioner and the Smiths involved no restrictions on petitioner's
control of the funds to be deposited in escrow by the Smiths. While the Smiths agreed to
cooperate with petitioner in transacting a section 1031 exchange, there is no evidence
indicating that they placed restrictions on the funds that they deposited in the Treehaven
property escrow. Thus, at the "critical point in time," when the Smiths deposited the
funds in escrow, petitioner had control over the funds. The only limitation on his control
of the funds was made at petitioner's "own behest".

Petitioner's control over the escrow funds is further demonstrated by his power to alter
the disposition of the funds by amending the escrow instructions. Originally, the escrow
instructions provided that "any and all proceeds" due to petitioner at the close of escrow
were assigned to Murphy. Petitioner, however, unilaterally amended the instructions to
provide for a $30,000 assignment to Murphy with the balance of the proceeds being paid
directly to himself. Discussing the doctrine of constructive receipt in an analogous
context, the Court of Appeals for the Ninth Circuit has recently stated that: " 'The power
to dispose of income is the equivalent of ownership of it. The exercise of that power to
procure the payment of income to another is the enjoyment, and hence the realization, of
the income by him who exercises it.' * * * [The taxpayer's] failure to receive cash was
entirely due to his own volition." Murphy v. United States, 992 F.2d 929, 931 (9th
Cir.1993) (quoting Helvering v. Horst, 311 U.S. 112, 118 (1940)).

Applying this description of constructive receipt to the facts here, we believe that
petitioner's exercise of his power to alter the disposition of the Treehaven property
proceeds in the escrow account demonstrates his ownership, enjoyment, and, thus,
constructive receipt of the escrow funds.

We also reject petitioner's contention that his oral agreement with Murphy constituted a
substantial limitation on his control over the escrow funds because of the statute of frauds
as codified in California.

Petitioner seems to argue additionally that his intent to undertake an exchange should
be sufficient to bring the transactions within the ambit of section 1031. This argument is
misplaced. Although intent can be relevant in determining what events transpired, Biggs
v. Commissioner, 69 T.C. at 915, it is not sufficient to cause these transactions to fall
within section 1031. Garcia v. Commissioner, 80 T.C. at 498.

Because we are satisfied that petitioner had control over, and thus constructive receipt
of, the Treehaven property escrow funds, we hold that the transactions here are properly
characterized as a sale followed by a reinvestment. Thus, we hold that petitioner's
disposition of the Treehaven property is not a nontaxable exchange under section 1031.

Decision will be entered for respondent.

FREDERICKS V. COMMISSIONER,
T. C. Memo 1994-27

In integrated and confusing set of facts, the taxpayer was involved in various aspects of
transactions that might, in toto, be considered a tax-deferred exchange under Code §1031.
This case involved an apartment complex of 305 units in Denver, Colorado.
The Court held that, although there were various options and activities by the taxpayer, it
was in essence an integrated 4-party exchange agreement that effectively allowed the
taxpayer, through an intermediary, to meet the requirements of Code §1031.

The Court held for the taxpayer, although admittedly the taxpayer could have structured
the transaction in a more favorable format.

Fred L. FREDERICKS, Petitioner,


v.
COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 19161-91.
United States Tax Court
T.C. Memo. 1994-27 (1994).

MEMORANDUM FINDINGS OF FACT AND OPINION

RUWE, Judge:

Respondent determined a deficiency of $1,033,941.00 in petitioner's Federal income


tax for 1983 and an addition to tax of $258,485.25 pursuant to section 6661. [FN1]

The issues for decision are: (1) Whether petitioner exchanged real property within the
meaning of section 1031(a); (2) if so, whether petitioner must recognize any gain on the
exchange under section 1031(b); and (3) whether petitioner is liable for the addition to
tax as determined by respondent

.
FINDINGS OF FACT

Some of the facts have been stipulated and are so found. The stipulations of fact and
attached exhibits are incorporated herein by this reference. Petitioner resided in Santa
Ynez, California, when he filed his petition.

On or about January 7, 1980, petitioner and four other individuals acquired interests in
Wildridge Apartments, a 305-unit apartment complex, located in Colorado Springs,
Colorado. Petitioner held a 90.83-percent interest in Wildridge Apartments and the other
four cotenants held a combined minority interest of 9.17 percent. Petitioner acquired his
interest in Wildridge Apartments by selling to the four minority owners an undivided
9.17-percent interest in the pending acquisition of Wildridge Apartments for $400,000,
by exchanging certain apartment units known as Parkdale and wholly owned by
petitioner, and by executing an 18-month "wrap around" note in the amount of $4
million.

In the latter part of 1980, petitioner began attempts to obtain permanent long-term
financing for Wildridge Apartments. Petitioner had difficulty obtaining such financing
since interest rates continued to rise and lenders "kept backing out". As of September 28,
1981, the interest rate on the 18- month promissory note was 23.5 percent. Under an
extension agreement dated September 24, 1982, petitioner was able to extend the original
due date (June 7, 1982) on the 18-month promissory note to July 9, 1983, by making a
$500,000 payment. On April 12, 1983, the Savings Bank of Puget Sound signed a loan
commitment letter for the refinancing of Wildridge Apartments in the amount of $6
million. On May 27, 1983, petitioner signed a promissory note for $6 million, executed a
Deed of Trust, Assignment of Rents, and Security Agreement in favor of the Savings
Bank of Puget Sound. On June 2, 1983, the loan transaction settled, and, after paying the
underlying indebtedness and settlement charges, petitioner received net loan proceeds of
$2,020,407.33.

On March 6, 1981, more than 1 year following petitioner's acquisition of Wildridge


Apartments, petitioner entered into an "Option Agreement" with the J. and M. Brock
Living Trust (Trust) to purchase certain parcels of unimproved real property, consisting
of approximately 11 acres located in Buellton, California (Buellton Property). [FN2] The
option period was to end September 6, 1982. Petitioner paid $50,000 for the option.
Along with entering into the "Option Agreement", the parties executed (1) "Agreement
Re Interpretation of Option Agreement and Purchase Agreement and Escrow
Instructions" [FN3] and (2) "Purchase Agreement and Escrow Instructions." [FN4]

On August 12, 1982, in consideration of an additional $50,000, the Trust extended the
above option to September 6, 1983. The terms of this new option agreement were
substantially similar to, and consistent with, the first option and attending agreements.
Fred L. Fredericks, Inc. (Company), made the $50,000 payment for the extension of the
option. Company later credited petitioner for the $50,000 he paid for the initial option.
Petitioner was the sole shareholder of Company. Company conducted business as a
licensed building contractor and as a real estate developer.

On February 25, 1982, Fred L. Fredericks Realty, Inc. (FLF Realty), a licensed real
estate broker, listed Wildridge Apartments for sale at a price of $9,200,000. Petitioner
was the sole shareholder of FLF Realty. In 1983, petitioner retained Paul Hamilton Co.,
an unrelated company, to sell Wildridge Apartments.

As early as May 4, 1983, petitioner and BHS Realty, Ltd. (BHS Realty), an unrelated
limited partnership, had agreed on certain terms of sale of Wildridge Apartments. On or
about May 20, 1983, petitioner, on behalf of himself and the minority owners of
Wildridge Apartments, and BHS Realty entered into an "Agreement of Purchase and Sale
With Closing Instructions" concerning the sale of Wildridge Apartments. The agreed
purchase price was $9,180,000. Under section 11.11 of the agreement, petitioner
disclosed to BHS Realty that prior to the close of escrow, petitioner intended to arrange a
like-kind exchange within the meaning of section 1031, whereby petitioner would
exchange Wildridge Apartments subject to the terms and provisions of the agreement, for
other property owned by Company. In the event this occurred, BHS Realty agreed to
purchase Wildridge Apartments from Company. Petitioner signed the agreement and, in
his capacity as president of Company, also signed the agreement acknowledging that
Company had read and understood all the terms and provisions. Pursuant to section 1.2(a)
of the agreement, on or about May 20, 1983, BHS Realty deposited $200,000 in an
escrow account with Safeco Title Insurance Co. (Safeco Title).

On June 10, 1983, petitioner entered into an "Agreement of Exchange of Property" with
Company, whereby petitioner was to convey Wildridge Apartments to Company.
Pursuant to the agreement, Company, as "the owner and developer of certain real
property in Buellton, California, consisting of approximately 11 acres", [FN5] was to (1)
construct certain improvements prior to July 1, 1988, including a restaurant, hotel, and
movie theater/ice cream parlor complex, and (2) transfer the improved property to
petitioner. For its services, Company was to receive the sum of $750,000. Petitioner
signed the "Agreement of Exchange of Property" in two capacities, individually and as
president of Company. There were no other parties to the agreement.

On June 27, 1983, petitioner conveyed Wildridge Apartments by grant deed to


Company. The deed was recorded on July 13, 1983. Company then sold Wildridge
Apartments to Wildridge Apartments, Ltd., an unrelated California limited partnership,
for $9,180,000. Wildridge Apartments, Ltd., had been created and substituted as
purchaser of Wildridge Apartments by the principals of BHS Realty. The conveyance of
title to Wildridge Apartments, Ltd., was likewise made by grant deed dated June 27,
1983, and the deed was recorded on July 13, 1983.

On June 30, 1983, pursuant to the escrow instructions, the $200,000 escrow deposit was
released to Company from the sales escrow by Safeco Title, the escrow agent. Upon the
closing of escrow, Wildridge Apartments, Ltd., (1) executed a "Purchase Money
Promissory Note" to Company as holder in the amount of $1,490,000; [FN6] (2) executed
a "Deed of Trust, Assignment of Rents and Security Agreement" dated July 13, 1983, in
favor of Company; and (3) paid the balance of the purchase price to Company. [FN7] On
or about July 22, 1983, the minority owners of Wildridge Apartments were paid $245,178
by Company, representing their share of the sale proceeds. On July 14, 1983, Company,
through escrow, paid FLF Realty a $125,000 listing commission. On September 19,
1983, Company paid Paul Hamilton Co. a $170,000 sales commission.

On August 26, 1983, Company purchased and acquired the Buellton Property for
$1,895,827, consisting of $379,165 in cash and a promissory note for the balance. The
Buellton Property was conveyed by grant deeds, consisting of an undivided 20-percent
interest from the J. and M. Brock Living Trust and an undivided 80-percent interest from
the California Polytechnic State University Foundation for the Parks and Brock Unitrust.
The grant deeds were recorded on September 1, 1983.

On December 1, 1984, petitioner and Company entered into an agreement for the lease
of the Buellton restaurant parcel. Petitioner leased the restaurant parcel from Company
during the months of December 1984 and January 1985. Upon completion of the
construction, Company conveyed the restaurant and theater/ice cream parlor parcels to
petitioner by grant deed dated December 27, 1984. On September 15, 1986, by grant
deed, Company conveyed the hotel to petitioner. Company was credited with its
$750,000 contractor's fee for the development of the Buellton Property as follows:
$200,000 for the restaurant in February 1985; $100,000 for the theater/ice cream parlor in
March 1985; and $450,000 for the hotel in September 1986.

The Buellton Property, with all improvements, had a value based upon cost of
$17,484,872, consisting of $2,249,664 for the restaurant, $1,087,506 for the theater/ice
cream parlor, and $14,147,702 for the hotel. As provided in the exchange agreement,
petitioner expended $271,094 in cash and assumed $8,004,707 in additional debt.

Petitioner filed a joint Federal income tax return for the taxable year 1983 with Paula R.
Fredericks, from whom he is now divorced. On his 1983 income tax return, petitioner
reported no gain or loss with respect to the Wildridge Apartments. In the notice of
deficiency, respondent determined that petitioner failed to report $2,288,390 of capital
gain resulting from the sale of Wildridge Apartments.

OPINION

Issue 1. Section 1031(a)

Section 1001(c) requires that the entire amount of the gain or loss on the sale or
exchange of property shall be recognized. Section 1031(a), however, provides for the
nonrecognition of gain or loss when property held for productive use in a trade or
business or for investment is exchanged solely for like-kind property that is to be held for
productive use in a trade or business or for investment. [FN8]

There is no question that Wildridge Apartments and the Buellton Property were of like
kind within the meaning of section 1031. [FN9] The parties disagree, however, on
whether petitioner "exchanged" Wildridge Apartments for the Buellton Property.
Respondent's determinations are presumed correct, and petitioner has the burden to
establish that they are erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115
(1933).

Essentially, section 1031(a) assumes that new property received in an exchange is


substantially a continuation of the old investment. See Commissioner v. P.G. Lake, Inc.,
356 U.S. 260, 268 (1958). In an exchange of like-kind property, the taxpayer's economic
situation after the exchange is fundamentally the same as it was before the exchange.
Koch v. Commissioner, 71 T.C. 54, 63 (1978). The Court of Appeals for the Fourth
Circuit in Coastal Terminals, Inc. v. United States, 320 F.2d 333, 337 (4th Cir.1963),
stated:

The purpose of Section 1031(a), as shown by its legislative history, is to defer


recognition of gain or loss when a direct exchange of property between the taxpayer and
another party takes place; a sale for cash does not qualify as a nontaxable exchange even
though the cash is immediately reinvested in like property.
See also Starker v. United States, 602 F.2d 1341, 1352 (9th Cir.1979). In Barker v.
Commissioner, 74 T.C. 555, 561 (1980), this Court noted:

The "exchange" requirement poses an analytical problem because it runs headlong into
the familiar tax law maxim that the substance of a transaction controls over form. In a
sense, the substance of a transaction in which the taxpayer sells property and immediately
reinvests the proceeds in like-kind property is not much different from the substance of a
transaction in which two parcels are exchanged without cash. Yet, if the exchange
requirement is to have any significance at all, the perhaps formalistic difference between
the two types of transactions must, at least on occasion, engender different results.
[Citations omitted.]

Petitioner's intent to exchange Wildridge Apartments is evidenced by the "Agreement


of Purchase and Sale With Closing Instructions" entered into between petitioner and BHS
Realty. [FN10] While "matters of taxation must be determined in the light of what was
actually done rather than the declared purpose of the participants", J.H. Baird Publishing
Co. v. Commissioner, 39 T.C. 608, 615 (1962) (citing Weiss v. Stearn, 265 U.S. 242
(1924)), intent is nevertheless relevant to a determination of what transpired. Barker v.
Commissioner, supra at 564 (citing Carlton v. United States, 385 F.2d 238 (5th
Cir.1967)); see also Garcia v. Commissioner, 80 T.C. 491, 497-498 (1983); Biggs v.
Commissioner, 69 T.C. 905, 915 (1978), affd. 632 F.2d 1171 (5th Cir.1980).

Courts have afforded great latitude in structuring exchange transactions. Estate of


Bowers v. Commissioner, 94 T.C. 582, 590 (1990); Biggs v. Commissioner, 69 T.C. at
918. While respondent raises many arguments with respect to this transaction, we agree
with petitioner that much of this transaction falls within the ambit of cases that have
addressed section 1031. See, e.g., Biggs v. Commissioner, supra (multiple parties can be
involved in the exchange with parties not owning any property at the time of entering into
an agreement to exchange); [FN11] Starker v. Commissioner, supra (the transfers need
not occur simultaneously); [FN12] Barker v. Commissioner, supra at 562 (a party can
hold transitory ownership solely for the purpose of effectuating an exchange); Mercantile
Trust Co. v. Commissioner, 32 B.T.A. 82, 87 (1935) (alternative sales possibilities are
ignored where conditions for an exchange are manifest and an exchange actually occurs);
Alderson v. Commissioner, 317 F.2d 790 (9th Cir.1963), revg. 38 T.C. 215 (1962)
(parties can amend a previously executed sales agreement to provide for an exchange);
J.H. Baird Publishing Co. v. Commissioner, supra (the taxpayer can oversee
improvements on the land to be acquired); Biggs v. Commissioner, 69 T.C. at 916-917
(the taxpayer can advance money toward the purchase price of the property to be
acquired).

Notwithstanding the liberal treatment afforded taxpayers, under certain circumstances,


a transaction will be treated as a sale and not as an exchange. For purposes of this case,
the transactions will not be treated as an exchange if (1) the taxpayer received or had
control over the sales proceeds from the transaction, see Coupe v. Commissioner, 52 T.C.
394, 409 (1969); (2) the transfer of Wildridge Apartments and receipt of the Buellton
Property was not part of an integrated plan, see Biggs v. Commissioner, supra; Greene v.
Commissioner, T.C.Memo. 1991-403; Anderson v. Commissioner, T.C.Memo. 1985-
205; or (3) Company acted as the taxpayer's agent for purposes of the exchange, see
Coupe v. Commissioner, supra at 406; Mercantile Trust Co. v. Commissioner, supra at
85; Biggs v. Commissioner, 632 F.2d at 1178.

A. Receipt or Control Over Wildridge Apartment Sales Proceeds

Respondent appears to argue that petitioner was in actual or constructive receipt of the
escrow account with Safeco Title. [FN13] We disagree and hold that there was no actual
or constructive receipt of the sales proceeds. [FN14] Section 1.451-2(a), Income Tax
Regs., provides:

Income although not actually reduced to a taxpayer's possession is constructively


received * * * [when] it is credited to his account, set apart for him, or otherwise made
available * * *. However, income is not constructively received if the taxpayer's control
of its receipt is subject to substantial limitations or restrictions. * * *

On May 20, 1983, petitioner and BHS Realty entered into an "Agreement of Purchase
and Sale With Closing Instructions", whereby petitioner agreed to sell Wildridge
Apartments to BHS Realty. Section 11.11 provided that petitioner intended to first
convey Wildridge Apartments to Company for purposes of arranging a like-kind
exchange and that, in the event this occurred, BHS Realty would purchase Wildridge
Apartments from Company. Petitioner also signed the agreement in his capacity as
president of Company acknowledging that Company had read and understood all the
terms and provisions.

Under section 1.2 of the agreement, BHS Realty agreed to pay the purchase price as
follows: (1) Upon execution of the agreement, deposit $200,000 in an interest bearing
account with Safeco Title, the escrow agent; (2) on or prior to the closing of escrow,
assume the obligations of seller under the $6,000,000 note and "First Deed of Trust" held
by the Savings Bank of Puget Sound; (3) at the closing of escrow, execute and deliver to
seller a "Second Deed of Trust" and promissory note made payable to seller in the
amount of $1,500,000 bearing interest at 12 percent per annum, and the principal and
interest shall be due and payable on the first anniversary of the closing date; and (4) also
on the closing date of escrow, pay the balance of the purchase price in the amount of
$1,480,000 together with the $200,000 deposit and interest earned thereon, in cash.

Section 5 of the agreement provides that the closing of escrow shall be on June 30,
1983. Schedule I, paragraph B, of the agreement provides:

In the event that for any reason other than a default of one of the parties hereto the
transactions contemplated hereby are not consummated on or prior to the Closing Date,
then the Escrow shall terminate and Escrow Holder shall return the Deposit, together with
accrued interest thereon, to Purchaser * * *
Pursuant to the agreement, on May 20, 1983, BHS Realty deposited $200,000 in an
escrow account with Safeco Title. On June 10, 1983, petitioner entered into an
"Agreement of Exchange of Property" with Company. On June 27, 1983, petitioner, in an
individual capacity, and BHS Realty amended the escrow instructions to provide that the
escrow holder was

directed and authorized to release $200,000 on deposit in escrow, to seller herein


subject to the receipt by escrow holder of signed extension of the purchase contract
through JULY 29, 1983, evidenced by sellers [sic] signature herein. * * *

That same day, petitioner conveyed Wildridge Apartments to Company and Company
conveyed Wildridge Apartments to Wildridge Apartments, Ltd. On June 30, 1983, the
$200,000 was released to Company from the sales escrow by Safeco Title.

Based on the foregoing, we hold that petitioner was not in constructive receipt of the
escrow funds. There were substantial restrictions preventing petitioner's ability to control
the escrow funds. Petitioner and BHS Realty agreed that if the terms of the contemplated
transactions could not be consummated, the $200,000 deposit plus interest was to be
returned to BHS Realty. See Garcia v. Commissioner, 80 T.C. at 500; cf. Klein v.
Commissioner, T.C.Memo. 1993-491.

Also, even though petitioner, in his individual capacity, entered into and amended the
escrow instructions on June 27, 1983, petitioner could not have amended the escrow
instructions unilaterally; to the contrary, BHS Realty was a necessary party to the
amendments. Cf. Klein v. Commissioner, supra. Indeed, BHS Realty was a party to the
amendments and authorized them. In a letter dated June 27, 1983, BHS Realty authorized
Safeco Title to prepare an addendum to the "Agreement of Purchase and Sale With
Closing Instructions" providing that the sum of $200,000 was to be released upon a
signed extension of the purchase contract.

Furthermore, the $200,000 deposit was not distributed until petitioner had conveyed the
title to Wildridge Apartments to Company and Company had in turn conveyed the title to
Wildridge Apartments, Ltd. Thus, the $200,000 was distributed to Company only after
Company had replaced petitioner as seller under the escrow agreement. [FN15] See
Garcia v. Commissioner, supra at 500.

B. Integrated Plan

Respondent argues that petitioner's purported exchange was not an integrated plan and
that the "purported exchange consisted of the petitioner's structuring paper transactions
around a pre-existing sales contract." Respondent contends that petitioner was
contractually committed to sell Wildridge Apartments before he attempted the exchange
and that the agreement to sell Wildridge Apartments was enforceable independent of any
obligation to exchange the Buellton Property. To support this, respondent relies on the
"Agreement of Purchase and Sale With Closing Instructions" entered into between
petitioner and BHS Realty.
Section 11.11 of the agreement, however, contemplates the type of like- kind exchange
that was ultimately carried out.

11.11 * * * Seller * * * intends, prior to the Close of Escrow, to arrange a like-kind


exchange, within the meaning of Section 1031 * * * whereby Seller shall exchange the
Real Property, subject to the terms and provisions of this Agreement, for other property
owned by * * * [Company] * * * Purchaser agrees * * * to purchase the Real Property
from * * * [Company] * * * In no event shall the Closing Date be extended beyond June
30, 1983 by reason of the exchange.

Furthermore, entering into a sales and escrow agreement before structuring an


exchange, would not, in and of itself, invalidate a subsequent exchange. In Coupe v.
Commissioner, 52 T.C. at 405, we stated:

It is now well settled that when a taxpayer who is holding property for productive use
in a trade or business enters into an agreement to sell the property for cash, but before
there is substantial implementation of the transaction, arranges to exchange the property
for other property of like kind, he receives the nonrecognition benefits of section 1031. *
* * [Emphasis added.]

Respondent also appears to contend that petitioner had substantially implemented the
purchase of the Buellton Property prior to structuring an exchange. We disagree. In
Coupe, this Court applied the "substantial implementation" test to only one side of the
transaction--the sale of the taxpayer's property. In Estate of Bowers v. Commissioner, 94
T.C. 582 (1990), however, we applied the "substantial implementation" test to the other
side of the transaction--the property to be acquired by the taxpayer. In Estate of Bowers,
we stated that while taxpayers have been given considerable latitude in structuring like-
kind exchanges, such latitude is not open-ended. Id. at 590.

In our view, the acquisition of an option to purchase real property is not "substantial
implementation" of a purchase transaction. Petitioner was under no obligation to exercise
the option. Had petitioner desired not to acquire the Buellton Property for purposes of an
exchange, petitioner could have simply chosen not to exercise the option. These facts and
the facts of Coastal Terminals are similar to the situation presented in Alderson v.
Commissioner, 317 F.2d 790 (9th Cir.1963), revg. 38 T.C. 215 (1962) (entering into a
sales contract and later amending the contract to provide for an exchange). The only
difference is that the acquisition of an option to purchase involves the other side of the
transaction, the purchase of the property desired by the taxpayer.

Respondent points to the fact that the grant deed conveying Wildridge Apartments
between petitioner and Company and the conveyance of the grant deed between
Company and Wildridge Apartments, Ltd., were executed on the same day and then
recorded on the same day. However, the fact that Company held only transitory
ownership of Wildridge Apartments is not determinative. In Barker v. Commissioner, 74
T.C. 555, 562 (1980), this Court stated:
it is not a bar to section 1031 treatment that the person who desires the taxpayer's
property acquires and holds another piece of property only temporarily before
exchanging it with the taxpayer. Similarly, it is not fatal to section 1031 treatment that the
person with whom the taxpayer exchanges his property immediately sells the newly
acquired property. [Citations and fn. ref. omitted.]

Similarly, in Alderson v. Commissioner, 317 F.2d at 795, the Court of Appeals for the
Ninth Circuit stated:

The Mercantile case appears to hold that one need not assume the benefits and burdens
of ownership in property before exchanging it but may properly acquire title solely for
the purpose of exchange and accept title and transfer it in exchange for other like
property * * * [Emphasis in original.]

Based on the foregoing, we hold that petitioner structured an integrated four-party


exchange:

(1) Petitioner was to convey Wildridge Apartments;


(2) BHS Realty, and then later Wildridge Apartments, Ltd., was
the prospective purchaser of the Wildridge Apartments;
(3) J. and M. Brock Living Trust and the Trustee for the Parks and
Brock Unitrust were the prospective sellers of the Buellton
Property; and
(4) Company was the party who received Wildridge Apartments
from petitioner, sold it to Wildridge Apartments, Ltd., and then
purchased the Buellton Property, made improvements thereon,
and transferred it to petitioner.
C. Agent

Respondent contends that Company was a mere conduit or agent for petitioner. In
Coupe v. Commissioner, 52 T.C. at 406, we agreed that an exchange would be
meaningless for purposes of section 1031 if the person with whom the taxpayer made the
exchange was acting as the taxpayer's agent. See also Mercantile Trust Co. v.
Commissioner, 32 B.T.A. 82, 84 (1935).

Company accepted title to Wildridge Apartments, albeit at petitioner's request, in order


to facilitate the exchange. Company also accepted title to the Buellton Property for the
purpose of facilitating the exchange and for the additional purpose of constructing
improvements thereon. [FN16] See J.H. Baird Publishing Co. v. Commissioner, 39 T.C.
608 (1962). This is not a case of petitioner using Company as a "sham" or "straw man".
See Garcia v. Commissioner, 80 T.C. 491, 500-501 (1983). Company was an active
corporation carrying on business as a licensed building contractor and real estate
developer. Furthermore, from the proceeds of the sale of Wildridge Apartments,
Company purchased the Buellton Property, acquired financing for the purpose of
constructing improvements thereon, and transferred title to the property and
improvements subject to the Company's obligations for a fee of $750,000. Company was
not a mere conduit or agent of petitioner. We have considered respondent's arguments on
this point and find them to be without merit. We, therefore, hold that petitioner is entitled
to the nonrecognition treatment of section 1031.

Issue 2. Section 1031(b)

Respondent alternatively argues that if the conveyance of Wildridge Apartments


qualifies as a like-kind exchange under section 1031(a), petitioner, nevertheless, failed to
recognize gain to the extent of boot received. Section 1031(b) provides:

If an exchange would be within the provisions of subsection (a) * * * if it were not for
the fact that the property received in exchange consists not only of property permitted by
such provisions to be received without the recognition of gain, but also of other property
or money, then the gain, if any, to the recipient shall be recognized, but in an amount not
in excess of the sum of such money and the fair market value of such other property.

Respondent contends that by refinancing Wildridge Apartments 1 week after entering


into the sales contract with BHS Realty, petitioner received over $2,020,407.33 in "other
property or money" representing the amount petitioner "cashed out" of his investment.
We disagree.

Section 1031(b) relates to property received in the exchange that consists of the
exchange property and "other property or money". The only property petitioner received
in exchange for his property was the Buellton Property. In addition, petitioner's liabilities
were well in excess of the $6 million he owed with respect to the Wildridge Apartments.
See 1.1031(b)-1(c), Income Tax Regs.; Garcia v. Commissioner, supra. Petitioner
received the $2,020,407.33 from the Savings Bank of Puget Sound as a result of
refinancing Wildridge Apartments. He did not receive it from Company as part of the
exchange.

Furthermore, we disagree with respondent's argument that "if the petitioner's sale of the
Wildridge apartments and his acquisition of the Buellton property were to be construed as
integrated events, his refinancing the Wildridge mortgage should likewise be construed as
a part of that plan." Petitioner had reasons for refinancing the mortgage that were
unrelated to the exchange. Petitioner's uncontroverted testimony was that he began
attempts to secure permanent long-term financing in the same year he purchased
Wildridge Apartments (1980). Petitioner also testified that due to rising interest rates he
had difficulty obtaining long-term financing. On September 28, 1981, the interest rate on
the note was 23.5 percent. In 1982, petitioner made a $500,000 payment on the
promissory note and, in consideration of this payment, the note was extended for one
more year. On April 12, 1983, the Savings Bank of Puget Sound signed a loan
commitment letter for the refinancing of Wildridge Apartments in the amount of $6
million. [FN17] Furthermore, the settlement of the Savings Bank of Puget Sound loan on
June 2, 1983, was timely and significant since the due date of the $3.5 million loan was
July 9, 1983. For example, in the event the exchange or sale failed, petitioner nonetheless
was in need of refinancing Wildridge Apartments.
Accordingly, we hold that petitioner did not receive other property or money other than
the Buellton Property in exchange for Wildridge Apartments. Therefore, petitioner is not
required to recognize boot pursuant to section 1031(b). [FN18]

Decision will be entered for petitioner.

* * * * (footnotes omitted)

NONSIMULTANEOUS EXCHANGE: INTERMEDIARY: CONSTRUCTIVE


RECEIPT:
PRIVATE LETTER RULING 9448010

This Ruling examines the basic fact pattern and reviews the requirements for a
nonsimultaneous exchange, including deeding, constructive receipt, use of intermediary
and related issues.

PRIVATE LETTER RULING 9448010


Section 1031 -- Exchange of property held for
productive use or investment
August 29, 1994
Publication Date: December 2, 1994

Dear _____:

This is in reply to your letter dated March 21, 1994 in which you requested a ruling on
behalf of your clients under section 1031 of the Internal Revenue Code. Additional letters
dated July 18, 1994 and August 1, 1994 were also received. Your correspondence
supplemented earlier letters dated September 21, 1993, October 26, 1993 and January 5,
1994.

Taxpayer is a domestic corporation engaged in a trade or business that consists, in part,


of purchasing various items and leasing them to third parties. Taxpayer proposes to
dispose of Equipment (relinquished property) previously subject to lease to a third party
and used in its trade or business, and to acquire property of a like kind (replacement
property) that is to be used in its trade or business. Taxpayer proposes to accomplish this
through the use of Intermediary in a transaction intended to qualify as a deferred like kind
exchange under section 1031 of the Code.

Initially, Taxpayer will enter into a contract (the sale agreement) to sell the relinquished
property to an unrelated third party. In this sale, the consideration will be cash. To
accomplish the sale, Taxpayer will enter into an agreement (the exchange contract) with
Intermediary. The exchange contract specifies that Intermediary will act as a qualified
intermediary as that term is defined in the Internal Revenue Code. The exchange contract
provides that, pursuant to an assignment agreement and with the purchaser's consent,
Intermediary will be assigned all of Taxpayer's rights, but not its obligations, under the
sale agreement, including the right to receive payment for the relinquished property.
Upon receipt of the purchase price from the purchaser, and pursuant to the exchange
agreement, Intermediary will deposit the cash received into an account administered by
an independent third party (the escrow holder) under the terms of an escrow agreement.
The escrow holder may be a financial institution that has performed, and is expected to
continue to perform, a wide range of financial services for Taxpayer and its affiliates.

All cash received by the escrow holder will be placed, at the sole discretion of
Taxpayer, either in an interest bearing account or non interest bearing account for the
benefit of Taxpayer. In the latter case, it is anticipated that Taxpayer would receive from
the escrow holder other forms of consideration approximating the value of the foregone
interest, including, by way of example, a waiver of certain bank fees or other charges that
would otherwise be incurred in respect of the banking relationship between Taxpayer and
the escrow holder. In either event, Taxpayer would not be entitled to receive, pledge,
borrow or otherwise obtain the benefits of the interest or other forms of consideration
before the end of the exchange period or, if earlier, the end of the identification period
without replacement property having been identified or the receipt by Taxpayer of the
replacement property. For purposes of this ruling, the term "exchange period" begins with
the transfer of the relinquished property and ends after the earlier of the day which is 180
days after the date on which Taxpayer transfers the relinquished property or the due date,
determined with extensions, for Taxpayer's income tax return for the year of the transfer
of the relinquished property. Similarly, the term "identification period" means the period
ending on the day which is 45 days after the date of that transfer. Upon satisfaction of all
the terms and conditions of the sale agreement, legal title to the relinquished property will
be directly transferred from Taxpayer to the purchaser.

In the second step of the transaction, Taxpayer will identify and contract (pursuant to
the purchase agreement) to purchase the replacement property from an unrelated third
party. The unrelated third party will be a lessee who will enter into the purchase
agreement and assign the purchase agreement to Taxpayer. The replacement property will
be acquired subject to the commitment of the lessee to lease the property.

Pursuant to the exchange contract, Taxpayer is to identify the replacement property by


midnight of the 45th day from the date it transfers the relinquished property, (that is, prior
to the end of the identification period) and is to receive the replacement property by
midnight of the 180th day from the date it transfers the relinquished property but in no
event later than the end of the exchange period. If and after either of these requirements is
not met, Intermediary's sole obligation is to release the proceeds from the transfer of the
relinquished property held by the escrow holder to Taxpayer. This is to be accomplished
by a joint notification to the escrow holder by Taxpayer and Intermediary. Within 45
days of the sale of the relinquished property Taxpayer will send Intermediary a letter
identifying replacement property for the exchange. Taxpayer anticipates that it will
identify replacement property for the relinquished property in accordance with the three
property rule as described in section 1.1031(k)-1(c)(4)(i)(A) of the Income Tax
Regulations. Under the terms of the exchange contract and the escrow agreement,
Taxpayer does not have the right to receive, pledge, borrow or otherwise obtain the
benefits of money or other property held by Intermediary before the end of the exchange
period or, if earlier, the end of the identification period if replacement property was not
identified or received by Taxpayer.

The exchange contract provides that, pursuant to an assignment agreement, all of


Taxpayer's rights, but not its obligations, under the purchase agreement will be assigned
to Intermediary and that the seller of the replacement property will transfer legal title to
the replacement property directly to Taxpayer. Taxpayer has agreed, pursuant to a written
agreement, to promptly notify the seller of the replacement property of the assignment to
Intermediary. Further, promptly following notification by Taxpayer of the assignment,
Intermediary will notify the seller of the replacement property that title to the
replacement property is to be transferred directly to Taxpayer. Intermediary and Taxpayer
will jointly direct the escrow holder to pay the seller the purchase price of the
replacement property out of funds held by the escrow holder. To the extent that the cost
of the replacement property exceeds the proceeds from the sale of the relinquished
property held by the escrow holder, Taxpayer will either pay such excess directly to the
seller of the replacement property or deposit such excess with the escrow holder so that
payment to the seller will be made from a single source.

In connection with the request for a ruling, Taxpayer has made the following
representations:

(1) The relinquished property and the replacement property will be


property of like class, as such is defined in section 1.1031(a)-
2(b) of the Income Tax Regulations.
(2) The relinquished property and the replacement property will be
property held for productive use in a trade or business or for
investment and will not be stock in trade or other property held
primarily for sale.

Section 1031(a)(1) of the Code provides, generally, that no gain or loss will 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 a like kind which is to
be held for productive use in a trade or business or for investment.

Section 1031(a)(3) provides, generally, that for purposes of section 1031(a), any
property received by the taxpayer will be treated as property which is not like kind
property if (i) such property is not identified as property to be received in the exchange
on or before the day which is 45 days after the date on which the taxpayer transfers the
relinquished property (the identification period) or (ii) such property is received after the
earlier of the date which is 180 days after the date on which the taxpayer transfers the
property relinquished in the exchange or the due date (including extensions) of the
taxpayer's return for the taxable year in which the transfer of the relinquished property
occurs (the exchange period).

Section 1031(d) of the Code provides that if property is acquired in an exchange


described in section 1031, then the basis will be the same as that of the property
exchanged, decreased in the amount of any money received by the taxpayer and increased
in the amount of gain or decreased in the amount of loss to the taxpayer that was
recognized on such exchange. If the property so acquired consisted in part of the type of
property permitted by this section to be received without the recognition of gain or loss,
and in part of other property, the basis provided in this subsection shall be allocated
between the properties (other than money) received, and for the purpose of the allocation
there shall be assigned to such other property an amount equivalent to its fair market
value at the date of the exchange. For purposes of this section, where as a part of the
consideration to the taxpayer another party to the exchange assumed a liability of the
taxpayer or acquired from the taxpayer property subject to a liability, such assumption or
acquisition (in the amount of the liability) shall be considered as money or other property
received by the taxpayer on the exchange.

Section 1.1031(k)-1(a) of the regulations provides that for purposes of section 1031, a
deferred exchange is an exchange in which, pursuant to an agreement, the taxpayer
transfers relinquished property and subsequently receives replacement property. The
regulations further provide that in order to constitute a deferred exchange the transaction
must be a transfer of property for property, as distinguished from a transfer of property
for money. Gain or loss may be recognized on a deferred exchange if the taxpayer or its
agent actually or constructively receives money or other non like kind property before the
taxpayer actually receives the like kind replacement property.

Section 1.1031(k)-1(g) of the regulations sets forth a series of safe harbors, the
satisfaction of which will result in a determination that the taxpayer is not in actual or
constructive receipt of money or other property for purposes of section 1031. One of the
safe harbors involves the use of a qualified intermediary. Section 1.1031(k)-1(g)(4)(ii)
defines a qualified intermediary as a person who is not the taxpayer or a disqualified
person and enters into a written agreement with the taxpayer and, as required by the
exchange agreement, acquires the relinquished property from the taxpayer, transfers the
relinquished property, acquires the replacement property and transfers the replacement
property to the taxpayer.

Section 1.1031(k)-1(g)(4) of the regulations provides that in a transfer involving a


qualified intermediary, the qualified intermediary is not considered the agent of the
taxpayer for purposes of section 1031(a) and for the determination of whether the
taxpayer is in actual or constructive receipt of money or other property before the
taxpayer actually receives like-kind replacement property. This sentence only applies if
the agreement between the qualified intermediary and the taxpayer expressly limits the
taxpayer's rights to receive, pledge, borrow or otherwise obtain the benefits of money or
other property held by the qualified intermediary.

Section 1.1031(k)-1(g)(6) of the regulations states generally that an agreement between


the qualified intermediary and the taxpayer limits the taxpayer's rights only if the
agreement provides 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. However, the agreement may provide that if the taxpayer has not identified
replacement property before the end of the identification period, the taxpayer may have
the rights to receive, pledge, borrow or obtain the benefits of the money or other property
at any time after the end of the identification period. The agreement may also provide that
if the taxpayer has identified replacement property, the taxpayer may have rights to
receive, pledge, borrow or otherwise obtain the benefits of money or other property after
the receipt by the taxpayer of all the replacement property to which the taxpayer is
entitled under the exchange agreement.

Pursuant to section 1.1031(k)-1(g)(4)(iv) and (v), an intermediary is treated as


acquiring and transferring the relinquished property if the intermediary (either on its own
behalf or as the agent of any party to the transaction) enters into an agreement with a
person other than the taxpayer for the transfer of the relinquished property to that person,
and pursuant to that agreement, the relinquished property is transferred to that person,
and an intermediary is treated as acquiring and transferring replacement property if the
intermediary (either on its own behalf or as the agent for any party to the transaction)
enters into an agreement with the owner of the replacement property for the transfer of
that property and, pursuant to that agreement, the replacement property is transferred to
the taxpayer. An intermediary is treated as entering into an agreement if the rights of a
party to the agreement are assigned to the intermediary and all parties to the agreement
are notified in writing of the assignment on or before the date of the relevant transfer of
property.

A disqualified person is defined generally in section 1.1031(k)-1(k) of the regulations as


a person who is the agent of the taxpayer or who bears a certain relationship with the
taxpayer or an agent of the taxpayer.

Section 1.1031(k)-1(g)(5) of the regulations states that the determination of whether the
taxpayer is in actual or constructive receipt of money or other property prior to receiving
the like-kind replacement property is made without regard to the fact that the taxpayer is
or may be entitled to receive any interest or growth factor with respect to the deferred
exchange, provided that the agreement limits the taxpayer's rights to receive the interest
or growth factor in the same manner that the taxpayer is restricted with respect to money
or other property being held by the qualified intermediary. That is, the taxpayer must be
restricted from obtaining any benefits in respect of the interest or growth factor prior to
the end of the exchange period, or, if earlier, the end of the identification period, if the
replacement property has not been identified, or the receipt of the replacement property.

Section 1.1031(k)-1(h) of the regulations provides that a taxpayer is treated as being


entitled to receive interest or a growth factor with respect to a deferred exchange if the
amount of money or property the taxpayer is entitled to receive depends upon the length
of time elapsed between the transfer of the relinquished property and the receipt of the
replacement property.

When a taxpayer disposes of an asset, there are three general requirements for
nonrecognition treatment under section 1031:
(1) there must be an exchange;
(2) the properties exchanged must be of like kind; and
(3) the property transferred and the property received must be held
for productive use in a trade or business or for investment.

Taxpayer's ruling request presents a proposed deferred exchange of relinquished


property for replacement property. Taxpayer is using Intermediary as a qualified
intermediary. Intermediary will be assigned Taxpayer's right under the sale contract and
will consequently receive the cash from the purchaser of relinquished property.
Intermediary will place the cash with escrow holder in an escrow account. Taxpayer will
then assign its rights under the purchase contract to Intermediary, and Intermediary and
Taxpayer will authorize the escrow holder to release the cash purchase payment to the
seller of the replacement property. Title to the replacement property will then be
transferred to Taxpayer. Therefore, based upon the information and representations
presented by Taxpayer, the proposed transaction constitutes an exchange.

The second requirement, that the properties exchanged be of like kind, has reference to
the nature or character of the property. Taxpayer has represented that the relinquished
property and the replacement property will be of like kind. However, when an exchange
is a deferred exchange, the requirement that the properties be of like kind will not be
satisfied if the replacement property is not timely identified or received, or if Taxpayer is
in actual or constructive receipt of property that is not of like kind before receiving like
kind property. Section 1031(a)(3) provides that for purposes of this section, any property
received by the taxpayer shall be treated as property that is not of like kind if the property
is not timely identified and received in compliance with the requirements of section
1031(d)(3).

Information supplied by Taxpayer in the present case indicates that the transaction as
proposed is intended to satisfy the timing requirements. However, compliance with these
timing rules will not assure Taxpayer that the transaction will not result in constructive
receipt of money or other property unless there is also compliance with certain other
requirements set forth in the regulations. These precautionary measures set forth in the
regulations insure that each transaction is a like kind exchange for purposes of section
1031. Section 1.1031(k)-1(g)(4)(i) provides that in the case of a transfer of relinquished
property involving a qualified intermediary, the qualified intermediary is not the agent of
the taxpayer for purposes of section 1031(a). Money or other property held by the
qualified intermediary is not treated as held by an agent of the taxpayer pursuant to
section 1.1031(k)-1(g)(4)(i). However, this only applies if the agreement between the
taxpayer and that intermediary expressly limits the taxpayer's rights to the money or other
property as described in section 1,1031(k)-1(g)(4)(ii) and (g)(6) of the regulations. In the
present case, Taxpayer has complied with the requirements of the regulations as to the
limitations on its rights to the money or other property to be held by Intermediary.

Taxpayer has indicated that it will make an assignment to Intermediary of its right to
sell Equipment and will give proper notice of this assignment. It will do the same as to its
right to purchase replacement property. This comports with the requirements of section
1.1031(k)-1(g)(4)(v) of the regulations.

Taxpayer's rights under the exchange agreement to receive the interest or other
consideration that approximates the value of the foregone interest comports with the
requirements of section 1.1031(k)-1(g)(5) of the regulations. Taxpayer's right to receive
such interest or consideration approximating the value of the foregone interest are limited
under the exchange contract as provided in section 1.1031(k)-1(g)(6) of the regulations.
Therefore, for purposes of section 1.1031(k)-1(f), Taxpayer is not considered to be in
actual or constructive receipt of such interest or foregone consideration before Taxpayer
receives the like kind replacement property.

In view of these facts and the provisions of the regulations cited above, it is concluded
that Taxpayer will not be in constructive receipt of money or other property held by
Intermediary unless or until such items are payable to or on behalf of Taxpayer. The third
requirement for nonrecognition of gain in a like kind exchange, that the properties
exchanged by Taxpayer are held for productive use in a trade or business or for
investment is met through Taxpayer's affirmative representations.

Accordingly, based on the facts and representations presented, and assuming that
Intermediary is a qualified intermediary, we rule as follows:

1. Taxpayer's transfer of the relinquished property in exchange for


the replacement property in the transaction described above
qualifies as a deferred like kind exchange under section 1031 of
the Internal Revenue Code.
2. The payment for the replacement property by Intermediary out
of proceeds held by Intermediary pursuant to the escrow
agreement will not adversely affect the qualification of the
above described transaction as a deferred like kind exchange
under section 1031 of the Code.
3. The receipt by Taxpayer of interest or other forms of
consideration that approximates the value of the foregone
interest on the terms set forth in the exchange contract will not
result in Taxpayer being in actual or constructive receipt of any
consideration held by Intermediary in respect of the sale of the
relinquished property prior to the time Taxpayer acquires the
replacement property and will not adversely affect the
qualification of the transaction as a deferred like kind exchange
under section 1031 of the Code.
4. The tax basis of the replacement property to be received in
exchange for Equipment will be determined in accordance with
section 1031(d) of the Code.

No opinion is expressed about the tax treatment of the transaction under other
provisions of the Code and regulations or about the tax treatment of any conditions
existing at the time of, or effects resulting from, the transaction that are not specifically
addressed by the above rulings.

This ruling is directed only to the taxpayer who requested it. Section 6110(j)(3) of the
Code provides that it may not be used or cited as precedent.

A copy of this letter should be attached to the federal income tax return of the taxpayer
involved for the taxable year in which the transaction covered by this letter ruling is
consummated. Sincerely yours, Assistant Chief Counsel

INTERMEDIARY: LOST FUNDS: IMPACT ON CODE §1031:


DEER CREEK, INC. V. COMMISSIONER,
510 S.E.2d 853, 235 Ga. App. 891 (1999)

Although this involved a Code §1031 issue, the controversy focused on who would lose
monies when part of the funds were lost when the intermediary absconded with funds.

DEER CREEK, INC.


v.
SECTION 1031 SERVICES, INC.
Curtis et al.
v.
Section 1031 Services, Inc.
Williamson
v.
Section 1031 Services, Inc.
Hugenberg
v.
Section 1031 Services, Inc.
Williamson et al.
v.
Section 1031 Services, Inc.

Nos. A98A2085-A98A2089.
Court of Appeals of Georgia.
510 S.E.2d 853
235 Ga.App. 891
Jan. 6, 1999.

HAROLD R. BANKE, Senior Appellate Judge.

Deer Creek, Inc., Daniel and Margaret Curtis, James Hugenberg, and Elaine
Williamson appeal the trial court's order of January 27, 1998 which confirmed arbitration
awards granted to David and Janice Miller and Burdine Enterprises, Inc. ("Burdine").
[FN1] They collectively enumerate 11 errors on appeal.
This case arose after each of the above-mentioned parties executed separate contracts
with Section 1031 Services, Inc. ("Section 1031 Services") to facilitate tax-free like-kind
exchanges of property pursuant to § 1031 of the Internal Revenue Code. The individual
contracts were essentially identical. As part of each agreement, the parties deposited
funds in Section 1031 Services' escrow accounts. Each agreement also contained an
arbitration clause which specifically applied to "any dispute as to the interpretation of the
content, extent, or applicability of this [a]greement or Exchangor's [the parties']
instructions to the Facilitator [Section 1031 Services]."

An individual who identified himself as James Gideon owned Section 1031 Services.
Although he initially completed several successful § 1031 transfers, just prior to the
commencement of this litigation, Gideon commingled funds in the escrow accounts,
withdrew over $2 million and left the country, leaving only $255,000 in the escrow
accounts. The parties later learned that Gideon gave the bank holding the escrow
accounts the social security number of a deceased person and probably used a false name.

After several unsuccessful attempts to contact Gideon, the Millers became concerned
and made a demand for arbitration under the agreement. Wachovia Bank of Ga. v. Miller,
232 Ga.App. 606, 502 S.E.2d 538 (1998). They also filed a civil action against Section
1031 Services and Wachovia Bank, successfully seeking a freeze on the assets in Section
1031 Services' two escrow accounts and a stay pending arbitration. Id. Shortly thereafter,
the arbitrator awarded the Millers the total amount they had deposited in the account,
$152,820.96.

After a hearing at which neither Gideon nor the bank holding the escrow accounts
appeared, the trial court confirmed the arbitration award and, at the Millers' request,
appointed a different facilitator to manage the tax-free exchange. Id. Shortly thereafter,
Burdine, which had transferred $204,454.41 into one of the escrow accounts, followed
this same procedure and received an arbitration award for the full amount of its claimed
investment. However, before Burdine received judicial confirmation of the award, Daniel
and Margaret Curtis filed a complaint against Gideon and Section 1031 Services, alleging
fraud, breach of fiduciary duty, and breach of contract. In that action, the Curtises moved
to vacate both arbitration awards and the Millers' judgment.

After entry of the Millers' confirmation order, Elaine Williamson filed a complaint
against those same defendants, alleging conversion, fraud, and breach of contract. She
also sought to enjoin the bank from disbursing any of the escrow funds. Williamson,
Hugenberg, and Deer Creek were permitted to intervene in the Millers' action. The bank
filed an interpleader action. The trial court then consolidated all the separate actions and
heard argument on the bank's motion to set aside the order confirming the Millers'
arbitration award. The other parties, except the Millers and Burdine, joined with the bank.
Neither Gideon nor Section 1031 Services responded to the pleadings or participated in
any of these proceedings

.
After several hearings, the trial court upheld its ruling confirming the Millers'
arbitration award and confirmed Burdine's arbitration award. The bank appealed these
rulings and this Court affirmed, finding that the bank lacked standing to raise the issues
appealed. Wachovia Bank, 232 Ga.App. at 607(1), 502 S.E.2d 538. Held:

This same principle applies to the enumerations raised by Deer Creek, the Curtises,
Hugenberg and Williamson (collectively "Deer Creek"). Parties who neither participated
in an arbitration, nor were served with a demand for arbitration or an order compelling
arbitration may challenge an award on only a few limited grounds. OCGA § 9-9-13(c);
Gilbert v. Montlick, 232 Ga.App. 91, 93(1), 499 S.E.2d 731 (1998) (absent one of the
statutory grounds trial courts are bound to confirm arbitration awards). Assuming without
deciding that Deer Creek is a "party" within the meaning of OCGA § 9-9- 13(c), the only
tenable statutory ground it raised is that by overstepping his authority, the arbitrator
prejudiced its rights. [FN2] OCGA § 9-9-13(c)(1).

FN2. Deer Creek has presented no evidence showing that the arbitration award was the
result of corruption, fraud or misconduct. OCGA § 9-9- 13(b)(1). The mere brevity of the
arbitration proceedings is insufficient to establish any of these elements.

The record shows that the Millers sought arbitration because they were unable to contact
Gideon to timely give the notifications required to initiate a tax-free exchange. They were
concerned that the statutory time would expire before Gideon could be contacted to
accomplish this. Burdine likewise became concerned about Gideon's unavailability.
Under this evidence, we cannot say that the trial court clearly erred in implicitly finding
that the Millers and Burdine sought arbitration regarding their instructions to Gideon and
the arbitrator therefore did not overstep his authority. Gilbert, 232 Ga.App. at 93(1), 499
S.E.2d 731.

Notwithstanding Deer Creek's argument to the contrary, nothing in the Code required
the Millers or Burdine to apply for an order compelling arbitration under OCGA § 9-9-6
before seeking arbitration. See OCGA § 9- 9-13(b)(4). Such an order would have had no
effect on Gideon and Section 1031 Services' absence from the proceedings. [FN3] See
Wilson v. Southern R. Co., 208 Ga.App. 598, 601(2), 431 S.E.2d 383 (1993) (the law
will not require a futile act). Nor did their absence necessarily invalidate the proceedings.
Our law does not unequivocally reject ex parte arbitration. See Antinoro v. Browner, 223
Ga.App. 664, 666, 478 S.E.2d 392 (1996).

As in Wachovia Bank, we find that Deer Creek lacks standing to raise the remaining
enumerations. Wachovia Bank, 232 Ga.App. at 607, 502 S.E.2d 538. Deer Creek's injury
does not "flow directly" from the Millers' and Burdine's acts. Maddox v. Southern
Engineering Co., 231 Ga.App. 802, 806(1), 500 S.E.2d 591 (1998) (RICO case). Its
claims are properly directed at Gideon and Section 1031 Services, the parties that
purportedly absconded with their funds, not the Millers and Burdine. The Millers and
Burdine contracted only with Section 1031 Services in an agreement which contemplates
neither the participation nor even the existence of Deer Creek. Deer Creek's failure to
offer proof of its status as an intended third party beneficiary of the contract the Millers
successfully enforced precludes their claim. See Patriot Gen. Ins. Co. v. Millis, 233
Ga.App. 867, 871(2), 506 S.E.2d 145 (1998) (For a third party to have standing to
enforce a contract, it must clearly appear from the contract that it was intended for his
benefit.).

Nor is Deer Creek entitled to relief under a constructive trust theory, assuming,
arguendo, that it has standing to assert such a claim and properly raised it in the trial
court. See OCGA § 53-12-93(a); Eason v. Farmer, 261 Ga. 675, 676(2), 409 S.E.2d 509
(1991). A constructive trust is a remedial device created in equity to prevent unjust
enrichment. Atlanta Classic Cars v. Chih Hung USA &c., 209 Ga.App. 908, 910(2), 439
S.E.2d 498 (1993).

Here, the Millers and Burdine were not Deer Creek's debtors or fiduciaries. Deer Creek
provided no evidence of their wrong-doing. Nor is there any evidence that the Millers and
Burdine knew or should have known of Gideon's scheme to abscond with the money. In
these circumstances, we cannot say that the Millers and Burdine would be unjustly
enriched if allowed to reclaim their own investments. Nor did Deer Creek establish that it
exhausted all available legal remedies. See Jordan v. Caswell, 264 Ga. 638, 639- 640(2),
450 S.E.2d 818 (1994).

Judgments affirmed in Case Nos. A98A2085, A98A2086, A98A2087, A98A2088, and


A98A2089.

JOHNSON, C.J., and SMITH, J., concur.

INTERMEDIARY, SAFE HARBOR: PARTNERSHIP AND CODE §1031:

TECHNICAL ADVICE MEMORANDUM 9907029


1999 WL 77957

At stake in this case for the taxpayer was whether the intermediaries acted properly
within the rules under the Regs. under Code §1031 and whether the safe harbor issues
were met. In addition, the question was whether, even without meeting the safe harbor
issue, the partnerships in question complied with Code §1031, without compliance with
the benefits of the safe harbor.

The Memorandum concluded that there was a partially tax-deferred exchange by the
partnership; the partnership was required to recognize part of the gain, since one of the
partners as to "his" share did not reinvest on a timely basis. Technically it was treated at
the partnership level; the partnership was required to pick up the gain relevant to the one
(1) partner who did not timely meet the requirements on behalf of the partnership.

Internal Revenue Service (I.R.S.)


TECHNICAL ADVICE MEMORANDUM 9907029
Issue: February 19, 1999
1999 WL 77957 (I.R.S.)
September 30, 1998

ISSUES:
(1) Whether Taxpayers are entitled to deferral of gain from the
involuntary conversion of Apartment Building under §1033 of
the Internal Revenue Code.
(2) Whether Taxpayers are entitled to deferral of gain from the
disposition of Property 1 in an exchange under §1031 of the
Code, following the involuntary conversion of Apartment
Building.
CONCLUSIONS:
(1) The partnership of which Taxpayers are partners that was
formed to own and operate Apartment Building and Property 1
is entitled to deferral of gain from the involuntary conversion of
Apartment Building under §1033 of the Code.
(2) The partnership of which Taxpayers are partners that was
formed to own and operate Apartment Building and Property 1
is entitled to treat the disposition of Property 1 and acquisition
of Property 3 as a like kind exchange under §1031 of the Code
but must recognize gain in an amount not to exceed $y.

A owned commercial property, including Property 1. On Date 1 of Year 1, A pooled his


commercial property and some cash with cash advanced by B and C. As part of this
transaction, A deeded an undivided 37% interest to B as co-tenant and an undivided 16%
interest to C as co-tenant in the commercial property, retaining a 47% interest for himself.

A, B, and C then secured a loan from a bank in their individual names to build
Apartment Building on Property 1. Apartment Building was constructed and placed in
service as Real Estate Venture on Date 2A. This improvement was insured in the names
of A, B, and C.

A Form 1065, U.S. Partnership Return of Income, was filed each year in the name of
Real Estate Venture from Year 3 to Year 25. Apartment Building and the underlying real
property (Property 1) were listed on the balance sheet of the Form 1065. Interest, taxes
and depreciation on Apartment Building and Property 1 were taken as deductions on the
Form 1065.

A bank account was opened in the name of Real Estate Venture. Rent from Apartment
Building was deposited in this account and all disbursements for Apartment Building and
Property 1 were paid from this account. Although invoices for insurance premiums, real
estate taxes and mortgage payments were sent to A, B, and C individually, these invoices
were paid from Real Estate Venture's bank account.

A, B, and C entered into a "partnership agreement" with regard to Real Estate Venture
on Date 2. Section 2 of the partnership agreement provides that the purpose of the
partnership shall be to construct and operate a x-unit apartment house on the real estate
shown on Exhibit A (Real Estate Venture) and one other apartment house on other real
estate. Exhibit A refers to Apartment Building located on Property 1. Section 3 provides
that the partnership shall commence on the date of the agreement and shall continue until
dissolved as provided in the agreement or by operation of law. Section 4 provides that the
capital contributions of the partnership shall be set forth on Exhibit B. Exhibit B provides
that A, B, and C made contributions to the partnership in exchange for a corresponding
percentage in the partnership. Exhibit B states that A's contribution includes the land on
which the apartment complex was built. Section 4 also provides that the depreciation of
the assets of the partnership shall inure in accordance with the percentage interest set
forth on Schedule B. Section 5 provides that the net profits and losses shall be divided in
accordance with the interests set forth on Schedule B. Section 7 provides that B shall
have the obligation of the management, conduct and operation of the partnership
business. The consent of all partners is required in the event that any or all of the
partnership assets are to be sold, mortgaged or otherwise encumbered or money borrowed
on behalf of the partnership. However, in the event that the partners cannot reach a joint
decision with respect to any sale or borrowing, then the majority vote as computed by
voting the percentage interest of ownership shall prevail. Section 9 permits the
partnership to have a bank account at a selected bank and in such other banks as the
managing partner shall select. Section 10 provides that upon a voluntary termination of
the partnership, the partners shall proceed with reasonable promptness to sell the real and
personal property of the partnership and that the partnership shall be dissolved by the sale
of all the real and personal assets of the partnership. Section 11 provides that a partner
may retire at the end of a fiscal year and that the other partners shall have the right to
purchase the retiring partner's interest. A, B, and C signed the agreement as partners.

In Year 20, B transferred half of his interest to his wife, D, pursuant to their divorce
settlement. Over the years, A, B, C, and D, by quit claim deeds, transferred their interests
in the land to revocable trusts, treated as grantor trusts by A, B, C, and D. [FN1] The
grantor of each trust is also the trustee of the trust.

Despite the partnership agreement, Real Estate Venture bank account, and Real Estate
Venture's filing of partnership tax returns, the mortgage loan documents, insurance
policies and property tax documents indicate that Taxpayers owned Apartment Building
and Property 1 in undivided interests. Further, Taxpayers represent that they entered into
the partnership agreement solely for the purposes of constructing and operating
Apartment Building and that they never intended to transfer ownership of either Property
1 or Apartment Building to the partnership. Taxpayers assert that they have not formed a
partnership for federal income tax purposes.

Real Estate Venture employed an on-site manager, a management company and a


bookkeeping service. Taxpayers represent that they have never furnished to their tenants
any but customary services in connection with an apartment house rental operation.
Apartment Building on Property 1 was destroyed by Natural Disaster on Date 3. A, B,
C, and D filed insurance claims and received cash in settlement of their claims. A, B, C,
and D subsequently determined that Apartment Building could not be repaired.

A, B, and D used their share of the insurance proceeds to purchase Property 2. Property
2 is a property similar or related in service or use to Apartment Building and was
intended to qualify as replacement property under §1033. The purchase price of Property
2 exceeded the gain realized by A, B, and D (and C) from the conversion of Apartment
Building.

A, B, and D thereafter attempted a deferred exchange of their respective interests in


Property 1 for Property 3. A, B, and D intended this transaction to qualify as a like-kind
exchange under §1031. Specifically, the transaction was structured as follows:

1. A, B, C, and D located a potential buyer for Property 1.


2. A, B, C, and D each retained Accommodator and each executed
an exchange agreement with Accommodator. Under the
agreements, A, B, C, and D could not receive any cash or
borrow or pledge against the sale proceeds of Property 1 until
after the expiration of the statutory period for identifying and
acquiring the replacement property. However, the agreement
could be terminated and the sales proceeds obtained if the
transferor did not identify replacement property prior to the end
of the statutory 45-day period for identifying replacement
property.
3. A, B, C, and D conveyed their respective interests in Property 1
to Accommodator, who conveyed them to a buyer on Date 4
through a sale escrow account established with an affiliate of
Accommodator.
4. All proceeds from the sale of Property 1 were received by
Accommodator who set up a separate "exchange account" for
each of A, B, C, and D.
5. A, B, and D identified Property 3 as the qualifying replacement
property on Date 5 (a date within the statutory 45-day period for
identifying replacement property). C did not identify
replacement property.
6. Accommodator acquired Property 3 through a replacement
escrow account and transferred undivided interests in that
property to A, B, and D on Date 6 (a date within the statutory
180-day period for acquiring replacement property). C did not
reinvest in replacement property and received cash in the
amount of $y.

All of these steps in this transaction were executed by A, B, and D separately as


trustees on behalf of the grantor trusts and not by Real Estate Venture. No other facts are
available concerning what C did with his share of the proceeds from the sale of Property
1 or from the insurance proceeds.

LAW AND ANALYSIS:


Partnership or Co-ownership

Section 761 provides that the term "partnership" includes a syndicate, group, pool, joint
venture, or other unincorporated organization through or by means of which any
business, financial operation or venture is carried on, and which is not a corporation, trust
or estate.

The determination of whether a partnership exists is to be made considering whether in


view of the parties' actions, the parties acting in good faith and acting with a business
purpose intended to join together in the present conduct of the enterprise. Commissioner
v. Culbertson, 337 U.S. 733, 742 (1949).

In McManus v. Commissioner, 583 F.2d 443 (9th Cir. 1978), taxpayers acquired real
estate for development and title to the property was placed in their names as individuals.
During the tax years the taxpayers held the property, financial transactions were recorded
in books that contained capital accounts for the "partners"; bank records indicated the
taxpayers were partners; and their attorneys, with the taxpayers' affirmation, referred to
the taxpayers as partners. Moreover, partnership returns were filed on behalf of the
taxpayers until, upon the advice of legal counsel, the practice was discontinued. The
taxpayers argued that they never intended to enter into a partnership and thus were not
partners for federal tax purposes. The Tax Court found that the parties had acted in a way
that sufficiently evidenced the relationship to be that of partners in a partnership. In
affirming the Tax Court, the Court of Appeals for the Ninth Circuit considered the
keeping of books on a partnership basis, the maintaining of a "partnership" bank account,
and "most importantly" the filing of partnership returns. The Ninth Circuit stated that the
holding of the property as tenants in common was at best neutral evidence. The court
found that the Tax Court's decision was not erroneous and noted that, in any case, a
taxpayer is estopped from later denying the status he claimed on his tax returns.

In Rev. Rul. 75-374, 1975-2 C.B. 261, two parties each own an undivided one- half
interest in an apartment project. A management company retained by the co- owners
manages the building. Customary tenant services such as heat and water, unattended
parking, trash removal, normal repairs, and cleaning of public areas are furnished at no
additional charge. Additional services, such as attendant parking, cabanas, and gas and
electricity are furnished by the management company for a separate charge. The ruling
holds that the furnishing of customary services in connection with the maintenance and
repair of an apartment project will not render a co-ownership a partnership. The revenue
ruling concludes that since the management company is not an agent of the owners and
the owners did not share in the income earned from the additional services, the owners
were not furnishing services. Therefore, the owners are to be treated as co-owners and not
as partners under §761.
Taxpayers argue that they never intended to form a partnership with regard to the
ownership of Apartment Building and Property 1. Taxpayers' representative, who is also
the accountant who filed the Forms 1065 for Real Estate Venture, explained that he
reported Real Estate Venture's income in this manner for the convenience of the
individuals in reporting taxable income and for the convenience of the Internal Revenue
Service in examining returns, and that he and many other tax professionals understood
this practice as done for reporting purposes only and not as an assertion of a form of
ownership.

In this instance, we conclude that the filing of partnership tax returns, the "partnership
agreement" entered into by A, B, and C, and the conduct of the parties indicates an
intention to operate Real Estate Venture as a partnership. Further, the inclusion of
Apartment Building on the balance sheet of the Form 1065, the reporting of depreciation,
real estate tax expense and mortgage interest expense on the partnership return, the
payment of these expenses from a bank account held in the name of "Real Estate
Venture" and the language used in the partnership agreement indicate an intention to treat
Apartment Building and Property 1 as assets of the partnership for federal income tax
purposes. Accordingly, we conclude that the arrangement between A, B, C, and D
regarding Real Estate Venture was, and continues to be, a partnership for federal income
tax purposes. Apartment Building and Property 1 were assets of a partnership for federal
income tax purposes.

Taxpayers also argue that Real Estate Venture is not a partnership because, similar to
the situation in Rev. Rul. 75-374, A, B, C, and D do not furnish their tenants with any but
the customary services in connection with apartment house rental operations. Without
making a determination concerning the level of services furnished by A, B, C, and D, we
conclude that the filing of partnership returns for more than twenty years, the
"partnership agreement," and the conduct of the parties (not relating to services) require a
result different from the one reached in Rev. Rul. 75-374.

Section 1031

Section 1031(a)(1) of the Code provides that no gain or loss shall be recognized on the
exchange of property 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.

Section 1031(a)(3) of the Code provides that for purposes of this subsection, any
property received by the taxpayer shall be treated as property which is not of like kind if--
(A) such property is not identified as property to be received in the exchange on or before
the day which is 45 days after the date on which the taxpayer transfers the property
relinquished in the exchange, or (B) such property is received after the earlier of (i) the
day which is 180 days after the date on which the taxpayer transfers the property
relinquished in the exchange, or (ii) the due date (determined with regard to extension)
for the transferor's return of the tax imposed by this chapter for the taxable year in which
the transfer of the relinquished property occurs ("exchange period").
Section 1031(b) of the Code provides that if an exchange would be within the
provisions of §1031(a) if it were not for the fact that the property received in exchange
consists not only of property permitted by such provisions to be received without the
recognition of gain, but also of other property or money, then the gain, if any, to the
recipient shall be recognized, but in an amount not in excess of the sum of such money
and the fair market value of such other property.

Property 1 is of like kind to Property 3. Moreover, the transaction ostensibly satisfies


these timing requirements for identification and receipt of replacement property. ABCD
Partnership identified Property 3 as replacement property within 45 days after the transfer
of Property 1. Furthermore, ABD Partnership, as a continuation of ABCD Partnership,
received the replacement property pertaining to the exchange within the statutory
replacement period. However, compliance with these timing rules will not assure ABCD
Partnership of avoiding actual or constructive receipt of cash or other non-like-kind
property unless there is also compliance with certain additional requirements. These rules
are precautionary measures (or "safe harbors") set forth in the regulations to help
taxpayers insure that the transaction is indeed an exchange of like-kind properties, as
opposed to a mere sale/repurchase. These safe harbors were promulgated to provide
specific measures which taxpayers could follow in order to avoid actual or constructive
receipt of money or other property (not of like kind) between the time of relinquishment
and the time of replacement.

Section 1.1031(k)-1(f)(1) of the regulations provides in part that a transfer of


relinquished property in a deferred exchange is not within the provisions of §1.1031(a) if,
as part of the consideration, the taxpayer receives money or other property. However,
such a transfer, if otherwise qualified, will be within the provisions of either §1031(b) or
(c). In addition, in the case of a transfer of relinquished property in a deferred exchange,
gain or loss may be recognized if the taxpayer actually or constructively receives money
or other property before the taxpayer actually receives like-kind replacement property.

In addition, actual or constructive receipt of money or other property by an agent of the


taxpayer is actual or constructive receipt by the taxpayer. Section 1.1031(k)-1(f)(2)
explains that except as provided in paragraph (g) of this section (relating to safe harbors),
for purposes of §1031 and this section, the determination of whether (or the extent to
which) the taxpayer is in actual or constructive receipt of money or other property before
the taxpayer actually receives like-kind replacement property, is made under the general
rules concerning actual or constructive receipt and without regard to the taxpayer's
method of accounting. The taxpayer is in actual receipt of money or property at the time
the taxpayer actually receives the money or property or receives the economic benefit of
the money or property. The taxpayer is in constructive receipt of money or property at the
time the money or property is credited to the taxpayer's account, set apart for the
taxpayer, or otherwise made available so that the taxpayer may draw upon it at any time
or so that the taxpayer can draw upon it if notice of intention to draw is given. Although
the taxpayer is not in constructive receipt of money or property if the taxpayer's control
of its receipt is subject to substantial limitations or restrictions, the taxpayer is in
constructive receipt of the money or property at the time the limitations or restrictions
lapse, expire, or are waived. In addition, actual or constructive receipt of money or
property by an agent of the taxpayer (determined without regard to paragraph (k) of this
section) is actual or constructive receipt by the taxpayer.

Section 1.1031(k)-1(g)(4) provides a safe harbor for qualified intermediaries. If the


taxpayer utilizes a qualified intermediary, the determination of whether the taxpayer is in
constructive receipt is made as if the qualified intermediary is not an agent of the
taxpayer. Section 1.1031(k)- 1(g)(4)(i) of the regulations provides that in the case of a
taxpayer's transfer of relinquished property involving a qualified intermediary, the
qualified intermediary is not considered the agent of the taxpayer for purposes of
§1031(a). Paragraph (g)(4)(ii) states that paragraph (g)(4)(i) applies only if the agreement
between the taxpayer and the qualified intermediary expressly limits the rights of the
taxpayer to receive, pledge, borrow, or otherwise obtain the benefits of money or other
property held by the qualified intermediary as provided in paragraph (g)(6) of this
section.

Section 1.1031(k)-1(g)(6)(i) of the regulations provides that an agreement limits a


taxpayer's rights as provided in this paragraph (g)(6) only if the agreement provides that
the taxpayer has no rights, except as provided in paragraphs (g)(6)(ii) and (g)(6)(iii) of
this section, to receive, pledge, borrow, or otherwise obtain the benefits of money or
other property before the end of the exchange period. Section 1.1031(k)-1(g)(6)(ii) states
that the agreement may provide that if the taxpayer has not identified replacement
property before the end of the identification period, the taxpayer may have rights to
receive, pledge, borrow, or otherwise obtain the benefits of money or other property at
any time after the end of the identification period. Section 1.1031(k)-1(g)(6)(iii)(A) states
that the agreement may provide that if the taxpayer has identified replacement property,
the taxpayer may have rights to receive, pledge, borrow, or otherwise obtain the benefits
of money or other property after the receipt by the taxpayer of all the replacement
property to which the taxpayer is entitled under the exchange agreement.

Section 1.1031(k)-1(g)(4)(iii) of the regulations provides that a qualified intermediary


is a person who--(A) is not a taxpayer or a disqualified person, and (B) enters into a
written exchange agreement with the taxpayer (the "exchange agreement") and, as
required by the exchange agreement, acquires the relinquished property from the
taxpayer, transfers the relinquished property, acquires the replacement property, and
transfers the replacement property to the taxpayer.

Section 1.1031(k)-1(g)(3) provides a safe harbor for qualified escrow accounts and
qualified trusts. Section 1.1031(k)-1(g)(3)(i) provides that in the case of a deferred
exchange, the determination of whether the taxpayer is in actual or constructive receipt of
money or other property before the taxpayer actually receives like-kind replacement
property will be made without regard to the fact that the obligation of the taxpayer's
transferee to transfer the replacement property to the taxpayer is or may be secured by
cash or a cash equivalent if the cash or cash equivalent is held in a qualified escrow
account or in a qualified trust. A qualified escrow account is defined as an escrow
account wherein (A) the escrow holder is not the taxpayer or a disqualified person (as
defined in §1.1031(k)-1(k)), and (B) the escrow agreement expressly limits the taxpayer's
rights to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash
equivalent held in the escrow account as provided in §1.1031(k)-1(g)(6). Section
1.1031(k)-1(g)(3)(v) provides that a taxpayer may receive money or other property
directly from a party to the exchange, but not from a qualified escrow account or a
qualified trust without affecting the application of paragraph (g)(3)(i) of this section.

In the present case, although there is no written exchange agreement executed on behalf
on ABCD Partnership, the exchange agreements with Accommodator entered into by the
individual partners A, B, C, and D have the effect of a written exchange agreement
between ABCD Partnership and Accommodator. Accommodator acquired Property 1, the
relinquished property, from ABCD Partnership, transferred it to the buyer, acquired
Property 3, the replacement property, and transferred it to ABD Partnership, as a
continuation of ABCD Partnership. However, ABCD Partnership, through its partner C,
actually or constructively received $y cash proceeds from the sale of Property 1 prior to
its receipt of the replacement property. This receipt of $y is a direct disbursement by
Accommodator to C of ABCD Partnership's proceeds from the sale of Property 1. Thus,
the exchange agreement between Accommodator and ABCD Partnership does not satisfy
the requirements of §1.1031(k)-1(g)(4)(ii) because the agreement did not in fact limit the
taxpayer's (ABCD Partnership) rights to receive, pledge, borrow, or otherwise obtain the
benefits of money or other property held by the qualified intermediary as provided in
§1.1031(k)- 1(g)(6).

However, although ABCD Partnership's exchange agreement with Accommodator does


not satisfy the qualified intermediary safe harbor, there is the question whether any of the
separate exchange accounts attributable to A, B, C, and D satisfy the requirements for
qualification as a qualified escrow account under §1.1031(k)-1(g)(3). Under these facts,
the exchange accounts are properly considered accounts of ABCD Partnership. By their
terms, the exchange accounts attributable to A, B, C, and D each satisfy the qualified
escrow account safe harbor. However, notwithstanding that the exchange accounts
considered separately satisfy the qualified escrow account safe harbor, ABCD
Partnership actually or constructively received money before the end of the exchange
period in violation of §1.1031(k)-1(g)(6)(i) because C did not identify replacement
property and received his share of the partnership's proceeds from the sale of Property 1
($y) in cash. Actual or constructive receipt of money occurred only as to the exchange
account attributable to C and not as to the money held in the other exchange accounts.

CHAPTER 11: MULTIPLE PARTY EXCHANGES

"Multiple party exchange" means simply that more than two parties are involved in the
total transaction. We may have three, four, or any number of parties involved in the
exchange. However, each step involves two parties. A may exchange with B, and B with
A. B may in turn, subsequently, exchange with C, and so forth.

To qualify under Section 1031 it must be structured properly. As an example, if X


transfers his property to Y, with Y transferring his property, labeled Y-1, to X, and X in
turn transfers the property he acquired, Y-1, to Z, X will not have a tax-deferred
exchange. He acquired the Y property with the immediate intent to transfer that property.
This is the official position by the government. Thus, this point should illustrate the
importance of the format. Y and Z could have exchanged their property, first, having the
Z-1 property flow to Y in the first step. And, subsequent to Step 1, if Y transferred the Z-
1 property to X in exchange for X's property, if the property was otherwise qualified
under Section 1031 by X, X could have a tax-deferred exchange.

From a lay standpoint, someone might view this transaction and conclude that the
essence or end result to X was the same: He has disposed of his X-1 property; he now
holds the Z-1 property. Even though the practical result may be the same, the tax law, as
a result of the wording of the Code, Revenue Rulings, cases, and so forth, may reach a
different conclusion. Since it can be argued that in the first example, X acquired the Y-1
property with the intent to immediately transfer it, it was not property used in his trade or
business or held for investment. It was property acquired primarily for a resale, a
retransfer. This supports the importance of format in multiple party exchanges.

FORMAT IN MULTIPLE PARTY EXCHANGES:


HADEN CO.

The older decision of Haden Co. held that an exchange involving multiple parties was
valid even though the pot theory and the structure of the deeds utilized were not ideal to
support the tax-deferred exchange treatment. Nevertheless, the taxpayer could have saved
time and money avoiding litigation by following proper format and having the deeds
structured in the correct order.

For example, if it is desired that A transfer his property to acquire C's property, and C
desires cash, with B desiring the A-1 property, the format must be set accordingly. If A
desires a tax-deferred exchange, the deed would run from C to B for cash. C would thus
have his cash in Step 1 and be out of the picture.

In Step 2, B, now owning the C-1 property, could transfer it to A for A-1, the property
which C desired.

Since A desired to hold the C property, why not simply have A transfer his property to
B, and have B transfer the cash to C, with C transferring his property to A?

Obviously, if the net result would be the same, the parties, without considering tax
issues, might be satisfied. However, as illustrated in the Haden case, the concern is that
there may be a subsequent controversy for tax purposes. Nevertheless, here the taxpayer
wanted to avoid Code §1031 and claim the loss.

W. D. HADEN CO.
v.
COMMISSIONER OF INTERNAL REVENUE.
48-1 U.S.T.C. Para. 9147, 165 F.2d 588
(5th Cir. 1948)

SIBLEY, Circuit Judge.


In redetermining income and excess profits taxes of W. D. Haden Company for 1940
and 1941, five claimed deductions were disallowed by the Tax Court which are the
subjects of this petition for review. The primary facts found are not disputed, and will be
stated briefly as to each controversy . . . * * * *

TAX-FREE EXCHANGE

2. Harrisburg Depot Transaction.


Briefly stated, taxpayer owned lot No. 16. The adjoining lot No. 15 was owned by one
Beeley. Another lot No. 17 was owned by Texas Company. All had water frontage. One
Goodwin, an independent real estate man, offered to get an exchange of No. 16 for No.
17, if taxpayer would pay him a commission of $750. Taxpayer declined the offer, but
offered to trade with him even. Goodwin then on his own account made arrangements
with Texas Company to buy lot 17 for $7,600, and to sell to Beeley a part of lot 16 for
$7,800. Beeley later agreed to purchase of Goodwin the remainder of lot 16 for $3,000.
All these trades were made in writing in Goodwin's name. The only contract signed by
taxpayer was with Goodwin, agreeing to exchange No. 16 for No. 17 with no money
consideration. When it came to making the deeds, instead of Goodwin taking Beeley's
money and buying of Texas Company lot 17 and deeding it to taxpayer, and taking
taxpayer's deed to No. 16 and then deeding it to Beeley, he requested Texas Company to
convey No. 17 to taxpayer and taxpayer to convey No. 16 to Beeley, which was done.
The Tax Court correctly held that the taxpayer had exchanged its lot for other property of
like kind, and had made no money sale, and that under Internal Revenue Code, Sec.
112(b)(1), 26 U.S.C.A.Int.Rev.Code, 112(b)(1), the transaction had no tax consequence
and realized no loss on No. 16, but that No. 17 took the cost basis of No. 16. Goodwin
could bind himself to exchange property he did not own but could acquire. Howell
Turpentine Co. v. Commissioner, 5 Cir., 162 F.2d 319. Taxpayer simply carried out the
contract it had made with Goodwin by conveying at Goodwin's direction to another.
Taxpayer did not sell to Beeley or get any of his money. It exchanged its lot for another
one. . . . * * * *

The decisions of the Tax Court are accordingly affirmed.* * * *

WHOSE FUNDS SHOULD BE USED FOR THE EXCHANGE?


124 FRONT STREET, INC.

The use of tax-deferred exchanges in three-party exchanges, or other multiple


exchanges may be substantially broadened as a result of 124 Front Street, Inc.

Here, the taxpayer had an advance of funds from X. The taxpayer used the funds from
X to exercise an option that the taxpayer held on real property. After the option was
exercised, the taxpayer exchanged this property with X, for property X held. This was
held to be a valid exchange, not a sale of an option, even though the taxpayer acquired
funds from X to exercise the option to acquire the property, to then make the exchange!
(This case was cited by the Biggs case.)

124 FRONT STREET, INC., PETITIONER


v.
COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

65 T.C. 6 (1975)
nonacq. in part and acq. in part,
1976-2 C.B. 2 & 3

STERRETT, Judge:
The respondent determined a deficiency in petitioner's Federal income tax and an
addition thereto under section 6653(a), I.R.C. 1954, [FN1] for the taxable year 1970 of
$242,352 and $12,118, respectively. Based upon an alternative position respondent
determined that the deficiency in petitioner's Federal income tax and an addition thereto
under section 6653(a) would be $153,956.30 and $7,697.82, respectively.

The primary issue presented is whether petitioner realized a short-term capital gain of
$425,000 on the exchange of a building, which petitioner acquired through the exercise
of an option, for another building. The secondary issue is whether $45,000 which
petitioner concedes represents additional gain recognized on the exchange should be
characterized as short-term or long-term capital gain. Respondent has conceded that there
is no addition to the tax due from the petitioner under section 6653(a) for the taxable year
1970.

Respondent alleges as an alternative position that petitioner realized a long- term


capital gain of $565,115 upon the disposition of its option. Based on this position
respondent determined a deficiency in petitioner's Federal income tax and an addition
thereto under section 6653(a) for the taxable year 1970 as noted above.

FINDINGS OF FACT

Most of the facts have been stipulated and are so found. The stipulation of facts,
together with the exhibits attached thereto, are incorporated herein by this reference.

124 FRONT STREET, Inc. (hereinafter petitioner), is a corporation, organized and


existing under the laws of California with its principal place of business in San Francisco,
Calif., at the time of filing its petition herein. Petitioner filed its Federal income tax return
for 1970 with the Western Service Center, Ogden, Utah. Petitioner reports its income on
the cash receipts and disbursements method of accounting utilizing the calendar year as
its accounting period.

Petitioner was incorporated in 1964 with 80 percent of its stock being issued amongst
the family of Harry Sugarman (hereinafter the lessee). Included in this group was Leland
C. Spiegelman (hereinafter Spiegelman), the lessee's son-in-law, who with his wife
owned a 20-percent interest. In 1969 Spiegelman served as petitioner's attorney and
financial adviser and represented petitioner throughout the transaction in issue.

In December 1963 the lessee leased from Bernice P. Jourdain, Hugo B. Beier, and
Estate of Amelia A. Beier, deceased (hereinafter the Jourdain group), certain real
property commonly known as 124 FRONT STREET, San Francisco (hereinafter the
option property). Under the terms of the lease, the lessee had the option to purchase the
option property after the expiration of 10 years from the commencement of the lease for
$200,000.

In 1964 this option was assigned to the petitioner by the lessee for $1,000. During this
period and up to 1969 petitioner was basically an inactive corporation with the option and
some cash being its only major assets.

Firemen's Insurance Co. of Newark, N.J. (hereinafter Firemen's), a property and


casualty insurance company, was interested in acquiring the option property. Firemen's
made a written offer to purchase the property in 1967.

Firemen's interest continued and in 1969 it was being represented by Alander F.


Hogland (hereinafter Hogland) who was associated with the San Francisco office of
Coldwell, Banker & Co. (hereinafter Coldwell), a real estate brokerage firm. Hogland
handled the negotiations between petitioner and Firemen's with respect to the transaction
in issue. He dealt principally with William Matchet (hereinafter Matchet), an executive of
Firemen's who was located in New York, and Spiegelman.

In May 1969 petitioner, lessee, and Firemen's entered into an Agreement of Sale and
Deposit Receipt under which petitioner would attempt to acquire the option property for
$250,000 and subsequently sell or exchange the option property with Firemen's. Pursuant
to this agreement Firemen's deposited into escrow a $25,000 check payable to the
Transamerica Title Insurance Co. (hereinafter Transamerica).

In June 1969 petitioner offered to buy the option property from the record owner, the
Jourdain group, for $250,000. The Jourdain group responded with a counteroffer to sell
the property for $425,000. Petitioner desired to acquire the option property at this price,
but it did not have the necessary funds. Spiegelman and Hogland discussed this
development with Hogland agreeing to determine whether Firemen's would assist
petitioner to acquire the option property.

Firemen's agreed to assist petitioner and, as a result of negotiations, a second


Agreement of Sale and Deposit Receipt (hereinafter the agreement) was executed by
petitioner, lessee, and Firemen's on August 1, 1969. The relevant portions of this
agreement are as follows: [FN2]

THIS AGREEMENT is made this 1st day of August, 1969, between 124 FRONT
STREET, INC., a corporation (hereinafter called Seller), HARRY SUGARMAN
(hereinafter called Lessee), and FIREMEN'S INSURANCE COMPANY OF NEWARK,
N.J., a corporation (hereinafter called Purchaser), and relates to the title and a leasehold
interest in certain real property (hereinafter called the Property) * * *

Each party, in consideration of the agreements of the other parties hereto, agrees as
follows:

1. The parties shall establish an escrow with American Title


Insurance Company, acting through (Transamerica) and
Purchaser shall deposit therein contemporaneously with the
execution of this agreement the sum of Twenty-Five Thousand
Dollars ($25,000.00), evidenced by its check in that amount, as
a deposit on account of the agreed purchase price of One
Million One Hundred Seventy-five Thousand Dollars
($1,175,000.00) for the Property and cancellation of the
leasehold interest of Lessee therein.
3. Seller agrees to endeavor to acquire title to the property within
thirty (30) days after the date of this agreement. If Seller shall
acquire title to the Property within said time and if there are no
valid objections to the marketability of the title to the Property
arising after Purchaser's original examination of title, the sale
of the Property shall be consummated, not later than one
hundred ninety (190) days from the date when Seller acquires
title to the Property, by delivery to Purchaser of a good and
sufficient Grant Deed to the Property in exchange for payment
of the purchase price of the Property to Seller and of Lessee's
leasehold estate to Lessee through the above-mentioned
escrow.
5. It is understood and agreed that Seller will attempt to obtain
fee title to the Property within the times above mentioned at a
cost to Seller not to exceed Four Hundred Twenty-five
Thousand Dollars ($425,000.00), such cost to include the
above-mentioned option price of Two Hundred Thousand
Dollars ($200,000.00) as provided in the lease from Owners to
Lessee, which option has been transferred to Seller. In no
event shall Seller be obligated to pay more than said Four
Hundred Twenty-five Thousand Dollars ($425,000.00) to
acquire fee title to the property. If Seller cannot obtain fee title
for the said sum of Four Hundred Twenty-five Thousand
Dollars ($425,000.00) within the times provided in Paragraph
3 above, Purchaser's deposit in the above-mentioned escrow
shall be returned to Purchaser and this agreement shall
terminate without further obligation of any party thereto.
6. Seller shall have the right to designate 'exchange property' in
lieu of all or any portion of the cash payment herein provided
at any time prior to the close of escrow and to require that title
to such exchange property shall be delivered to Seller as its
consideration for the sale of the Property herein provided. If
Seller gives written notice to Purchaser of such designation of
exchange property, Purchaser agrees to use its best efforts to
acquire title to such exchange property within thirty (30) days
after receipt of such notice, provided, however, that the total
cost to Purchaser for acquisition of such exchange property
shall not exceed One Million Twenty-five Thousand Dollars
($1,025,000.00). If such exchange property is designated by
Seller, then Seller shall be entitled to control the escrow and
instructions issued in connection therewith insofar as the same
relate to the exchange property and Purchaser shall conform to
Seller's valid and lawful instructions, provided that the same
do not increase Purchaser's obligation beyond the above-
mentioned maximum amount.
12. Purchaser agrees within thirty (30) days after the date of this
agreement to deposit the sum of Four Hundred Twenty-five
Thousand Dollars ($425,000.00) on account of the agreed
purchase price of One Million Twenty-five Thousand Dollars
($1,025,000.00) in said escrow, and further agrees that said
sum of Four Hundred Twenty-five Thousand Dollars
($425,000.00) may be used by Seller for the purchase of the
fee title to the Property. The title company shall be authorized
to pay said sum of Four Hundred Twenty-five Thousand
Dollars ($425,000.00) on Seller's behalf to Owners when it has
in its possession a grant deed from Owners to Purchaser
conveying title and fee to the Property to Seller and
instructions authorizing the recordation of said deed and when
it has in its possession a grant deed to the Property from Seller
to Purchaser plus irrevocable instructions from Seller
authorizing the title company to record said deed upon close of
escrow and in no event more than One Hundred Ninety (190)
days after recordation of the deed from Owners to Seller. If
said deed from Owners and said deed from Seller to Purchaser
are not both deposited in said escrow within thirty (30) days
from the date of this agreement, said sum of Four Hundred
Twenty-five Thousand Dollars ($425,000.00) shall be returned
to Purchaser.

Based on this agreement, petitioner accepted the Jourdain group's counteroffer.

Pursuant to the terms of the agreement an escrow account was established on August
20, 1969, with Transamerica in respect to the option property. Firemen's deposited an
additional $401,632.35 into the escrow account, which together with the $25,000
previously deposited fulfilled its obligations under the agreement. [FN3] On August 11,
1969, a deed was executed by the Jourdain group naming the petitioner as the grantee of
the option property. This deed was deposited into the escrow account on August 20,
1969, and was recorded on August 25, 1969.

On August 21, 1969, irrevocable escrow instructions were entered into between
petitioner, Firemen's, the lessee, and Transamerica. These instructions provide in relevant
part as follows: [FN4]

Seller deposits herewith the Deed from Seller to Purchaser covering the above-
captioned property. This Deed is hereby irrevocably deposited with you as trustee for the
benefit of Purchaser, and you are authorized to record this Deed, from Seller to
Purchaser, not less than 190 days after recordation of the Deed from Bernice P. Jourdain
to 124 FRONT STREET, Inc., provided, however, that in the event Seller obtains
'exchange property' in order to obtain the benefits of a tax deferred exchange, then and in
that event, Seller may instruct you to record this Deed within the 190 days.

Also submitted to Transamerica at this time were the following documents: a short
form agreement of sale between petitioner as seller and Firemen's as buyer, a copy of
which was recorded, cancellation of the lessee's existing lease, and a new lease between
the lessee and Firemen's. This new lease, although dated August 22, 1969, was not to take
effect until the recordation of the sale of the option property to Firemen's.

On August 25, 1969, the funds deposited into the escrow account by Firemen's were
distributed to the Jourdain group and others covering the purchase price of the option
property and the accompanying fees. For the remainder of 1969 the option property
remained in petitioner's name.

Petitioner on its 1969 Federal tax return reported the option property as its asset and the
funds deposited by Firemen's as its liability. Petitioner also received rent from the option
property and reported it as income and claimed a depreciation deduction. Petitioner also
insured the option property and in October 1969, Firemen's refused to make a repair to
the option property claiming that it was not the owner.

In January 1970 Firemen's offered to purchase for $1,120,000 real property and
improvements thereon located at 240 Stockton Street, San Francisco, Calif. (hereinafter
the exchange property). Firemen's offer consisted of $560,000 in cash, a promissory note
of $400,000, and taking the exchange property subject to an outstanding note of
approximately $160,000. This offer was accepted by the owner of the exchange property,
the Schroth Co. (hereinafter Schroth).

Both Firemen's and Schroth executed escrow instructions and delivered to


Transamerica the necessary documents to effect this transaction. Included in Firemen's
instructions was the requirement that Transamerica hold for Firemen's, marked as
canceled, its $400,000 promissory note payable to Schroth. Petitioner was to execute its
own promissory note for $400,000 payable to Schroth. This note was delivered on
February 16, 1970, when the deeds to the option property and the exchange property were
recorded in Firemen's and petitioner's names, respectively.
On February 13, 1970, the transaction between Firemen's and Schroth was closed with
Firemen's receiving the deed to the exchange property. Firemen's and petitioner then
formally exchanged the option and the exchange properties. As a result of these
simultaneous and reciprocal transfers, petitioner became the owner of the exchange
property subject to two deeds of trust securing aggregate debt of $563,944.34 at an
agreed fair market value of $1,120,000.

On February 13, 1970, petitioner was advised by Coldwell that $45,000 which
petitioner was to receive as a part of this transaction was ready to be disbursed to
petitioner at its order. On February 16, 1970, Firemen's sent a letter to Coldwell stating
that it had no interest in the $45,000. This amount was subsequently paid to petitioner on
June 25, 1970.

Petitioner on its 1970 tax return reported this transaction as an exchange of properties
which was covered by the provisions of section 1031. The amount realized included the
fair market value of the exchange property, release of indebtedness on the option property
(the $426,632 advanced by Firemen's), and cash of $10,059. Petitioner included in its
basis its adjusted basis in the exchange property and the assumption of the indebtedness
($563,944.34) and reported a gain realized of $567,005.

Since the indebtedness incurred exceeded the indebtedness forgiven, petitioner only
recognized gain to the extent of the cash received. Petitioner now concedes that the
additional $45,000 it received represents additional gain recognized on the transaction.

Respondent disallowed this treatment * * * * .

In an amendment to his answer, respondent raised an alternative position that petitioner


disposed of its option and received the exchange property in return. Respondent alleges
that this transaction does not qualify under the provisions of section 1031 and that
petitioner has recognized a long-term capital gain of $565,115 * * * *.

OPINION

The case at bar requires us to determine whether the transaction between petitioner and
Firemen's represents a sale of petitioner's option or whether it represents an exchange of
properties within the provisions of section 1031. If it is the latter we must then determine
whether petitioner must include the amount deposited by Firemen's into the escrow
account which petitioner used to exercise its option as gain recognized on the exchange,
and whether the $45,000 which petitioner concedes represents additional gain recognized
on the exchange should be characterized as short-term or long-term capital gain.

Respondent's position, that in reality the transaction between petitioner and Firemen's
was merely a sale of the option, was raised by him in an amendment to his answer to
petitioner's petition. Generally it is the petitioner who must bear the burden of proof in
matters before this Court; however, it is the respondent who bears the burden of proof
with respect to this position. Rule 142(a), Tax Court Rules of Practice and Procedure.
Respondent's primary argument is that we should view this transaction in its entirety
and not consider its individual, component steps. However we have been presented with a
series of legal documents that carefully track the development of this transaction. We do
not believe that these documents can be ignored. Furthermore, it appears that the
structure of the transaction is consistent with the intent of the parties.

In the instant case, under the agreement between the parties petitioner always had the
right to designate exchange property as consideration for the option property in lieu of
cash. Petitioner also, as will be discussed later, acquired the option property which was
later exchanged for the exchange property.

Respondent disregarded the form of the transaction and determined that petitioners had
sold their property and then purchased the exchange property in two separate
transactions.

After a careful review of the evidence we find no indication that petitioner intended to
sell, or that Firemen's intended to buy, petitioner's option. We believe the agreement
between the parties anticipated a sale or exchange of the option property after petitioner
exercised its option.

Respondent also argues that petitioner intended to sell its option (its major asset) when
it listed its stock for sale with Coldwell. This listing occurred in 1967 and we believe it is
too remote to have a bearing on the transaction in issue.

Consequently, we do not find that petitioner sold its option to Firemen's, but rather we
find a valid plan to exchange properties within the intent of section 1031. Having made
this determination we can now move on to a consideration of the consequences of the
transaction.

Respondent's argument is that, even if the parties exchanged properties, the $425,000
represents part of the consideration received by petitioner on the exchange of properties
and, as such it is 'boot' which must be included as an additional portion of the gain
realized that must be recognized. Petitioner argues that the $425,000 represents a loan by
Firemen's to enable it to purchase the option property which was repaid when the
properties were exchanged.

Petitioner held an option to purchase property that Firemen's wished to acquire.


Petitioner however did not have the financial resources to exercise the option. Petitioner,
through Hogland, asked Firemen's for assistance in the acquisition of the option property.
Negotiations followed which resulted in the agreement as described in our findings of
fact. We believe that the agreement and the surrounding circumstances support
petitioner's position.

Under the agreement Firemen's was to deposit the $425,000 into the escrow account.
This sum was to be used by petitioner to purchase the option property. If this goal could
not be accomplished, the agreement specifies that the $425,000 was to be returned to
Firemen's. Further, the agreement contemplates a sale or exchange of the option property
between the parties. This could only be accomplished after petitioner first acquired the
option property.

We do note that, under the agreement after the option property was acquired, it was to
be transferred to Firemen's within a specified period of time. Although petitioner was to
have the building for only a short period, we believe that during this time it was the actual
owner of the option property.

Petitioner's title to the option property was acquired in August 1969, and it was not
formally transferred to Firemen's until February 1970. In addition to possessing legal
title, it appears that the 'benefits and burdens' of ownership were with the petitioner. See
Gordon J. Harmston, 61 T.C. 216 (1973), on appeal (9th Cir., Feb. 8, 1974).

Petitioner received the rental income generated by the option property and reported it
along with the depreciation deduction associated with the option property on its 1969 tax
return. Petitioner also insured the property and Firemen's, in October 1969, refused to
make a repair to the option property claiming it was not the owner. Furthermore, although
Firemen's entered into a lease with the lessee in August 1969, it was not to take effect
until Firemen's had title to the option property.

The transaction as structured involves three parties-- the Jourdain group, petitioner, and
Firemen's. However it appears that Firemen's played two distinct roles-- financier and
purchaser. If petitioner had borrowed the necessary funds from a fourth party, the option
property along with the indebtedness could have then been transferred to Firemen's. The
$425,000 could then have been used by Firemen's to liquidate the debt. We do not believe
that the source of petitioner's funds should influence our ultimate conclusion.

We believe the facts of this case are consistent with the finding that the funds advanced
by Firemen's represented a loan to petitioner. With these funds petitioner acquired the
option property which it then transferred to Firemen's. Consequently, we believe that the
$425,000 does not represent consideration received by petitioner in exchange for the
option property, but rather represents an amount received to acquire the option property.

Finally we must determine whether the $45,000 petitioner received on the exchange
and which it concedes does represent gain recognized as to be characterized as short-term
or long-term capital gain. Title to the option property was formally recorded in
petitioner's name on August 25, 1969. On February 13, 1970, the exchange between
petitioner and Firemen's was closed. On February 16, 1970, less than 6 months beyond
August 25, 1969, this deed was formally recorded in Firemen's name. This fact is
dispositive of the issue of long-term versus short-term gain. The question of whether the
$45,000 was or was not available within the 6-month period is irrelevant (although we
believe it was) once the foregoing factual conclusion is made.

Decision will be entered under Rule 155.


ALDERSON

Alderson, reversing the Tax Court, is one of the leading decisions in the multiple party
exchange area. It supports the proposition of great flexibility when dealing with Section
1031 exchanges.

As the Court said, the question was whether the transaction, whereby the taxpayers
transferred one parcel of realty and acquired another, constituted a sale and thus was
taxable under Section 1002, or whether it was a nontaxable exchange under Section 1031.

Property was acquired solely for the exchange. No gain was recognized on the
taxpayers' transfer of land to a corporation, pursuant to an escrow agreement, which
contemplated that the corporation would acquire title to the other land, selected by the
taxpayers, and would in turn convey that land to the taxpayers. The details of the case
have been abridged to focus on the exchange issues.

James ALDERSON, surviving husband


and Estate of Clarissa E. Alderson, Deceased,
James Alderson, Executor, Petitioners,
v.
COMMISSIONER OF INTERNAL REVENUE, Respondent.

63-2 U.S.T.C. Para. 9499,


317 F.2d 790 (5th Cir. 1963),
rev'd 38 T.C. 215

CRARY, District Judge.


Petitioners seek review of the decision of the Tax Court, entered May 8, 1962,
determining a deficiency in income tax for the taxable year 1957 in the amount of
$39,530.58.

The question presented is whether the transactions whereby taxpayers transferred one
parcel of realty and acquired another constituted a sale, the gain from which is
recognizable under Section 1002[FN1] of the Internal Revenue Code of 1954, or a non-
taxable exchange within the meaning of Section 1031 [FN2] of said Code.

On May 21, 1957, following negotiations between petitioners and Alloy Die Casting
Company, hereinafter referred to as Alloy, representatives of petitioners and Alloy
executed escrow instructions to the Orange County Title Company, hereinafter referred to
as Orange, constituting a purchase and sale agreement whereby petitioners agreed to sell
their Buena Park property, consisting of 31.148 acres or agricultural property, to Alloy
for $5,550.00 per acre, a total price of $172,871.40. Pursuant to the terms of said
agreement, Alloy deposited $17,205.00 in the Orange escrow toward purchase of the
Buena Park property.
The title to the Lexington Street property was acquired by the Title Company for the
purpose of the exchange, and it follows by analogy that there was no need for Alloy to
acquire a 'real' interest in the Salinas property by assuming the benefits and burdens of
ownership to make the exchange qualify under the statute although respondent asserts
that failure of Alloy to hold a 'real' interest in the Salinas property precluded the
transactions involved from being construed as constituting an exchange.

The Mercantile case appears to hold that one need not assume the benefits and burdens
of ownership in property before exchanging it but may properly acquire title solely for
the purpose of exchange and accept title and transfer it in exchange for other like
property, all as a part of the same transaction with no resulting gain which is recognizable
under Section 1002 of the Internal Revenue Code of 1954.

Referring again to the Salinas escrow and the instructions to Orange, it is to be noted
that the terms of the buyer's instructions in the Salinas escrow and the instructions to
Orange were not carried out in important details not heretofore mentioned. Although the
petitioners authorized Orange to pay $19,000.00 into the Salinas escrow and to pay
$171,000.00, when available, into the Salinas escrow, and although the Salinas escrow
provided for the depositing of $171,000.00 into the Orange escrow (R.Br. 5), this was not
done. The $171,000.00 nor any part thereof was ever paid into the Orange escrow, but on
the contrary $172,871.40, property of Alloy, was by its attorney, Pentz, deposited in the
Salinas escrow in Alloy's behalf.

The court concludes the holding of the Tax Court, 'that in essence petitioners acquired
the Salinas property in a separate transaction; that payment of the $172,871.40, made by
Alloy, was a payment made for petitioners' (R. 32), is not supported by the Tax Court's
Findings of Fact, Stipulation of Facts or by the evidence in the case when considered in
all of its aspects.

The court further concludes that there was no sale by petitioners of the Buena Park
property to Alloy, but that the pertinent transactions resulted in an exchange of the Buena
Park property for property of like kind to be held either for productive use in trade or for
investment, and that by reason thereof there was no gain or loss from said exchange
which should be recognized for income tax purposes. For the reasons set forth above, the
Decision of the Tax Court of the United States Entered herein May 8, 1962, 'That there is
a deficiency in the income tax for the taxable year 1957 in the amount of $39,530.58', * *
* * is reversed.

CARLTON

In the Fifth Circuit decision of Carlton, factually there was little dispute. In 1959, the
taxpayers were engaged in the ranching business. They owned a tract of land. They
executed a contract with General Development Corp. which gave General an option to
acquire the ranch.
General paid a $50,000 deposit to be credited to the total purchase price, if the option
was exercised. The contract also provided that the "sellers," as owners of the property,
could acquire, through General, an agreement by notifying it in writing that they desired
to have an exchange as opposed to an outright sale. General would then supply funds to
acquire other land for the exchange. The question was whether this transaction
constituted a valid exchange, since the taxpayers did attempt to modify the transaction to
allow for the exchange under their prior agreement.

The taxpayers lost. The Court stated: . . . "We are compelled to conclude that the
transfer of the ranch property to General constituted a sale, and rendered the non-
recognition of gain provisions of Section 1031 inapplicable. Considering how close the
appellants (taxpayers) came to satisfying the requirements of that section and the
stipulation that an exchange was intended, this result is obviously harsh. But there is no
equity in tax law."

June Pinson CARLTON and Charles T. Carlton,


as Administrators of the Estate of Thad H. Carlton, and June Carlton, Appellants,
v.
UNITED STATES of America, Appellee.

67-2 U.S.T.C. Para. 9625,


385 F.2d 238 (5th Cir. 1967)

GEWIN, Circuit Judge: This is an appeal from a judgment of the United States District
Court for the Southern District of Florida denying the claim of the appellants for a refund
of income taxes and interest paid after a deficiency was assessed by the Internal Revenue
Service for the tax year 1959. In their joint return for 1959, the appelants[FN1] did not
recognize the gain realized on the transfer of several parcels of real property but treated
the transfers as an exchange of property under 1031 of the I.R.C. of 1954. The I.R.S.
asserted that the transfers constituted a sale and not an exchange and assessed a
deficiency of $34,337.63 together with interest. The appellants paid the deficiency
assessed, and filed a timely claim for refund. The claim was disallowed by the District
Director of Internal Revenue and this suit followed. The district court concluded that the
transfers constituted a sale and repurchase and rendered judgment for the Government.
We affirm.

The facts of the case are fully stipulated. During the year 1959 and for several years
prior thereto the appellants had been engaged in the ranching business. In connection
with that business they owned a tract of land in Saint Lucie County, Florida, (ranch
property) having a basis of $8,918.91. On October 18, 1958, they executed a contract
with General Development Corporation (General) which gave General an option to
acquire the ranch property for $250.00 an acre. General paid the appellants $50,000
deposit which was to be credited to the total purchase price should General exercise its
option. The contract also provided that the appellant could require General, by notifying
it in writing, to acquire such other land as designated by the appellants for the purpose of
exchange in lieu of a cash payment or mortgage. General's obligation to supply funds for
any down payment which might be needed to bind any contracts to purchase other land
for exchange was not to exceed the $50,000 advanced at the time the option was
executed. In the event such an exchange could not be effected, General was to pay for the
ranch property by cash and a mortgage securing the balance of the purchase price. From
the outset of negotiations with General, the appellants desired to continue ranching
operations and intended to exchange the ranch property for other property suitable for
ranching. They also desired an exchange as opposed to a sale in order to obtain the tax
benefits incident to an exchange under 1031. At all times General desired simply to
purchase the ranch property.

Following the execution of the option contract with General, Thad Carlton (Carlton)
found two suitable parcels of land, one in Gladen County, Florida (Lyons), and one in
Hendry County, Florida (Fernandez). He conducted all the negotiations for the
acquisition of these lands and paid the deposit for each by a cashiers check issued by his
bank. The total deposit on both pieces of property did not exceed the fifty thousand
dollars paid by General. When the negotiations to acquire the Lyons and Fernandez
properties were complete, Carlton notified General in writing that he would require it o
purchase these lands for the purpose of exchanging them for his ranch property, and the
actual agreements of sale were executed by General.[FN2] On May 11, 1959 General
exercised its option to acquire the ranch property and arrangements were made to close
the entire transaction around August 1, 1959. The closing of the several transactions
actually occurred on August 3rd and 4th and in closing the appellants deviated from the
original plan which resulted in the tax problem here in issue.

In order to avoid unnecessary duplication in title transfer, a procedure was adopted


whereby title to the Lyons and Fernandez properties would be conveyed directly to the
appellants instead of to General and then to the appellants. To accomplish this result,
General, on August 3rd, assigned to the appellants its contracts to purchase the two pieces
of property and paid the appellants, by check, the total amount it would have been
required to pay if it had actually first purchased the Lyons and Fernandez property in its
own name and then conveyed the land to the appellants. Later that same day Carlton took
the assignment of the contracts to purchase and purchased the Lyons property, using his
personal check to close the sale. On August 4 he purchased the Fernandez property in a
similar manner. At the time Carlton issued these checks, the balance in his checking
account was too small to cover them, but he deposited the check received from General
when the transaction with it was closed to meet these outstanding checks. This check was
the balance of the cash purchase price and was in addition to the $50,000.00 paid when
the option was executed.

The district court held that on the basis of these facts the transfers constituted a sale and
repurchase. The court concluded that because General never acquired the legal title to the
Lyons and Fernandez property, it could not have exchanged those properties for the ranch
property. Rather, the court found that the appellants sold the ranch property to General
and applied the cash thereby acquired to the purchase of the Lyons and Fernandez
properties. The court also noted that Carlton was the active party in arranging the
acquisition of the Lyons and Fernandez tracts and that he was personally liable on the
notes and mortgages involved in such acquisitions. The appellants contend on this appeal
that the district court erred in focusing on one aspect of a continuing transaction. They
assert that the procedure adopted must be viewed as a single unitary transaction through
which they intended to exchange properties, and which resulted in their acquiring
property suitable for ranching and relinquishing their rights to like property. They insist
that intent is the essential element which distinguishes a sale from an exchange. Since the
Government has stipulated that an exchange was intended, and since the net result of the
transaction was an exchange of ranching properties, they conclude, the transfers must be
considered an exchange. * * * * [FN3]

There is little doubt that the ranch property and the Lyons and Fernandez properties are
of like kind, and that the properties were held by the appellants for productive use. The
only question presented here is whether the transfer of the properties constituted a sale or
an exchange.

Both parties agree that had the appellants followed the original plan, whereby General
would have acquired the legal title to the Lyons and Fernandez properties and then
transferred the title to such properties to the appellants for their ranch property, the
appellants would have been entitled to postpone the recognition of the gain pursuant to
1031. However, instead of receiving the title to the Lyons and Fernandez properties from
General for their ranch property, the appellants received cash and an assignment of
General's contract rights to those properties.

Thus, the ultimate question becomes whether the receipt of cash by the appellants upon
transferring their ranch property to General transformed the intended exchange into a
sale. The Government asserts that it does, and under the facts and in the circumstances of
this case, we agree.

Section 1031 was designed to postpone the recognition of gain or loss where property
used in a business is exchanged for other property in the course of the continuing
operation of a business. In those circumstances, the taxpayer has not received any gain or
suffered any loss in a general and economic sense. Nor has the exchange of property
resulted in the termination of one venture and assumption of another. The business
venture operated before the exchange continues after the exchange without any real
economic change or alteration, and without realization of any cash or readily liquefiable
asset. * * * *

The statute specifically limits the nonrecognition of gain or loss to exchanges of


property, and it is well settled that a sale and repurchase do not qualify for nonrecognition
treatment under the section. * * * * Thus, even though the appellants continued their
ranching business after the transaction here in question, that does not control the tax
consequences of the transfers. Rather, it is essential that the transfers constituted an
exchange and not a sale and repurchase if the tax benefits of 1031 are to be applicable.

The appellants contend that the entire transaction must be viewed as a whole in
determining whether a sale or an exchange has occurred. They argue that the transfer of
the ranch property to General for the cash and assignments was part of a single unitary
plan designed and intended to effect an exchange of their ranch property for other
property suitable for ranching. Thus, they conclude, the transfers of property should be
construed to be an exchange.

While it is true that the incidence of taxation is to be determined by viewing the entire
transaction as a whole, Kanawaha Gas & Util. Co. v. C.I.R. * * * * (5 Cir. 1954), that
rule does not permit us to close our eyes to the realities of the transaction and merely look
at the beginning and end of a transaction without observing the steps taken to reach that
end. * * * * The requirement is that the transaction be viewed in its entirety in order to
determine its reality and substance, for it is the substance of the transaction which decides
the incidence of taxation. * * * * In the instant case, while elaborate plans were laid to
exchange property, the substance of the transaction was that the appellants received cash
for the deed to their ranch property. * * * * [FN4] Where, as here, there is an immediate
repurchase of other property with the proceeds of the sale, that distinction between a sale
and exchange is crucial. Further, General was never in a position to exchange properties
with the appellants because it never acquired the legal title to either the Lyons or the
Fernandez property. Indeed, General was not personally obligated on either the notes or
mortgages involved in these transaction. Thus it never had any property of like kind to
exchange. Finally, it can not be said that General paid for the Lyons and Fernandez
properties and merely had the properties deeded directly to the appellants. [FN5] The
money received from General by the appellants for the ranch property was not earmarked
by General to be used in purchasing the Lyons or Fernandez properties. It was
unrestricted and could be used by the appellants as they pleased. The fact that they did
use it to pay for the Lyons and Fernandez properties does not alter the fact that their use
of the money was unfettered and unrestrained. It is an inescapable fact that the money
received by appellants from General was money paid to them for a conveyance of their
land. As a result, the separate transaction between General and the appellants must be
construed to be a sale, and the transactions between the appellants and Lyons and
Fernandez as a purchase of other property. * * * *

The appellants' intention and desire to execute an exchange does not alter the reality
and substance of the situation. It is well established that the intention of a taxpayer to
avail himself of the advantages of a particular provision of the tax laws does not
determine the tax consequences of his action, * * * * but what was actually done is
determinative of the tax treatment. * * * * Thus, the intention of the appellants to effect
an exchange does not convert the transfer of property for cash into an exchange. The
cases on which the appellants rely in support of their assertion that intent determines
whether a transfer is a sale or exchange are factually distinguishable and
inapposite.[FN6] They deal with the question of whether certain transfers between
corporations and their stockholders are sales, exchanges for corporate stock, or capital
investments. The sections under which they were decided and the problems they present
are far different from the subject matter with which 1031 is concerned.

Therefore, we are compelled to conclude that the transfer of the ranch property to
General constituted a sale, and rendered the nonrecognition of gain provisions of 1031
inapplicable. Considering how close the appellants came to satisfying the requirements of
that section and the stipulation that an exchange was intended, this result is obviously
harsh. But there is no equity in tax law, * * * * and such must the result be if the
limitation in 1031 to exchanges is to have any meaning. The judgment of the district
court is Affirmed.

FN4. While the characterization by a taxpayer of the nature of a transaction is not


determinative, what the taxpayer said and did during the course of the transaction may
shed some light on what was actually done. Although not of controlling importance, the
following stipulated facts shed some light on what the taxpayer did in this case:
'Simultaneously with the forwarding of the executed copies of the aforementioned
contract to General on September 27, 1958, Plaintiffs entered into an agreement with two
real estate brokers who were instrumental in negotiating the options. The agreement
obligated Plaintiffs to pay stipulated commissions to said brokers in the event that the
options were exercised and 'the transactions of sale and purchase * * * closed." 'On
January 4, 1959, Decedent physically inspected the Lyons property, and then advised the
representatives of the Lyons Estate that he was working out a final schedule with General
in order to determine the amount of time 'I will need to close the purchase." 'Decedent
(Carlton) reiterated an earlier statement that 'it was his intention to close the purchase of
the Lyons property, * * * irrespective of whether or not General Development
Corporation elects to exercise its option to purchase my property. I cannot well afford to
forfeit the $32,500.00 payment, if it can possibly be avoided." 'On May 14, 1959, after
receipt of the aforementioned election by General, Decedent requested the Estate to
update the abstracts on its property and have them sent to him. On the same date, he
requested permission from the Estate to clean up the premises of the Lyons property and
to begin construction of two houses and a barn on them on or about June 1, 1959, in order
to have the construction completed at the time of closing, when he desired to move his
ranching operation there. Decedent promised to prohibit any liens from attaching to the
premises, and stated that the sale of his property to General 'will be closed at the same
time I close my purchase with you'.' 'On June 2, 1959, the following endorsement was
added to this contract over the signature of Decedent, as required by Mr. and Mrs.
Fernandez: "I accept and agree to the provisions of the foregoing, and I further agree with
the sellers, that when the property is conveyed to me, I will assume the mortgage and be
personally responsible for its payment. I further agree that sellers shall have 90 days from
date of closing to remove their cattle from the property." 'The closing of the transaction
involving the sale from Plaintiffs to General was held in Miami as scheduled on August
3, 1959. The amount shown on the closing statement as 'cash to close' was paid by
General by means of a cashier's check in the amount of $199,797.78 payable to Plaintiffs.
On the same date, General issued its ten-year, interest-bearing, installment promissory
note, in the amount of $952,143.00 to Plaintiffs.'

ROGERS

In 1965, the Petitioners in Rogers had entered an option agreement to sell their
property. However, before the exercise of the option by the optionee, the Taxpayers also
entered other negotiations for the purchase of other property from a third party, and to
transfer the option property, subject to the option, to that third party.

Eventually the Taxpayer executed a deed in the name of an escrow agent with
instructions to the agent to deed the property to the third party when the third party, if he
did, obtained title to the other property. The third party eventually delivered the title to
the escrow agent; but, prior to that time, the optionee exercised the option from the
taxpayer. The optionee made a payment to the escrow agent of the full price under the
option.

The Court was faced with the question of whether this would qualify as a valid Section
1031 exchange. The Court held that it did not qualify. Apparently, at that time, it was too
far afield. This decision was prior to the Starker cases; however, even in the Starker
cases, money was not held in escrow, nor was it structured in the fashion of the Rogers
case.

JOHN M. ROGERS AND GLADYS B. ROGERS, PETITIONERS,


v.
COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

44 T.C. 126 (1965)

ATKINS, Judge:
The respondent determined deficiencies in income tax of petitioners in the amounts of
$111,707.80 for the year 1958 and $1,417.90 for the year 1960. The parties have reached
agreement as to all issues for 1960 and all issues for 1958 except the issue of whether the
transfer by petitioners in 1958 of a parcel of realty and the acquisition of another
constituted a nontaxable exchange within the meaning of section 1031 of the Internal
Revenue Code of 1954 as the petitioners contend, or whether the petitioners' transfer
constituted a sale, gain from which is to be recognized under section 1002 of the Code, as
determined by the respondent.

FINDINGS OF FACT

Some of the facts have been stipulated and the stipulations are incorporated herein by
this reference.

The petitioners are husband and wife residing at Walnut Creek, Calif. They filed joint
Federal income tax returns on the cash method for the taxable years 1958, 1959, and
1960 with the district director of internal revenue, San Francisco, Calif. Hereinafter John
M. Rogers is referred to as the petitioner.

Late in 1955 the petitioner retired from his position as an executive of a large
international engineering construction organization and thereafter was concerned with
securing investment income. In April 1956, petitioners acquired for investment an office
building situated at 571 Market Street, San Francisco, Calif. (hereinafter referred to as
571 Market Street), and thereafter held such property for the income derived from rents
and profits. Coldwell, Banker & Co., a San Francisco real estate firm which had been
instrumental in the sale of the property to petitioners, performed for a fee the various
duties associated with the management of the building.

The Standard Oil Co. of California (hereinafter referred to as Standard Oil) desired to
acquire five adjoining properties, including 571 Market Street, as the site for a proposed
new office building, and prior to August 22, 1957, commissioned Buckbee Thorne & Co.,
a San Francisco real estate firm (hereinafter referred to as Buckbee Thorne), to negotiate
for the purchase of such five properties on behalf of Standard Oil as undisclosed
principal. Since Standard Oil wished to remain an undisclosed principal until all five
properties had been assembled, Buckbee Thorne, with the authorization of Standard Oil
named California Pacific Title Insurance Co. (hereinafter referred to as the title company)
to acquire title for its principal.

During August 1957, petitioners were approached by a representative of Buckbee


Thorne who desired to obtain an option to purchase 571 Market Street. They advised
such representative that they would sell for a price of $750,000 plus the real estate
commission, and on August 13, 1957, an escrow account (numbered 462011) was opened
at the title company under the name 'Buckbee Thorne-- Rogers.'

On August 22, 1957, petitioners granted to the title company an option to purchase 571
Market Street. The option agreement provides in pertinent part as follows:

For and in consideration of the sum of SEVEN THOUSAND SEVEN HUNDRED


AND TWELVE AND 50/100 ($7,712.50) Dollars to seller in hand paid, the receipt of
which is hereby acknowledged by said seller, to apply on the purchase price, the
undersigned JOHN M. ROGERS and GLADYS B. ROGERS herein designated as the
seller, hereby grants the right and option to purchase and agrees to sell to CALIFORNIA
PACIFIC TITLE INSURANCE COMPANY herein designated as the purchaser, or its
assigns, at any time within 120 days from the date hereof, the following described
property in the City and County of San Francisco, State of California, to wit: * * *

(Here follows description of 571 Market Street) For the purchase price of SEVEN
HUNDRED SEVENTY ONE THOUSAND TWO HUNDRED FIFTY AND 00/100
($771,250.00) dollars lawful money of the United States of America, payable as follows:
CASH

If said purchaser elects to purchase said property at the price and on the terms herein set
forth, and within the time specified, the said purchaser shall give said seller due notice in
writing and shall pay an additional sum of $69,412.50 for account of said seller to
Buckbee Thorne & Co. * * * said sum to apply on the purchase price * * *

By letter dated August 30, 1957, Buckbee Thorne transmitted to the title company the
option granted by petitioners to the title company as well as options for the other
properties Standard Oil was seeking to acquire.
OPINION

The respondent determined, and contends, that the transactions by which the petitioners
disposed of 571 Market Street and acquired the Sharon Building do not qualify as an
exchange under the nonrecognition provisions of section 1031 of the Internal Revenue
Code of 1954,[FN2] but that, rather, the petitioners sold 571 Market Street pursuant to
the option which they had entered into with the title company, acting on behalf of
Standard Oil, and purchased the Sharon Building. It is his position that capital gain must
be recognized upon the disposition of 571 Market Street under the provisions of section
1002 of the Code.[FN3]

The petitioners, on the other hand, contend that after the option was granted, and was
still an executory contract, they entered into an agreement to exchange 571 Market Street
for the Sharon Building; that thereafter they did effect such an exchange; and that
therefore none of the gain realized by them on the disposition of 571 Market Street is to
be recognized, in view of the provisions of section 1031 of the Code.

The purpose of section 1031(a) is to defer recognition of gain or loss when a direct
exchange of property between a taxpayer and another party takes place. The sale of
property and the purchase of similar property does not constitute an exchange.

In support of their claim that there was an agreement between them and the Sharons to
exchange 571 Market Street for the Sharon Building the petitioners introduced in
evidence a document entitled 'Agreement to Exchange.' Therein it was recited that the
petitioners agreed to such an exchange. However, such document was signed only by the
petitioners, and therein their undertaking is referred to as an 'offer.' Such 'offer' was made
subject to the petitioners' obtaining a loan on the Sharon Building. The petitioner testified
that it was his understanding that Coldwell, Banker & Co. discussed with the Sharon
interests the matter of an exchange and that Coldwell, Banker & Co. informed him that
the Sharons would enter into an exchange on the basis of $1,150,000 for their property.
He further testified that he considered himself bound to carry out the exchange with the
Sharons and that he was at all times prepared to exchange with the Sharons, irrespective
of whether the option was exercised, if the Sharons were willing to accept 571 Market
Street subject to the terms of the Standard Oil option.[FN4] Apparently there was no
exchange agreement signed by both the petitioners and the Sharon representatives.
Whatever agreement there was between them was apparently reached through Coldwell,
Banker & Co. There is no testimony by any representative of Coldwell, Banker & Co. or
the Sharon interests.[FN5] Accordingly, we must resort to the escrow instructions issued
to the title company by the petitioners and by the Sharon interests in order to determine
the substance of the agreement.

In their instructions, issued December 17, 1957, the petitioners directed the title
company to deliver to the order of the Sharon interests the deed covering 571 Market
Street when the title company had vested in the petitioners title to the Sharon Building
and had a loan of $550,000 from an insurance company and notes of the petitioners
therefor secured by a mortgage on the Sharon Building.
On December 19, 1957, Standard Oil exercised, through the title company, its option to
purchase 571 Market Street and paid to the title company for the account of the
petitioners an additional amount of $69,412.50, in accordance with the terms of the
option agreement. On the same date Standard Oil gave to the title company its check to
cover the remaining purchase price of 571 Market Street, and instructed the title company
to take title to the property in its own name and to then convey the property, together with
the other properties, to Standard Oil in one deed.

It was not until January 16, 1958, that the owners of the Sharon Building delivered to
the title company, as escrow agent, deeds in favor of the petitioners covering the Sharon
Building, and issued instructions to such escrow agent. Such instructions specifically
provided that the deeds were to be delivered by the escrow agent to the petitioners when
such escrow agent had received for the Sharons the amount of $1,118,750, to consist of a
payment of $368,750 from the petitioners and $750,000 from Standard Oil, whereupon
the escrow agent was to execute a deed conveying 571 Market Street to Standard Oil. It
appears, therefore, that from the standpoint of the Sharon interests, there was no intention
of committing themselves to accepting title to 571 Market Street until such time as
Standard Oil had exercised its option and had paid the purchase price to the title
company. Indeed, at the time the Sharon interests delivered deeds to the Sharon property
and issued instructions to the escrow agent Standard Oil had already exercised the option
and had paid the purchase price of the property to the title company. It seems clear to us
that by that time a valid and binding contract of purchase and sale of 571 Market Street
had been consummated between petitioners and Standard Oil, and that Standard Oil was
entitled to receive a deed to that property.[FN6] This being true, it also seems clear to us
that the Sharon interests never obtained any ownership in 571 Market Street. The
petitioners contend that an optionor may transfer property subject to the option. Be that as
it may, we think it clear that the petitioners did not transfer 571 Market Street to the
Sharons. Their transfer of title to 571 Market Street to the title company in the name of
the latter did not effect a transfer to the Sharons. And it was not until January 16, 1958,
that the Sharons delivered deeds covering the Sharon Building to the title company.
Clearly, up to that time there was no exchange between the petitioners and the Sharons.
And by that time it was impossible for the Sharons to obtain any ownership of 571
Market Street since the petitioners had already effectively disposed of that property to
Standard Oil.[FN7] The Sharon interests therefore were not in receipt of any property
from the petitioners and hence there was no exchange between them and the petitioners.
While the petitioners, at the time they delivered a deed transferring title to 571 Market
Street to the title company, issued instructions to the title company 'to deliver said deed to
the order of Hurford C. Sharon, et al.,' and while Hurford C. Sharon issued instructions
on January 16, 1958, to the title company in which he 'authorized' the title company to
execute a deed conveying the property to Standard Oil, these were mere formal matters
which do not reflect the substance of the transaction, as pointed out hereinabove

It is, accordingly, our conclusion that the petitioners sold 571 Market Street to Standard
Oil pursuant to the option, that the proceeds therefrom were used by them to purchase the
Sharon Building, and that there was not an exchange by the petitioners of 571 Market
Street for the Sharon Building.

We have carefully considered the cases of Alderson v. Commissioner, (C.A. 9) 317


F.2d 790; Coastal Terminals, Inc. v. United States, supra; and Mercantile Trust Co. of
Baltimore, 32 B.T.A. 82, cited by the petitioners. Each of those cases is distinguishable
from the instant case. In each of the cited cases the taxpayer had agreed to transfer
property to another party for property which the other party did not then own. However,
in each the other party obtained property and carried out the terms of the agreement. In
each of those cases both the form and the substance of the transaction was an exchange.
In the instant case there was no exchange between the petitioners and the Sharon interests
because the Sharons did not acquire ownership of 571 Market Street. There was no
exchange between the petitioners and Standard Oil because the latter did not transfer any
property to the petitioners. The petitioners, of course, recognize this but on brief contend
that in principle the cited cases are governing. They state that they might have placed
themselves in the precise position of the taxpayers in those cases by including Standard
Oil to purchase the Sharon Building so that an exchange could have been effected with
Standard Oil, in which event the result would have been the same in that petitioners
would hold the Sharon Building, Standard Oil would hold 571 Market Street, and the
Sharons would have realized cash. They state that the difference in how the end result is
accomplished is immaterial. We cannot agree. Our decision must be governed by what
was actually done, rather than by what might have been done. Television Industries, Inc.
v. Commissioner, (C.A.2) 284 F.2d 322, and cases cited therein, affirming 32 T.C. 1297.

Decision will be entered under Rule 50.

INTENT IS NOT ENOUGH: HALPERN

In the 1968 District Court decision of Halpern, the taxpayer had taken a number of
steps as to an exchange. At the outset of the transaction, the plaintiff, Halpern, owned a
$32,000 equity in the Verbena property. Chennault owned an equity of $15,000 in the
Wadley property, and also had $17,000 in cash. Kidd and Smith, together, had an equity
in the Hollywood property worth $19,000. Bartlett had an equity in the Gordon property
worth $77,000.

At the end of the transactions, the plaintiff's assets of $46,000 had been changed into
the Wadley property of $15,000, the Hollywood property of $19,000 equity, and $12,000
worth of equity in the Gordon property. Chennault's $32,000 worth of assets had been
wholly transmuted into the Verbena equity; Kidd and Smith had $19,000 in cash; Bartlett
had $12,000 in cash, and plaintiff's note for $65,000.

Obviously, the facts are not complete, and they are certainly confusing. Taxpayer
contended that the series of transactions which brought about the various changes in
position was designed to make a transaction which was tax-free under Section 1031. The
government, on the other hand, took the position the plaintiff had exchanged his Verbena
property solely for the Wadley property, with certain boot. As such, it took the position
that part of the transaction was taxable under Section 1031.

The Court said that the real question remaining in the case was whether the transfer of
certain of the properties was an integral part of the other transfers.

The Court stated that as a result of the separate transactions between the parties, and
despite the various interrelationships involved, there was no Section 1031 exchange.
Although it came close to satisfying these requirements, and there was a stipulation that
an exchange was intended, the Court said that the level for an exchange was not met. The
Court did say that this was obviously a harsh result, but "there is no equity in tax law."

Bernard HALPERN and Shirley Halpern


v.
UNITED STATES of America.

286 F.Supp. 255 (1968)


EDENFIELD, Judge.

ORDER

The facts in this action by a taxpayer seeking a refund of taxes paid are fully set forth in
a stipulation by the parties. There being no conflict between the evidence and the
stipulation, the latter is hereby incorporated in this order.

For convenience, however, the substance of the facts as they appear to the court may be
briefly stated. At the outset of the transactions in question, plaintiff owned an equity in
the Verbena property of $32,000 and had $14,000 in cash. Chennault owned an equity in
the Wadley property of $15,000 and had $17,000 cash. Kidd and Smith together had an
equity in the Hollywood property worth.$19,000. Bartlett had an equity in the Gordon
property worth $77,000. At the end of the transactions, plaintiff's assets of $46,000 had
been transmuted into the Wadley equity ($15,000), the Hollywood equity ($19,000), and
$12,000 worth of equity in the Gordon property. Chennault's $32,000 worth of assets had
been wholly transmuted into the Verbena equity; Kidd and Smith had.$19,000 in cash;
Bartlett had $12,000 in cash, and plaintiff's note for $65,000. (Plaintiff's mortgage on the
Verbena property of $38,700 and Chennault's mortgage on the Wadley property of
$25,800 had each been assumed by the new owners of the properties.)

The taxpayer contends that the series of transactions which brought about these changes
in position was designed and executed so as to make the transaction a unitary one and
thus a tax-free exchange (for Halpern) of like property within the scope of Internal
Revenue Code of 1954 1031(a).[FN1] The Government, on the other hand, contends that
the plaintiff exchanged his Verbena property solely for the Wadley property of Chennault
plus a cash 'boot' paid by Chennault, which the plaintiff promptly reinvested in the
Hollywood and Gordon properties. If this latter contention is so, then plaintiff's profits
from the Verbena-Wadley transfer are taxable under the provision of 1031(b) [FN2] as an
exchange not wholly in kind.

These profits are calculated as the decrease in mortgages payable by plaintiff ($13,000),
plus the difference between the sum of the fair market value of the Wadley property
($40,000) and the cash received by plaintiff ($17,000), and plaintiff's basis in the
Verbena property of $48,000, or a total difference of $9,000. The gain realized by
plaintiff is thus approximately $22,000 ($13,000 + $9,000), which when taxed at 50%,
results in the $10,740.67 in dispute here.

Both sides have cited and distinguished numerous cases attempting to show that the facts
in this case are or are not similar to those in some other case before some other court.
These cases have been carefully studied, and it would appear that regardless of the details
of the transactions involved (which inevitably vary from case to case), certain principles
have been relatively consistently applied.

It is clear, for instance, that it is legally irrelevant that the taxpayer- plaintiff intended to
devise a transaction which would bring him within the letter of the statute. Intent to avoid
a tax is not determinative of no liability, just as a lack of intent cannot operate to create a
liability if the taxpayer is otherwise entitled to favorable treatment. C.I.R. v. Duberstein,
363 U.S. 278, 286, 80 S.Ct. 1190, 4 L.Ed.2d 1218, 1225 (1960); Carlton v. United States,
385 F.2d 238 (5th Cir., 1966).

Equally irrelevant is plaintiff's contention that plaintiff signed the contracts to purchase
the Hollywood and Gordon properties as some sort of accommodation to Chennault, and
in accord with the agreement between plaintiff and Chennault executed on May 6, 1961.
That agreement did not require and at no time in the course of the transaction did
Chennault acquire any legal interest in either of the two properties in which the profits
realized by the plaintiff from the original two-party exchange were subsequently
invested. Chennault's only role in these transactions, even by the terms of the May 6
agreement, was to 'arrange to secure the conveyance to Halpern by warranty deed of the
parcels of (Gordon Road and Hollywood Road) property.' The agreement provided
further that the 'conveyances to Halpern of the parcels (Wadley, Gordon and Hollywood)
shall be in consideration of the conveyance to Chennault by Halpern of the (Verbena)
property. * * *' There is no evidence that Chennault 'arranged' the transfer of the Gordon
and Hollywood properties[FN3] or that these clauses are anything more than a
transparent self-serving attempt to create some apparent link between Chennault and the
properties Halpern intended to acquire.

wo more of plaintiff's remaining contentions are likewise of no great weight. It is


conceded by the Government that all of the real property involved in these transactions is
of 'like kind' as required by the statute. However, it is not enough that the property be of
'like kind', as required by 1031(a). There must be an exchange of like property. Similarly,
it is not controlling that the Government has treated part of the Verbena-Wadley
exchange as an exchange of like property within the ambit of 1031(b). The question is
whether the Hollywood and Gordon properties were exchanged, rather than merely
purchased by plaintiff. Only if plaintiff assumes the only point in question (whether the
transaction was a single or severable one) does the Government's treatment of the
Verbena-Wadley exchange have any significance.

Therefore, the sole question remaining is really whether the transfer of the Hollywood
and Gordon properties was an integral part of the Wadley-Verbena transfer or whether it
was in fact a reinvestment of the profits resulting from the Wadley-Verbena transfer.
Central to this question, in the court's view of the problem, is the fact that at no time in
either the planning or execution of the transaction did Chennault ever acquire even an
equitable title to the Hollywood or Gordon properties. Nor were the contracts with the
owners of the Hollywood and Gordon properties, which were separately negotiated by
the plaintiff, dependent in any way on the consummation of the transaction with
Chennault. The facts show that the transaction with Chennault was not at all dependent
on the Hollywood and Gordon transactions, although the agreement purports to make it
so. When the owner of the Gordon property discovered she could not deliver a warranty
deed on June 1, 1961, the transfer with Chennault was consummated regardless and the
Gordon property was finally transferred to Halpern in a completely separate title closing
on September 19, 1961. There is no indication that Chennault or the owner of the
Hollywood property made their part in the transaction contingent in any way upon
Halpern's being able to complete his deal with Mrs. Bartlett for the Gordon property. In
all the cases relied on by plaintiff in which a third party's property was received by the
plaintiff, the title to that property first passed through the second party who was the
primary exchange partner. See Coastal Terminals, Inc. v. United States, 320 F.2d 333
(4th Cir., 1963); Alderson v. Comm'r. of Internal Revenue, 317 F.2d 790 (9th Cir., 1963);
J. H. Baird Publishing Co. v. Comm'r., 39 T.C. 608 (1962). In effect, the exchange in
each of these cases was between two parties, one of whom had, in his own manner,
previously acquired property which was to be subsequently exchanged with that of the
taxpayer. Nor is plaintiff's situation comparable to the true three-party transaction
described in Rev.Rul. 57-244, in which the participation of each party is essential to the
contract and the failure of any one element of the exchange would cause the entire
contract to be unenforceable. Cf., W. D. Haden Co. v. Comm'r., 165 F.2d 588(2) (5th
Cir., 1948).[FN4] Rather than the triangular relationship envisioned in Rev.Rul. 57-244,
the present case is one in which the taxpayer is separately obligated to each of the other
two parties, who have no mutual obligations between themselves. Mere simultaneity of
execution cannot make separate contracts an indivisible whole, regardless of the naked
intention of one of the parties.

The fact that plaintiff never actually received in hand the cash resulting from the
exchange with Chennault is not critical. While the receipt of cash may require a
conclusion that a particular transaction is a sale (see Carlton v. United States, supra), the
failure to actually receive the cash does not automatically require a corollary finding that
a transaction is an exchange. In the present case, Lawyers Title Insurance Company was
clearly acting as a mere temporary depository of the surplus funds resulting from the
Verbena-Wadley exchange. On receipt of them, it was to pay to the owners of the Gordon
and Hollywood properties the amounts stipulated if Halpern approved the title he was to
receive. If he did not accept the title within six months, then the money could be used for
the purchase of such other property as Halpern directed. But if Halpern after six months
had called for the money to be paid to him in cash, it is difficult to see who would have
had the standing to object. Certainly Halpern received a constructive right to receipt of
the money when it was paid to Lawyers Title under these circumstances, and its failure to
actually come to rest in his hands need not detain us.

Much of the decision in Carlton v. United States, supra, seems directly applicable to the
present case. 'The requirement is that the transaction be viewed in its entirety in order to
determine its reality and substance, for it is the substance of the transaction which decides
the incidence of taxation. In the instant case, while elaborate plans were laid to exchange
property, the substance of the transaction was that the appellants received cash for the * *
* and not another parcel of land. * * * Further, General (read 'Chennault') was never in a
position to exchange properties with the appellants because it never acquired the legal
title to either the Lyons (read 'Hollywood') or the Fernandez (read 'Gordon') property. * *
* The money received from General by the appellants for the ranch (read 'Verbena')
property was not earmarked by General to be used in purchasing the Lyons or Fernandez
properties. It was unrestricted and could be used by the appellants as they pleased. The
fact that they did use it to pay for the Lyons and Fernandez properties does not alter the
fact that their use of the money was unfettered and unrestrained. It is an unescapable fact
that the money received by appellants from General was money paid to them for a
conveyance of their land. As a result, the separate transaction between General and the
appellants must be construed to be a sale, and the transactions between the appellants and
Lyons and Fernandez as a purchase of other property. * * * Considering how close the
appellants came to satisfying the requirements of that section (1031) and the stipulation
that an exchange was intended, this result is obviously harsh. But there is no equity in tax
law.' 385 F.2d 238 at 241-243.

Therefore, judgment is rendered for the defendant.

CHANGING THE FORMAT FROM SALE TO EXCHANGE:


LESLIE COUPE

The Leslie Coupe case, although favorable to the taxpayer, is a situation where
litigation could have been avoided if the taxpayers had structured the transaction properly
in the first place. Because they structured the transaction as a sale, then went back and
adjusted the transaction for an exchange, there seemed to be a problem of form and
substance. Since the parties clearly intended the sale in the first place, and merely
changed it to facilitate certain tax benefits, the government argued that this was improper.
However, the Court has held that the parties may modify their position under Coupe-type
circumstances: As long as the transaction has not taken place, the parties can amend their
position. (This is not always true in other areas of the Internal Revenue Code and with
other tax laws.) This position has been supported in numerous subsequent cases.
Nevertheless, it is worthwhile to be aware that a properly structured transaction may
avoid a future battle, even if that battle might result in success.
Someone must make the law, there is no doubt about that. The type of question that has
arisen in the Coupe case, that is, modifying a prior agreement to now allow for an
exchange, would have come in some setting. Prudent taxpayers would favor some other
individual being the pioneer in the area and making the law. It is best to structure the
transaction, at an inception, for an exchange, if that is what is desired. It is also important
to know that if parties did not anticipate an exchange when they initially signed the
contract, but subsequently realized the benefits of the same, or realized they could
restructure their positions to facilitate an exchange, there is strong authority supporting
the viability of this position.

LESLIE Q. COUPE AND MAYBELLE COUPE, PETITIONERS v.


COMMISSIONER OF INTERNAL REVENUE,RESPONDENT
52 T.C. 394 (1969)

FORRESTER, Judge:
Respondent has determined deficiencies in petitioners' Federal income taxes for the
calendar years 1960 and 1961 in the amounts of $16,807.34 and $47,453.81, respectively.

The issues for decision are:

Whether the taxpayers sold their entire farm for cash, or whether they exchanged part
of it for property of like kind. If there was an exchange, the amount of the unrecognized
gross sales price attributable to petitioners' exchange must be determined.

The amount which petitioners received for the sale of their residence located on the
farm.

Whether any amount of cash received in connection with the sale of the farm
represented interest income to petitioners.

Whether $5,000 and $6,000 amounts received by petitioners' attorneys during 1960 and
1961, respectively, in connection with the farm sale, represented income to petitioners
and, if so, whether such amounts also constituted deductible expenditures.

The correct allocation and deductibility of selling expenses which petitioners incurred
in the sale of their farm.

FINDINGS OF FACT

Some of the facts are stipulated and they are so found.

Petitioners Leslie Q. Coupe and Maybelle Coupe (hereinafter sometimes called the
Coupes or Leslie and Maybelle, respectively), husband and wife, resided in Galt, Calif.,
at the time the petition in the instant case was filed. Their joint Federal income tax returns
for the calendar years 1960 and 1961 were filed with the district director of internal
revenue at San Francisco, Calif.
Leslie and Maybelle are farmers. In 1945 they purchased 188.943 acres of farmland
near Elk Grove, Calif. (hereinafter sometimes called the Elk Grove property). During all
pertinent times the land was farmed continuously and primarily held for the purpose of
farming.

In 1958 and 1959 Leslie and Maybelle received two unsolicited offers from a neighbor
to buy the Elk Grove property for first $250 per acre and then $800 per acre. They
refused both offers. On March 12, 1960, the Coupes granted an option to Malcolm K.
Grant (hereinafter sometimes referred to as Grant), a real estate broker, to purchase the
farm for $2,250 per acre. This option eventually led to a contract between the Coupes and
Southern Pacific Co. (hereinafter sometimes referred to as S.P.), which called for the
Coupes to sell the Elk Grove property for $2,500 per acre. The relevant provisions of this
agreement are produced below:

THIS AGREEMENT, made this 1st day of June, 1960, by and between LESLIE
QUENTIN COUPE and MAYBELLE COUPE, husband and wife, Sellers, and
SOUTHERN PACIFIC COMPANY, a corporation, Buyer; WITNESSETH: Sellers
hereby agree to sell and Buyer agrees to buy, subject to terms hereof, that real property
situate, lying and being in the County of Sacramento, State of California, described as
follows: . . .

1. Sellers, at their expense, will cause said property to be surveyed


by a registered civil engineer who shall furnish a mutually
satisfactory and simplified metes and bounds description of the
property, and who shall determine the number of acres in said
property. The metes and bounds description shall replace the
above description for all purposes hereunder.
2. Purchase price of the land or any part or parcel thereof shall be
Two Thousand, Five Hundred (2,500) Dollars per acre acreage to
be determined by the aforementioned survey.
3. Buyer shall acquire title to, and Sellers shall convey said
property in parcels, as follows:
(a) Upon execution of this agreement, Buyer shall deposit the
sum of Twenty-five Thousand (25,000) Dollars in escrow;
Sellers shall as soon as practicable convey to Buyer a
portion or parcel with area equal to twenty-nine (29) percent
of the total area of said land, the location of said portion to
be mutually agreed by the parties. At the time of such
conveyance Buyer will pay the balance of the purchase price
of said twenty-nine (29) percent portion over and above the
initial payment of Twenty-Five Thousand (25,000) Dollars,
and this first escrow shall close. It is understood the portions
herein referred to are not undivided interests in the whole of
said land, but rather parcels within said land.
(b) Buyer shall acquire at least twenty-five (25) percent of the
remainder of the area of said land in each of the four (4)
years following the conveyance set forth in (a) above,
paying therefor at the rate herein specified, provided, that
Buyer may accelerate acquisition in any manner it desires
after one (1) year from the conveyance set forth in (a), and
provided further that payment may be made by an exchange
transaction as hereafter described.
4. Buyer shall pay interest at the rate of six (6) percent per annum
on unpaid portions of the total purchase price for all the land.
5. Buyer shall have the right to pay for any acquisition covered in
3(b) hereof by a conveyance of property, hereafter called
'exchange property' of value equal to or less than the price of the
parcel being acquired. If the value of such exchange property is
less than the price of the parcel acquired, Buyer shall pay the
difference in cash. It is understood, however, Buyer shall pay by
means of exchange property only if at the time of such
transaction a purchaser stands ready, willing and able to buy such
exchange property from Sellers. The value of the exchange
property to Sellers shall be measured by the price offered by such
purchaser.
6. After execution of this agreement Sellers shall remain in
possession of all of the property without rental or other payment
to Buyer for a period of one hundred eighty (180) days.
Thereafter Buyer shall have possession of all of the property
without rental or other payment to Sellers, and together with all
rights incident thereto, including the right to lease, to receive
rental, and to conduct operations of every sort.
7. Sellers shall make all conveyances hereunder by good and
sufficient grant deed, free and clear of all encumbrances except
easements of record.
8. Sellers shall provide and pay for policy or policies of title
insurance for Buyer. Sellers shall pay for all revenue stamps and
any broker's or other commissions due on this transaction.
Current taxes shall be pro-rated as of the date first herein written.
Buyer shall pay all recording fees. Other expenses shall be in
accordance with usual practice in Sacramento County,
California.
9. This agreement shall inure to the benefit of and be binding upon
the successors and assigns of the Sellers and the assigns of
Buyer.

IN WITNESS WHEREOF, Sellers and Buyers have executed these presents the day and
year first herein written.

(S) LESLIE QUENTIN COUPE


(S) MAYBELLE COUPE SOUTHERN PACIFIC COMPANY.
By (Illegible), Vice President
Attest:(Illegible) Assistant Secretary

In a separate agreement, the COUPES agreed to pay Grant a commission of 10 percent


of the sales price, payable one-half at the close of the first escrow under paragraph 3(a),
and the balance at the close of the escrow under paragraph 3(b).

After signing the above agreement, the Coupes went over its provisions and noticed
that while paragraph 3 called for a series of conveyances for cash, paragraph 5 provided
for the possibility of an exchange of properties rather than a cash payment by S.P. for all
conveyances after the first one. Since the Coupes wished to continue to farm after they
had disposed of the Elk Grove property, they contacted Edwin B. Polhemus (hereinafter
sometimes referred to as Polhemus), an attorney, with regard to arranging an exchange
whereby they could receive farm property for the Elk Grove property. Prior to contacting
Polhemus, the Coupes had not been represented by counsel.

Polhemus advised the Coupes that it would be possible for them to delay paying a
capital gains tax on the sale of the Elk Grove property if they exchanged it for property of
like kind. After reviewing the above agreement he informed the Coupes that he thought it
would be possible to have S.P. acquire properties which it would then use for an
exchange under paragraph 5. This type of arrangement was agreeable to the Coupes and
they authorized Polhemus to see if he could find suitable properties and arrange the
exchange. Shortly thereafter Polhemus was joined by another attorney, John L. Brannely
(hereinafter sometimes referred to as Brannely), for the purpose of arranging and
transacting the exchanges.

Polhemus attempted to persuade S.P. to modify the sales agreements' terms to provide
for S.P.'S purchase of suitable exchange properties, and during the same period of time he
made arrangements for the purchase of two parcels of farmland which the Coupes had
chosen for the exchanges.

On July 7, 1960, Polhemus and Brannely, acting as 'trustees and agents for an
undisclosed principal,' obtained an option on a farm owned by Paul and Jessie
McEnerney (hereinafter referred to as the McEnerney property). The option called for a
cash downpayment of $19,800 on a total purchase price of $66,000. The remaining
$46,200 was to be secured by a note and deed of trust on the McEnerney property. At the
time Polhemus and Brannely executed the agreement, they intended that the undisclosed
principal would be S.P. and not the Coupes.

On July 15, Brannely made an offer to Polhemus to purchase farmland from the Estate
of Elizabeth Sala, deceased (hereinafter referred to as the Sala property), for $55,000.
The offer was made to Polhemus, as he was administrator of the estate, and was accepted
by him subject to court approval. Polhemus had recommended the property to the
Coupes, but informed them that, under the provisions of the California law, he as
administrator could exchange it only for cash. A sale of the property to Brannely for cash
and Brannely's sale of the property to S.P. for exchange of the property with the Coupes
was thus agreed upon as the most practical course to pursue. Though Brannely agreed to
purchase the property for purposes of the exchange, he was not acting as agent for the
Coupes in the purchase and was willing to retain the property if an exchange with the
Coupes or sale to S.P. did not materialize.

Polhemus attempted but failed to have S.P. agree to take title in its name to either the
McEnerney or Sala property for purposes of exchanging property for the Elk Grove
property, however, he was able to persuade S.P. to allow the Coupes to exchange an Elk
Grove parcel of land for the McEnerney and Sala properties with third parties and then
have S.P. purchase the Elk Grove parcels from those third parties.

Under the June 1 sales agreement between S.P. and the Coupes, supra, the Elk Grove
property was to be conveyed in a series of transactions. Under paragraph 3(a), 29 percent
of the Elk Grove property was to be transferred to S.P. for cash as soon as practicable and
the balance a minimum of 1 year thereafter. Pursuant to the provisions of that agreement,
on August 2, 1960, S.P. placed $111,982.50 in escrow with the Alameda County-East
Bay Title Co. (hereinafter referred to as East Bay), which amount added to a prior
$25,000 deposit called for by the agreement totaled $136,982.50 in full satisfaction of
S.P.'S obligation under paragraph 3(a). The escrow instructions were in accord with the
June 1 agreement, with the exception that the instructions provided that the escrow
amount was to be paid to the Elk Grove owners of record rather than to the Coupes. That
paragraph reads as follows:

We have been informed that the Coupes desire to convey the property described in Item
#3 in exchange for other property they desire and that this party or parties will convey to
Alameda County-East Bay Title Company. Therefore, you are instructed to cause the
total sum of $136,982.50, which includes the $25,000 now on deposit with Western Title
Guaranty Company, to be paid to owners of record when property outlined in Item #3
above is conveyed to Alameda County-East Bay Title Company for account of Southern
Pacific Company under usual form of holding agreement and Western Title Guaranty
Company is prepared to issue its standard form of policy of title insurance in amount
$136,982.50 showing title vested in Alameda County-East Bay Title Company, free and
clear of all encumbrances except easements of record and taxes for fiscal year 1960-61 a
lien not yet due and payable.

Between August 2 and 8, 1960, escrows were established with instructions furnished to
the Western Title Guaranty Co. by S.P. or East Bay, the Coupes, the McEnerneys, and
John Brannely, which resulted in * * * * grant deeds being recorded simultaneously on
August 9, 1960, and escrows as of that date: * * * *

On December 28, 1960, S.P. instructed the East Bay Title Co. that it was completing
the Elk Grove property purchase and that, inter alia, East Bay was to pay $335,375 plus
interest of $7,657.73 in accordance with the terms of the June 1, 1960, agreement. As in
the instructions for the transfer of the 29-percent interest, reference was made to the
owners of record of the Elk Grove property rather than to the Coupes for purposes of title
transfer and payment of expenses. The instructions specified that the transaction was to
be completed on or before January 3, 1961.

Though the June 1 agreement provided that the final purchase of the Elk Grove
property was not to occur until 1 year from the completion of the first escrow, the Coupes
were amenable to an early completion of the agreement. In the meantime two other
parcels of farmland had been found which petitioners wished to obtain. For convenience
these properties will be referred to as the Schauer and the Bettencourt property,
respectively. In an attempt to further reduce the Coupes' currently taxable capital gain,
Polhemus also felt that an exchange of Elk Grove property for the $46,200 deed of trust
note on the McEnerney property plus the interest thereon would qualify for
nonrecognition treatment. In addition he decided that if the Coupes sold the 1.936 acres,
which constituted their residence, separately for $20,000, rather than for the $2,500 per
acre called for by the June 1 agreement, they would be able to further postpone part of
this gain under section 1034 of the Code,[FN1] which provides for nonrecognition of
gain on the sale of a residence to the extent that it is replaced by a residence of equal or
greater value within 1 year of the date of sale.

In order to accomplish the above objectives, prior to any transactions involving the
proposed 1961 transactions, the Coupes agreed with Polhemus and Brannely that the
latter would no longer be the Coupes' attorneys. Any services performed by them for the
Coupes' benefit would be merely as an accommodation. Instead of attorneys' fees being
paid to them, it was intended that the attorneys realize a $6,000 profit in regards to the
proposed exchanges. In fact, however, in the following transactions and negotiations,
Polhemus prepared a number of escrow instructions for the Coupes and at times
represented himself to others as the Coupes' attorney. * * * *

On November 1, 1960, the Coupes moved their household goods to their new residence
on the McEnerney property. Their livestock stayed on the Elk Grove property until early
in 1961. At the date of trial the Coupes continued to live on the McEnerney property and
raise beef cattle and hay. They also continued to own the other properties received in the
1960 and 1961 transactions. The Sala property was leased to a dairy for $2,400 per year
and used in connection with the dairy business; the Bettencourt property was
sharecropped for one-third of the seed produced; and the Schauer property was leased for
$3,600 a year and used to grow crops.

OPINION

On June 1, 1960, petitioners entered into an agreement with Southern Pacific Co. (S.P.)
to sell S.P. their 188.943-acre farm (Elk Grove property) for $2,500 per acre, plus
interest. S.P. made an initial $25,000 deposit. Thereafter in two separate escrow
transactions (terminating on August 9, 1960, and January 10, 1961, respectively), S.P.
paid in the amounts of $111,982.50 and $343,032.73, respectively, with the instruction
that such amounts were paid to the title holders of the Elk Grove property. The latter
amount included $7,657.73 in interest, S.P. thereafter received Elk Grove parcels of
54.793 acres and 134.150 acres in 1960 and 1961, respectively.
Rather than simply transferring title in the Elk Grove property to S.P. and receiving
cash, however, petitioners arranged to have it transferred to S.P. after they had entered
into certain exchanges for said property, simultaneously with the closing of the two
escrows with S.P. After the exchanges were completed they had received title to four
parcels of property, called the McEnerney, Sala, Schauer, and Bettencourt properties,
respectively. In addition they received cash and a note secured by a deed of trust on the
McEnerney property.

On their Federal income tax return for the years 1960 and 1961, petitioners reported
their transfers of the Elk Grove property, in part, as tax-free exchanges of property for
property of like kind under section 1031[FN4] of the Code, in part as a partially tax-free
sale of their residence for $20,000, and its replacement by another residence costing
$18,000, under section 1034[FN5] of the Code, and the balance as a currently taxable
sale of property to S.P., upon which they reported their gain as shown in the Findings of
Fact. Petitioners are now also contending that their transfer of part of the Elk Grove a
property for the McEnerney deed-of-trust note also constituted a tax- free exchange under
section 1031. In his statutory notice of deficiency, respondent determined the amount of
petitioners' capital gains arising from the two transactions and, with the exception of the
transfer of 1.936 Elk Grove acres for the McEnerney residence, further determined that
the gains constituted currently taxable income to petitioners in 1960 and 1961. Assigning
a sales price of $4,840 for the Elk Grove residence (1.936 acres at $2,500 per acre),
respondent determined that petitioners' capital gain from its sale qualified for
nonrecognition treatment under section 1034 of the Code, as petitioners had replaced
their residence with one of an equal or greater cost than the $4,840 sales price.
Respondent also determined that petitioners received $7,657.73 in interest income in
1961.

In his statutory notice, respondent allowed certain selling expenses to be deducted from
the sales price received by petitioner on the determined taxable transactions. In so doing
he disallowed certain expenses and reallocated others which petitioner had deducted from
the gross sales price of the various parcels in determining their gain.

DIRECT DEEDING/POT THEORY:


PRIVATE LETTER RULING 8008113

The following Letter Ruling reflects support for direct deeding to avoid transfer taxes.
However, because taxpayers reading this Private Letter Ruling cannot rely on it,
taxpayers should avoid direct deeding, where possible. Nevertheless, it may show the
government's flexibility in this area. (But, see the Brauer case, in this Chapter, as to the
government's resistance to this position.) However, now see Rev. Rul. 90-34, allowing
direct deeding in some cases.

PRIVATE LETTER RULING 8008113

This is in reply to a letter dated March 30, 1979, written on your behalf by your
authorized representatives, in which rulings are requested that A's exchange of
improvements on land in exchange for other real property qualify for nonrecognition
treatment under section 1031 of the Internal Revenue Code of 1954 and that the rents
from the groundlease qualify as rents under section 856(d) of the Code.

The information submitted indicates that A is a real estate investment trust (REIT) that
owns land and improvements of a shopping center. This shopping center has been
operated on behalf of A by an independent contractor.

A (the Assignor) wishes to transfer its interest in the improvements of the shopping
center to B (the buyer). At the present time, B has no properties to exchange. A will
identify properties (the 'Exchange Properties') that it chooses to receive in exchange for
the improvements. B will thereafter acquire these properties from C (the corollary party
or parties). Under the contemplated agreements, B will buy the Exchange Properties from
C. C will be instructed to convey the Exchange Properties to A. It is represented that
these agreements will not be specifically enforceable against A by C.

As part of the exchange, A will repay in full any mortgage indebtedness to which the
improvements of the shopping center are subject. B intends to finance its purchase of the
Exchange Properties by borrowing funds from an unrelated third party. This indebtedness
will be secured by B's interest in the improvements of the shopping center after B
acquires these improvements.

In order to avoid the state transfer taxes that would occur upon a transfer of the
Exchange Properties from C to B and then from B to A, the proposed transaction
provides for a single transfer of the deed from C to A.

If A is unable to identify Exchange Properties with a high enough exchange value, B


will have the right to acquire the shopping center in part with whatever Exchange
Properties have been identified and the balance in cash.

It is further proposed that A would lease the land underlying the improvements of the
shopping center to B for a term of 35 years. The rent under this groundlease would equal
10 percent of the fair market value of the land as of the date of closing plus all the real
property taxes assessed against the land plus all maintenance and insurance charges
attributable to the land. The fixed rental portion would increase to 12 1/2 percent of the
value of the land at the end of the second year and, commencing in the sixth year of the
groundlease, would increase to 15 percent of such value.

Section 1031(a) of the Code provides that no gain or loss shall be recognized if
property held for productive use in trade or business or for investment (excluding certain
enumerated property) is exchanged solely for property of like kind to be held either for
productive use in trade or business or for investment.

In order to qualify for section 1031 nonrecognition, three elements must be present: (1)
the property transferred by the taxpayer must have been held by him either for productive
use in a trade or business or for investment; (2) the property received by the taxpayer
must be held by him either for productive use in a trade or business or for investment, and
(3) the properties transferred and received must be of like kind.

Section 1.1031(a)--1(b) of the Income Tax Regulations states 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.

Rev. Rul. 55--749, 1955--2 C.B. 295, holds that where rights, under applicable state
law, are considered real property rights, the exchange of such rights for a fee interest in
land constitutes a nontaxable exchange under section 1031 of the Code.

In the instant case, improvements that are affixed to land are real property under the
applicable state law. Therefore the improvements of the shopping center which are
exchanged for a fee simple interest in the Exchange Properties satisfy the 'like kind'
requirements of section 1031 of the Code.

It is represented that A has held the shopping center, including improvements, for over
five years as investment property and that A intends to hold the Exchange Properties for
investment after the exchange.

The fact that C, at the direction of B, transfers the Exchange Properties directly to A,
rather than deeding these properties first to B and then to A, has no effect on the
qualification of the exchange under section 1031 of the Code. See Haden v.
Commissioner, 165 F.2d 588, 590 (5th Cir. 1948).

Accordingly, we conclude that A is entitled to the nonrecognition treatment under


section 1031 of the Code with respect to the exchange of the shopping center
improvements for the Exchange Properties.

Section 1031(b) of the Code provides that when an exchange consists of like kind
property and other property, any gain from the transaction shall be recognized in an
amount not to exceed the fair market value of the other property.

Accordingly, if the fair market value of the Exchange Properties is less than the fair
market value of the shopping center improvements and B pays A in cash to make up the
difference, A will recognize gain only to the extent of this cash payment.

Section 1.1031(d)--2 of the regulations provides that the amount of any liabilities of the
taxpayer assumed by the other party to the exchange is to be treated as money received
by the taxpayer upon the exchange.

In the instant case A will repay in full any liabilities it has with respect to the shopping
center improvements.
Accordingly, since A will not be relieved of any liabilities on the improvements, A will
not be deemed to have received money for these liabilities as prescribed by section
1.1031(d)--2 of the regulations.

DIRECT DEEDING REVENUE RULING 90-34

This Ruling supports the position that direct deeding can take place. However, proper
structure is, nevertheless necessary. See also Appendix 1, Proposed Treasury Reg.
§1.1031(a)-(3), Example 4, where direct deeding was not allowed in a different fact
setting. However, the Proposed Regulations were changed under the Final Regulations,
which Regulations allow direct deeding in some instances.

REVENUE RULING 90-34


Publication Date: April 16, 1990

ISSUE

If X transfers property to Y in exchange for property of a like kind, may the exchange
as to X qualify for nonrecognition of gain or loss under section 1031 of the Internal
Revenue Code even though legal title to the property received by X is never held by Y?

FACTS

X and Y are unrelated persons. X files its U.S. income tax return on a calendar year
basis. On May 14, 1989, X and Y enter into a contract that requires X to transfer
Blackacre to Y and Y to transfer to X property of a like kind with the same fair market
value. Blackacre, unencumbered real property, has been held by X for productive use in
its trade or business and has a fair market value of $1,000,000. Under the contract, X is
required to locate and identify property with a fair market value of $1,000,000 that is of a
like kind to Blackacre within 45 days of X's transfer of Blackacre to Y (the 'identification
period'), and Y is required to purchase and transfer the identified property to X before the
earlier of 180 days from the transfer of Blackacre or the due date (including extensions)
for X's U.S. income tax return for the taxable year in which X's transfer of Blackacre to Y
occurs (the 'exchange period'). If X fails to identify the property to be received in the
transaction before the end of the identification period or Y fails to purchase and transfer
such property to X before the end of the exchange period, Y is required to pay
$1,000,000 to X. Neither X nor Y contracts to exchange Blackacre with any other party.

On May 23, 1989, X transfers Blackacre to Y. On June 1, 1989, X properly identifies


Whiteacre as the property to be received. Whiteacre, owned by Z, a person unrelated to
X, is unencumbered real property that has a fair market value old $1,000,000 and is of a
like kind to Blackacre. On July 10, 1989, Y purchases Whiteacre from Z, to X before the
end of the exchange period. X, thereafter, holds Whiteacre for productive use in its trade
or business.

LAW AND ANALYSIS


Under section 1031(a)(1) of the Code, no gain or loss is 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 that is to be held either for productive use in
a trade or business or for investment.

Section 1031(a)(3) of the Code provides that any property received by a taxpayer will
be treated as property which is not like-kind property if (A) such property is not
identified as property[to be rec after the date on which the taxpayer transfers the property
relinquished in the exchange, or (B) such property is received after the earlier of (i) the
day which is 180 days after the date on which the taxpayer transfers the property
relinquished in the exchange, or (ii) the due date (including extensions) for the taxpayer's
federal income tax return for the taxable year in which the transfer of the relinquished
property occurs.

If Z had actually transferred legal title to Whiteacre to Y and Y had then transferred
legal title to Whiteacre to X, the exchange of Whiteacre for Blackacre, as to X, would
clearly qualify for nonrecognition of gain or loss under section 1031(a) of the Code.
However, section 1031(a) does not require that Y hold legal title to Whiteacre, but merely
that X receive solely property of a like kind to the property transferred in order for the
exchange to qualify for nonrecognition of gain or loss. Therefore, the failure of Y to
acquire legal title to Whiteacre does not disqualify X from nonrecognition of gain or loss
under section 1031(a) on the transfer of Blackacre to Y in exchange for Whiteacre.

HOLDING

X's transfer of property to Y, in exchange for property of a like kind, qualifies as to X


for nonrecognition of gain or loss on the exchange under sectIon 1031 of the Code even
though legal title to the property received by X is never held by Y.

DRAFTING INFORMATION

The principal author of this revenue ruling is D. Lindsay Russell of the Office of
Assistant Chief Counsel (Income Tax and Accounting). For further information regarding
this revenue ruling, contact Mr. Russell on (202) 343-2381 (not a toll-free call).

Although direct deeding was allowed herein, see this same issue as to Example #4 in
Proposed Treas. Regs. §1.1031(a)-(3), Appendix 1.

BIGGS

The Biggs case (1978), since affirmed on appeal, has a unique fact setting which is
almost the worst imaginable position for a taxpayer to create and still desire and qualify
under Section 1031.

The taxpayer, Biggs, maintained his residence in Florida. He owned parcels of land in
Maryland. Some time before October, 1968, the Maryland property was listed for sale
with the REALTOR, who had a client, Powell, who was interested in acquiring the
property.

Biggs and Powell met and entered a contract for the sale. Although apparently the
parties had discussed an exchange, the contract memorandum never mentioned an
exchange.

Biggs then talked with his attorney, Porter. Porter warned the parties, especially Mr.
Powell, that the memorandum did not meet the intent desired for an exchange. After this
conversation, Biggs looked for a suitable property for the exchange. Acceptable property
was found in Virginia.

Mr. Biggs drew contracts to enter into the purchase of the Virginia property. Once
again, Porter advised the parties that they should be drawn to indicate that there was an
exchange, and in fact Biggs was really acting as an agent for a syndication.

Powell was either unable or unwilling to take title to the Virginia property to facilitate a
three-way exchange. Therefore, Biggs arranged to have his title transferred to the Shore
Title Co., Inc., a Maryland corporation controlled by Porter and his family. However, it
was not until December 26, 1978, that the Board of Directors at the Shore Title Co., Inc.,
authorized it to take title to the Virginia property.

Although the Court found that the parties clearly intended and agreed that there would
be an exchange of properties, the structure was not well received.

The Court said:

The starting point of our analysis is the well-established principle that the substance of
a transaction, rather than the form of which it is cast, ordinarily determines its tax
consequences.

..

The Court mentioned the very involved set of facts and then stated:

At the outset, it is clear that the parties intended and agreed that there would be an
exchange of properties. From the beginning of the negotiations between the petitioner
and Mr. Powell, the petitioner insisted that as part of the considerations for the transfer of
his Maryland property, he receive a like-kind property in exchange. . . Mr. Powell orally
agreed to an exchange of properties, and Mr. Porter, after confirming that such an
agreement in fact existed, advised the petitioner that he would begin looking for suitable
property to be received in exchange. The petitioner located the Virginia property and
negotiated for the sale of such property. For reasons not disclosed in the record, Mr.
Powell, at that time, was either unable or unwilling to enter into the contract to purchase
the Virginia property or to take title to it. Accordingly, the petitioner made the contract of
sale to him acting as agent for the syndicate and thereafter arranged to have the title
transferred to Shore . . .

Mr. Powell subsequently contracted to purchase the Virginia property from Shore. The
February 27, 1969 contract of sale between the petitioner and Mr. Powell was a written
formalization of their prior agreement to exchange properties: The petitioner agreed to
convey his Maryland property to Mr. Powell, and as part of the consideration for the
Maryland property, Mr. Powell assigned his right to purchase the Virginia property to the
petitioner. The exchange agreement was consummated at the May 26, 1969, closing, at
which time the petitioner conveyed title to the Maryland property to Mr. Powell's
assignees, and received title to the Virginia property.

Although it was not the best format, the Court said that after considering all of the
evidence involved, a Code §1031 transaction had occurred

FRANKLIN B. BIGGS, PETITIONER


v.
COMMISSIONER of INTERNAL REVENUE, RESPONDENT
69 T.C. 905 (1978)

SIMPSON, Judge:
The Commissioner determined a deficiency of $5,261.42 in the petitioner's Federal
income tax for 1969. The sole issue remaining for decision is whether the petitioner's
transfer of real property situated in Maryland and receipt of real property situated in
Virginia constituted an exchange within the meaning of section 1031 of the Internal
Revenue Code of 1954. [FN1]

FINDINGS OF FACT

Some of the facts have been stipulated, and those facts are so found.

The petitioner, Franklin B. Biggs, maintained his legal residence in Florida at the time
he filed his petition in this case. He filed his Federal income tax return for 1969 with the
District Director of Internal Revenue, Wilmington, Del.

On, and for some years before, October 23, 1968, the petitioner owned in fee simple
two parcels of land located in St. Martin's Neck, Worcester County, Md. (the Maryland
property). Sometime before October 23, 1968, the Maryland property was listed for sale
with a realtor. The realtor informed Mr. Biggs that he had a client, Shepard G. Powell,
who was interested in acquiring the property.

On October 23, 1968, Mr. Biggs and Mr. Powell met and discussed the possible
acquisition of the Maryland property by Mr. Powell. At the outset of the discussion, Mr.
Biggs informed Mr. Powell that as part of the consideration for the transfer of the
Maryland property to Mr. Powell or his assigns, Mr. Biggs insisted that he receive real
property of like kind. It was understood that Mr. Biggs would locate the property to be
received in exchange, and Mr. Powell agreed to cooperate in the arrangements for an
exchange, as long as it was not harmful to him.

On October 25, 1968, Mr. Biggs [FN2] and Mr. Powell executed a written
memorandum of intent with respect to the sale of the Maryland property to Mr. Powell.
Such memorandum provided in relevant part:

MEMORANDUM OF INTENT
I. PURCHASE PRICE: $900,000 NET to SELLERS. . .
c. $25,000.00 down payment at signing of contract, * * *
d. $75,000.00 additional payment at time of settlement, which
shall be within ninety (90) days after contract signing,
making total cash payments of $100,000.00.
II. MORTGAGE:
a. Balance of $800,000.00 secured by a first mortgage on Real
Estate to SELLERS at a 4% interest rate; 10 year term. . . .

The memorandum of intent contained no reference to any proposed exchange of


properties.

Sometime between October 20 and October 24, 1968, Mr. Biggs consulted his attorney,
W. Edgar Porter, concerning the proposed transfer of the Maryland property to Mr.
Powell. Subsequently, Mr. Porter reviewed the memorandum of intent which had been
executed by the parties; he advised Mr. Biggs that such memorandum was not in
accordance with the proposed transaction as it had been described by Mr. Biggs, in that
there was no reference to a proposed exchange of properties. Mr. Porter also advised Mr.
Powell by telephone that the memorandum of intent did not comport with Mr. Porter's
understanding of the proposed transaction. Mr. Powell agreed to have his attorney work
out the terms of a written exchange agreement with Mr. Porter.

After his conversation with Mr. Powell, Mr. Porter advised Mr. Biggs that he could
begin looking for suitable property to be received in exchange for the Maryland property.
To this end, Mr. Biggs advised John Thatcher, a Maryland realtor, of his desire to locate
real property which was of substantial value and which was similar in nature to the
Maryland property. Subsequently, Mr. Biggs was contacted by John H. Davis, a real
estate broker, who had in his inventory four parcels of land situated in Accomack County,
Va., collectively known as Myrtle Grove Farm (the Virginia property), which appeared to
satisfy Mr. Biggs' specifications. After viewing the Virginia property, Mr. Biggs
instructed Mr. Davis to draft contracts of sale.

Mr. Porter reviewed the proposed contracts prior to their execution and advised Mr.
Davis that they should be drawn so as to indicate that Mr. Biggs was acting as an agent
for a syndicate; before their execution by Mr. Biggs, the contracts were modified to
describe the purchaser as "Franklin B. Biggs, (acting as agent for syndicate)." On October
29 and 30, 1968, the four land sales contracts were executed; the terms of such contracts
were as follows:

Paid on execution of contract $13,900.00


Balance due at settlement 115,655.14
Indebtedness created or
142,544.86
assumed
Total - gross sales price: $272,100.00

At the time such contracts were signed, Mr. Biggs paid $13,900 to the sellers of the
Virginia property

Mr. Powell was either unable or unwilling to take title to the Virginia property. Mr.
Biggs therefore arranged to have title transferred to Shore Title Co., Inc. (Shore), a
Maryland corporation owned and controlled by Mr. Porter and his family. However, it
was not until December 26, 1968, that the board of directors of Shore authorized it to take
title to the Virginia property.

On January 9, 1969, prior to the transfer of the Virginia property to Shore, Mr. Biggs
and Shore executed an agreement with respect to the Virginia property, which provided
in relevant part:

1. At any time hereafter that either party hereto requests the other
party to do so, Shore Title Co., Inc. will and hereby agrees to
convey unto the said Franklin B. Biggs, or his nominee, all of the
above mentioned property, for exactly the same price said Shore
Title Co., Inc. has paid for it, plus any and all costs, expenses,
advances or payments which Shore Title Co., Inc. has paid or
will be bound in the future to pay, over and above said purchase
price to Shore Title Co., Inc., in order for Shore Title Co., Inc. to
acquire or hold title to said property; and it (is) further agreed
that at that time, i.e.--- when Shore Title Co., Inc. conveys said
property under this paragraph and its provisions, the said
Franklin B. Biggs., or his nominee will simultaneously release or
cause Shore Title Co., Inc. to be released from any and all
obligations which the latter has created, assumed or become
bound upon in its acquisition and holding of title to said
property.
2. All costs for acquiring or holding title to said property by both
the said Shore Title Co., Inc. and Franklin B. Biggs, or his
nominee shall be paid by the said Franklin B. Biggs, or his
nominee at the time of transfer of title under paragraph numbered
1 hereof.
On or about January 9, 1969, the contracts for the sale of the Virginia property were
closed; pursuant to a direction by Mr. Biggs, the sellers delivered warranty deeds
evidencing legal title to the property to Shore. The $115,655.14 balance due at settlement
was advanced to Shore by Mr. Biggs; by a bond secured by a deed of trust on the
property, Shore agreed to repay the same amount to Mr. Biggs. Shore also assumed
liabilities of $142,544.86 which were secured by deeds of trust in favor of the sellers and
another mortgagee. On January 13, 1969, Mr. Biggs paid a finder's fee of $3,026 to Mr.
Thatcher; Mr. Biggs also paid all of the closing costs incident to Shore's acquisition of
the Virginia property.

On February 26, 1969, Shore, as vendor, entered into an agreement of sale with Mr.
Powell or his assigns, vendee, for the sale and purchase of the Virginia property. The
agreement provided for the payment of the purchase price as follows:

Upon execution of the agreement $100.00


Vendee assumed and covenanted to pay the following
promissory notes, all secured by deeds of trust on the
Virginia property:
To Shore Savings & Loan 58,469.86
Association
To those from whom Shore acquired 84,075.00
the Virginia property
To Franklin Biggs 115,655.14
Balance due at settlement 13,900.00
Total purchase price: $272,200.00

On February 27, 1969, Mr. Biggs, as seller, and Mr. Powell or assigns, as purchaser,
entered into a contract of sale for the Maryland property. The terms of such contract were
as follows:

Cash, upon execution $ 25,000.00


Cash, at settlement 75,000.00
First mortgage note receivable from Mr.
Powell 800,000.00
Total: $900,000.00

Such contract further provided:

Sellers and Purchaser acknowledge the existence of a Contract of Sale dated February
26th, 1969, between Shore Title Co., Inc., Vendor-Seller, and Shepard G. Powell or
Assigns, Vendee-Purchaser, copy of which is attached hereto and made a part hereof,
whereby that Vendor has contracted to sell and that Vendee has agreed to buy from that
Vendor at and for the purchase price of Two Hundred Seventy Two Thousand Two
Hundred Dollars ($272,200.00) * * * (the Virginia property). As a further consideration
for the making of this Contract of Sale * * * for the sale and purchase * * * of * * * (the
Maryland property) the said Shepard G. Powell or Assigns, for the sum of One Hundred
Dollars ($100.00) in cash, in hand paid, receipt whereof is hereby acknowledged, does
hereby bargain, sell, set over and transfer unto said Franklin B. Biggs all of the right, title
and interest of the said Shepard G. Powell or Assigns in and to said Virginia property and
said Contract of Sale relating thereto, upon condition that the said Franklin B. Biggs
assumes and covenants to pay (which he hereby does) all of the obligations assumed by
the said Shepard G. Powell under the aforesaid Contract of Sale between him and Shore
Title Co., Inc.; and said Franklin B. Biggs hereby agrees to hold Shepard G. Powell or
Assigns harmless from any liability under any and all of said obligations on said Virginia
property, and the said Shepard G. Powell and said Franklin B. Biggs do hereby jointly
and separately agree to execute and deliver any and all necessary papers to effect delivery
of title to said Virginia property to said Franklin B. Biggs and to relieve said Shepard G.
Powell from any and all obligations assumed by him thereon. (Emphasis supplied.)

Also on February 27, 1969, Mr. Powell and his wife assigned their contractual right to
acquire the Maryland property to Samuel Lessans and Maurice Lessans. By an agreement
of sale and assignment, dated May 22, 1969, the Lessans [FN3] sold and assigned their
rights to acquire the Maryland property to Ocean View Corp. (Ocean View), a Maryland
corporation, for $1,300,000. Of the total purchase price, $150,000 was to be paid into
escrow at the time such contract was signed; an $800,000 note (executed by Ocean View
in favor of Mr. Biggs) was to be given to Mr. Biggs at settlement; a $250,000 note
(executed by Ocean View in favor of the Lessans) was to be given to the Lessans at
settlement; and a $100,000 note (executed by Ocean View in favor of the realtors) was to
be given to the realtors at settlement.

Ocean View was incorporated on May 21, 1969. At the first meeting of the board of
directors, held May 22, 1969, the directors authorized the corporation to execute all
documents necessary to consummate the contract of sale assigned by the Lessans to
Ocean View. The minutes of such first meeting reveal that it was:

FURTHER RESOLVED:
That the proper officers of this Corporation are hereby authorized and empowered to
quit claim any of the Corporation's interest in the tract of land located in the State of
Virginia referred to in the said contract of sale;

However, neither the Lessans nor Ocean View had any option, contract, or obligation to
purchase the Virginia property, or any other interest in such property.

On May 24, 1969, Shore executed a deed conveying all its right, title, and interest in the
Virginia property to Mr. Biggs as grantee. Mr. Powell and his wife, the Lessans, and
Ocean View joined in executing the deed as grantors. The deed provided that:

the said Shore Title Co., Inc., a Maryland corporation, executes this deed to the Grantee
herein for the purpose of conveying the * * * Virginia property hereinafter described by
good and marketable title, subject to the assumption by the Grantee herein of the
obligations hereinafter referred to, and all of the other Grantors herein join in the
execution of this deed for the purpose of releasing and quit-claiming any interest in and
to the property described herein and for the purpose of thereby requesting Shore Title
Co., Inc. to convey said property to the Grantee herein in the manner herein set out;
(Emphasis supplied.)

Ocean View signed the deed upon the advice of its attorney, who, although he believed
that Ocean View had no interest in the Virginia property, did not object because Ocean
View was signing only a quitclaim deed involving no warranties. By the same deed, Mr.
Biggs agreed to assume and pay the notes in favor of the mortgagee and the owners from
whom Shore had acquired the Virginia property, in the total amount of $142,544.86. On
May 29, 1969, Mr. Biggs executed a deed of release in favor of Shore, evidencing
payment in full of the bond dated January 10, 1969, in the amount of $115,655.14.

On May 26, 1969, Mr. Biggs and his wife, Mr. Powell and his wife, and the Lessans
executed a deed conveying title to the Maryland property to Ocean View.
Contemporaneously, Ocean View executed a purchase money obligation secured by a
mortgage, in the face amount of $800,000, in favor of Mr. Biggs. Also on May 26, 1969,
all of the contracts were closed; Ocean View received the deed to the Maryland property,
and Mr. Biggs received the deed to the Virginia property.

OPINION

The purpose of section 1031 (and its predecessors) was to defer recognition of gain or
loss on transactions in which, although in theory the taxpayer may have realized a gain or
loss, his economic situation is in substance the same after, as it was before, the
transaction. Stated otherwise, if the taxpayer's money continues to be invested in the
same kind of property, gain or loss should not be recognized * * * *

The transaction involved in the case before us is a variant of the so-called "three-
corner" exchange. In such a transaction, the taxpayer desires to exchange, rather than to
sell, his property. However, the potential buyer of the taxpayer's property owns no
property the taxpayer wishes to receive in exchange. Therefore, the buyer purchases other
suitable property from a third party and then exchanges it for the property held by the
taxpayer.

In numerous cases, this type of transaction has been held to constitute an exchange
within the meaning of section 1031 * * * *.

In so holding, the courts have permitted taxpayers great latitude in structuring


transactions. Thus, it is immaterial that the exchange was motivated by a wish to reduce
taxes. Mercantile Trust Co. of Baltimore et al., Trustees v. Commissioner, supra at 87.
The taxpayer can locate suitable property to be received in exchange and can enter into
negotiations for the acquisition of such property. Coastal Terminals, Inc. v. United States,
320 F.2d 333, 338 (4th Cir. 1963); Alderson v. Commissioner, 317 F.2d at 793; Coupe v.
Commissioner, 52 T.C. at 397-398. Moreover, the taxpayer can oversee improvements on
the land to be acquired (J. H. Baird Publishing Co. v. Commissioner, 39 T.C. at 611) and
can even advance money toward the purchase price of the property to be acquired by
exchange (124 Front Street, Inc. v. Commissioner, 65 T.C. 6, 15-18 (1975)). Provided the
final result is an exchange of property for other property of a like kind, the transaction
will qualify under section 1031.

Despite the liberal treatment previously accorded taxpayers by the courts, the
Commissioner asks us to hold that the petitioner's transfer of the Maryland property and
receipt of the Virginia property did not constitute an exchange within the meaning of
section 1031. The Commissioner argues that there was no contractual interdependence
between the transfer of the Maryland property and the receipt of the Virginia property.
He asks us to view what transpired as two separate transactions: a sale for cash of the
Maryland property, and a separate and unrelated purchase of the Virginia property. The
Commissioner stresses the form in which the transaction was cast. He asserts that the fact
that the petitioner advanced funds to be used by Shore in its acquisition of the Virginia
property, coupled with the fact that Mr. Powell, the Lessans, and Ocean View never
acquired legal title to the Virginia property from Shore, preclude a finding that the
transaction constituted an exchange.

The starting point of our analysis is the well established principle that the substance of a
transaction, rather than the form in which it is cast, ordinarily determines its tax
consequences. E.g., Smith v. Commissioner, 537 F.2d 972, 975 (8th Cir. 1976), affg. a
Memorandum Opinion of this Court; J. H. Baird Publishing Co. v. Commissioner, 39
T.C. at 615-616. If, in substance, what occurred was a sale of the petitioner's Maryland
property for cash, and a separate and unrelated purchase of the Virginia property, then the
Commissioner's determination must be sustained. On the other hand, if the petitioner's
transfer of the Maryland property and receipt of the Virginia property were
interdependent parts of an overall plan, the result of which was an exchange of like kind
properties, the transaction comes within the ambit of section 1031 * * * *. Having
carefully reviewed the evidence in the case before us, we are convinced that the transfer
of the Maryland property and receipt of the Virginia property were part of an integrated
plan intended to effectuate an exchange of like kind properties, the substantive result of
which was an exchange within the meaning of section 1031.

At the outset, it is clear that the parties intended and agreed that there would be an
exchange of properties. From the beginning of the negotiations between the petitioner
and Mr. Powell, the petitioner insisted that as part of the consideration for the transfer of
his Maryland property, he receive like kind property in exchange. Alderson v.
Commissioner, 317 F.2d at 792-793. Mr. Powell orally agreed to an exchange of
properties, and Mr. Porter, after confirming that such an agreement in fact existed,
advised the petitioner that he could begin looking for suitable property to be received in
exchange. The petitioner located the Virginia property and negotiated for the sale of such
property. Coastal Terminals, Inc. v. United States, 320 F.2d at 338; Alderson v.
Commissioner, supra. For reasons not disclosed in the record, Mr. Powell, at that time,
was either unable or unwilling to enter into the contract to purchase the Virginia property
or to take title to it. Accordingly, the petitioner made the contract of sale to him "acting as
agent for syndicate" and thereafter arranged to have the title transferred to Shore. Coupe
v. Commissioner, 52 T.C. at 407. Mr. Powell subsequently contracted to purchase the
Virginia property from Shore. The February 27, 1969, contract of sale between the
petitioner and Mr. Powell was a written formalization of their prior agreement to
exchange properties: the petitioner agreed to convey his Maryland property to Mr.
Powell, and as part of the consideration for the Maryland property, Mr. Powell assigned
his right to purchase the Virginia property to the petitioner. The exchange agreement was
consummated at the May 26, 1969, closing, at which time the petitioner conveyed title to
the Maryland property to Mr. Powell's assignees and received title to the Virginia
property.

This Court previously had occasion to consider a markedly similar transaction in the
case of Coupe v. Commissioner, supra. Coupe dealt with a transaction involving four
parties: (1) The taxpayer, who wished to exchange properties; (2) a prospective purchaser
of the taxpayer's property, who did not own the property the taxpayer wished to receive
in exchange; (3) a prospective seller of the property the taxpayer wished to receive in
exchange; and (4) a fourth party. The taxpayer transferred his property to the fourth party,
who sold it to the prospective purchaser for cash. With such cash, the fourth party
purchased the property the taxpayer wished to receive in exchange and transferred it to
the taxpayer. The Court held that the transaction constituted an exchange within the
meaning of section 1031. 52 T.C. at 406. In Coupe, as in the case before us, the
prospective purchaser of the taxpayer's property was either unable or unwilling to obtain
title to the exchange property. 52 T.C. at 407. However, that factor was not
determinative; the Court found that the statute requires only that, as the end result of an
agreement, property is received as consideration for property transferred by the taxpayer.
52 T.C. at 409. Accordingly, there is no merit in the Commissioner's argument that the
transaction before us cannot qualify under section 1031 because Mr. Powell, the Lessans,
and Ocean View never received legal title to the Virginia property. See also W. D. Haden
Co. v. Commissioner, 165 F.2d at 590; but see Carlton v. United States, 385 F.2d 238,
242-243 (5th Cir. 1967).

Moreover, the fact that the petitioner advanced funds to Shore to enable it to purchase
the Virginia property is not fatal to his case. Similar arguments were advanced in the case
of 124 Front Street, Inc. v. Commissioner, supra. In that case, the taxpayer owned an
option to acquire property that Firemen's wished to own. Firemen's agreed to advance
funds to the taxpayer so that it could exercise its option and then sell or exchange the
option property with Firemen's. The Court rejected the Commissioner's argument that the
taxpayer had sold its option to Firemen's. Instead, the Court held that the transaction
represented a valid exchange of properties under section 1031. 65 T.C. at 15. The Court
further held that the funds advanced by Firemen's to the taxpayer represented a loan, and
not boot received by the taxpayer on the exchange. 65 T.C. at 18.

In the case before us, the petitioner helped to finance Shore's acquisition of the Virginia
property: he paid an earnest money deposit of $13,900 at the time the contracts of sale
were signed and subsequently advanced $115,655.14 to Shore to enable it to close the
contracts, for a total of $129,555.14. Although the petitioner received $900,000 when the
exchange agreement was closed ($100,000 in cash and an $800,000 promissory note),
$129,555.14 of such amount in fact represented repayment of loans previously made by
the petitioner to Shore. Cf. 124 Front Street, Inc. v. Commissioner, supra. In addition, the
Virginia property which the petitioner received was subject to mortgages in the total
amount of $142,544.86, which the petitioner assumed; thus, part of the cash he received
at the closing was to reimburse him for the assumption of such mortgages. In substance,
the petitioner exchanged his Maryland property for the Virginia property and $627,900 in
cash or its equivalent.

We recognize that there are factual differences between the case before us and other
cases dealing with three- and four-party exchanges. For example, in Coupe v.
Commissioner, supra, the Court found as a fact that the fourth party was acting as the
agent of the purchaser of the taxpayer's property, rather than as the taxpayer's agent. 52
T.C. at 406-407. We have made no such finding with respect to Shore's role here.
Moreover, in Coupe, because of the form in which the transaction was cast, the taxpayer
never handled the cash used to acquire the exchange property. 52 T.C. at 409. However,
in substance, the transaction in the case before us is not materially different from that in
Coupe v. Commissioner.

In Coupe, although the Court found that the fourth party was not the agent of the
taxpayer, the fourth party undertook, at the request of the taxpayer, to arrange, for the
benefit of the taxpayer, an exchange of property that would qualify under section 1031. In
the case before us, Shore assumed a similar role. In contracting to purchase the Virginia
property, the petitioner made clear that he was acting, not for himself, but on behalf of
Mr. Powell. When it developed that Mr. Powell was unable or unwilling to take title to
the Virginia property, Shore accepted title to facilitate an exchange. Thus, in both Coupe
and the case before us, the fourth party was used to facilitate an exchange, and the
taxpayer never acquired legal title to the property before the exchange.

Nor do the financial arrangements in the case before us differ significantly. If Shore had
borrowed money from another person to finance its acquisition of the Virginia property,
and if at the closing Ocean View had paid Shore the funds to pay off such loan and
discharge the mortgages, the petitioner would have received, at the closing, the Virginia
property and $627,900 in cash. Certainly such a transaction would qualify as a section
1031 exchange under the rule of Coupe. In the case before us, although the formal
structure of the transaction is different, the net result is the same. To reach a different
result in the case before us, merely because the transaction was not so artfully arranged,
would be to exalt form over substance.

Such an emphasis on the form in which the transaction is cast has been the object of
criticism among commentators [FN5] and has led an appellate court to observe that the
cases in this area are " 'hopelessly conflicting.' " Bell Lines, Inc. v. United States, 480
F.2d at 714. Moreover, undue reliance on the form of these transaction frustrates the
legislative purpose, that is, to defer recognition of gain or loss in instances in which the
taxpayer continues his investment in property of a like kind. Undue reliance on form also
produces capricious results; in cases which are not substantively different, courts are led
to reach differing results. On the other hand, if we focus instead on the substance of the
transactions, taking into consideration all steps which are part of an integrated plan, we
reach results which are consonant with the legislative purpose and which treat all
taxpayers evenhandedly. Traditionally, the courts have been guided by substance, not
form, in deciding tax controversies (e.g., Commissioner v. Court Holding Co., 324 U.S.
331 (1945); Gregory v. Helvering, 293 U.S. 465 (1935); Weiss v. Stearn, 265 U.S. 242
(1924)), and such principle must be applied in deciding the case before us.

The Commissioner argued that under the rule enunciated in Golsen v. Commissioner, 54
T.C. 742, 757 (1970), affd. on another issue 445 F.2d 985 (10th Cir. 1971), cert. denied
404 U.S. 940 (1971), we are bound to follow the decision of the Court of Appeals for the
Fifth Circuit in Carlton v. United States, 385 F.2d 238 (1967). In Carlton, the taxpayers,
who had given an option on their ranch property, negotiated to acquire other ranch
property which they wished to receive in a tax-free exchange. The optionee contracted to
buy the other property but never acquired title to such property. Instead, the optionee paid
cash for the taxpayers' property and assigned to the taxpayers its contractual right to
acquire the other property. Two days later, the taxpayers purchased the other property,
using the money previously received from the optionee to close the transaction. The court
found that the transaction constituted a sale by the taxpayers and a purchase of other
property. * * * * The court distinguished an earlier decision, W. D. Haden Co. v.
Commissioner, supra, pointing out that the money received by the taxpayers was not
earmarked to be used in purchasing the exchange property; thus, the taxpayers had
unrestricted use of the money received. 385 F.2d at 243.

Clearly, the court in Carlton was troubled by the harshness of the result it reached. 385
F.2d at 243. In a subsequent case, Redwing Carriers, Inc. v. Tomlinson, 399 F.2d 652
(5th Cir. 1968), the court distinguished Carlton. In Redwing, there was a sale of old
property and an acquisition of new property; but, since the court found that the sale and
acquisition were interdependent, it treated them as merely steps in a single transaction,
which constituted an exchange under section 1031. The court distinguished Carlton on
the basis that in Carlton there was no similar finding of interdependence of steps in the
purported exchange. * * * *

The facts in the case before us are significantly different from those in Carlton. In
Carlton, the taxpayers conveyed their property for cash and 2 days later reinvested the
proceeds; here, the transfer of the Maryland property and receipt of the Virginia property
occurred simultaneously. Moreover, the petitioner already had committed funds to the
purchase of the Virginia property; thus his use of the cash received was not unfettered or
unrestricted, as was found in Carlton. Here, we have found that the events were merely
steps designed to effect an exchange, and under these circumstances, we are satisfied that
our decision is not inconsistent with the holdings of the Fifth Circuit in Carlton and
Redwing. Cf. Kent v. Commissioner, 61 T.C. 133, 137-138 (1973).

To reflect concessions by the parties and to give effect to our opinion herein, Decision
will be entered under Rule 155.
[Biggs, on appeal A] [Biggs, on appeal B]
[Biggs, on appeal C] [Biggs, on appeal D]
[Biggs, on appeal E] [Biggs, on appeal F]
[Biggs, on appeal G] [Biggs, on appeal H]
[Biggs, on appeal I]

BARKER

In Barker, the Court was faced with a multiple party exchange involving the question of
form and substance.

The taxpayer, Barker, owned a property referred to as the Demoin property in


California. Barker desired to purchase the property known as the Casa El Camino
property.

The Covington Brothers, Inc., a real estate firm, agreed to buy the three lots, identified
as C-1. Covington then exchanged the C-1 lots with Barker for the Barker property.
Covington would then sell the Demion property to the party who desired it, Goodyear.

There were certain escrow arrangements that were agreed. The Demion property was
deeded to Covington Brothers, and then from Covington Brothers, this was purchased by
cash put in by Goodyear and proceeds of a new trust deed taken out by Goodyear on the
Demion property. The proceeds from the sale of the Demion property were applied to
satisfying the existing first trust deed on the property and a second deed of trust on that
property. Other expenses incidental to the sale were satisfied out of the loan proceeds.

As for the consideration paid for the lots, it was the transfer of the property, Demion,
including the taxpayers also agreeing to assume a first deed on the property, and
executing a second deed of trust on the property in favor of Covington. There was also a
transfer of cash from escrow.

It was these escrow arrangements and these transactions which gave rise to the
government's position that the transaction was really a sale and a reinvestment.

Notice that each of the contractual arrangements occurred simultaneously; therefore,


there was not a Starker-type problem of a nonsimultaneous transfer.

The Court held that these transactions were interdependent, and therefore Section 1031
applied. The Court held that, "when liabilities are paid off contemporaneously with the
exchange, the taxpayer does not obtain dominion and control over the cash and the
taxpayer's net investment and the new like-kind property is no less than his net
investment in the old."

The Court further held, "Accordingly, we hold that boot-netting is permissible in a case
where contemporaneously with the exchange of properties and where clearly required by
the contractual arrangements between the parties, cash is advanced by the transferee, in
this case Goodyear through Covington Brothers, to enable the transferor-taxpayer . . .to
pay off a mortgage on the property to be transferred by the taxpayer, here the Demion
property."

Once again, we see great flexibility in this area relative to looking to the substance as
opposed to the form, the ability to have cash coming in and out of the transactions in the
sense of a simultaneous netting, new financing placed on the property at the time of the
transfer of the deed, use of an escrow arrangement, and other degrees of flexibility.

EARLENE T. BARKER, PETITIONER


v.
COMMISSIONER of INTERNAL REVENUE, RESPONDENT

74 T.C. 555
Docket No. 1721-78.
Filed June 10, 1980.

NIMS, Judge:
Respondent determined a deficiency in taxes of $160 for the year 1973 and $4,824 for
the year 1974. After concessions by the parties, there are two issues remaining for our
decision:

(1) Should petitioner have recognized gain in 1974 on a


transaction in which she disposed of her Demion property and
acquired the Casa El Camino property?
(2) Did the buildings located on the petitioner's Casa El Camino
property have a useful life of 30 years at the time such property
was acquired by petitioner, as determined by respondent?

FINDINGS OF FACT

Most of the facts were fully stipulated and are found accordingly. The stipulation of
facts and the exhibits attached thereto are incorporated by this reference.

The residence of the petitioner at the time the petition was filed in this case was
Oceanside, Calif.

In June 1971, the petitioner acquired from Covington Bros., Inc., a parcel of real
property, consisting of a four-plex residential building located at 18551 Demion Way,
Huntington Beach, Calif. (the Demion property), along with personal property, consisting
of furnishings related to the property. Covington Bros., Inc., was a California corporation
in the business of buying and selling real estate. The Demion property was held by the
petitioner primarily for rent to tenants.

In the spring of 1974, Mr. and Mrs. Goodyear contacted petitioner to inquire about
purchasing the Demion property. Petitioner spoke to her accountant, Richard A. Harrison,
about setting up a tax-free exchange to dispose of the property. After the contact by the
Goodyears, petitioner contacted Covington Bros. and arrangements were made to effect
an exchange through Covington Bros. and Grover Escrow Corp. Grover Escrow was
handling three parcels of property, lots 15, 16, and 17 of the Casa El Camino subdivision,
which were sought by petitioner. Petitioner then told the Goodyears that she would make
the Demion property available to them but that the transaction would have to be done as
an exchange through Grover Escrow.

To effect these transactions as an exchange, the parties entered into a series of


contractual arrangements which took the form of escrow agreements. The intent of the
parties was to structure a simultaneous transaction through these escrow agreements and
escrow accounts by which Covington Bros. would acquire the Casa El Camino lots and
exchange the lots for petitioner's Demion property which Covington Bros. would then
sell to Virginia Goodyear. The parties to the various agreements are set forth below:

Escrow # Seller Buyer Property


4-2863-01 Barker Covington Demion
4-2864-01 Barker Goodyear Demion
4-2861-01 Covington Barker Casa El Camino #15
4-2862-01 Covington Barker Casa El Camino #17
4-2906-01 Covington Barker & Bear Casa El Camino #16

Escrow No. 4-2863-01, dated April 15, 1974, was established for the transfer of the
Demion property from petitioner to Covington Bros. It listed Covington Bros. as the
purchaser and petitioner as the seller. The escrow agreement provided, in pertinent part,
as follows:

OPINION

This case involves another variant of the multiple-party, like-kind exchange by which
the taxpayer, as in this case, seeks to terminate one real estate investment and acquire
another real estate investment without recognizing gain. The statutory provision for
nonrecognition treatment is section 1031. [FN1] The touchstone of section 1031, at least
in this context, is the requirement that there be an exchange of like-kind business or
investment properties, as distinguished from a cash sale of property by the taxpayer and a
reinvestment of the proceeds in other property.

The "exchange" requirement poses an analytical problem because it runs headlong into
the familiar tax law maxim that the substance of a transaction controls over form. In a
sense, the substance of a transaction in which the taxpayer sells property and immediately
reinvests the proceeds in like-kind property is not much different from the substance of a
transaction in which two parcels are exchanged without cash. Bell Lines, Inc. v. United
States, 480 F.2d 710, 711 (4th Cir. 1973). Yet, if the exchange requirement is to have any
significance at all, the perhaps formalistic difference between the two types of
transactions must, at least on occasion, engender different results. Accord, Starker v.
United States, 602 F.2d 1341, 1352 (9th Cir. 1979).
The line between an exchange on the one hand and a nonqualifying sale and
reinvestment on the other becomes even less distinct when the person who owns the
property sought by the taxpayer is not the same person who wants to acquire the
taxpayer's property. This means that multiple parties must be involved in the transaction.
In that type of case, a like-kind exchange can be effected only if the person with whom
the taxpayer exchanges the property first purchases the property wanted by the taxpayer.
This interjection of cash, especially when the person who purchases the property desired
by the taxpayer either uses money advanced by the taxpayer or appears to be acting as his
agent, or both, makes the analysis that much more difficult.

In the instant case, petitioner faced just such a problem. Virginia Goodyear wanted to
acquire petitioner's Demion property, and an unidentified third party owned the Casa El
Camino property that petitioner sought to acquire. To effect the exchange, petitioner
brought in a fourth party, Covington Bros., Inc., who, in a simultaneous transaction, was
supposed to acquire both properties and transfer the Casa El Camino property to
petitioner in return for the Demion property and the Demion property to Goodyear for the
cash. This cash and the proceeds of new mortgages taken out by petitioner on the Casa El
Camino property was used to compensate the ex-owners of the Casa El Camino property.
The contractual arrangements took the form of escrow agreements and the dollars were
evened out through escrow accounts.

Petitioner contends that the parties successfully completed a like-kind exchange;


respondent contends otherwise, maintaining that petitioner sold the Demion property and
reinvested the proceeds in the Casa El Camino property, all of which amounted to a
taxable transaction.

We begin by observing that there is nothing inherent in a multiple-party exchange that


necessarily acts as a bar to section 1031 treatment. Thus, it is not a bar to section 1031
treatment that the person who desires the taxpayer's property acquires and holds another
piece of property only temporarily before exchanging it with the taxpayer. Mercantile
Trust Co. of Baltimore v. Commissioner, 32 B.T.A. 82 (1935); Alderson v.
Commissioner, 317 F.2d 790 (9th Cir. 1963), revg. 38 T.C. 215 (1962); Starker v. United
States, supra; Rev. Rul. 75-291, 1975-2 C.B. 332. [FN2] Similarly, it is not fatal to
section 1031 treatment that the person with whom the taxpayer exchanges his property
immediately sells the newly acquired property. W. D. Haden Co. v. Commissioner, 165
F.2d 588 (5th Cir. 1948); Mays v. Campbell, 246 F. Supp. 375 (N.D. Tex. 1965).

Difficulties arise, however, when the transaction falls short of the paradigm in which
transitory ownership is the only feature distinguishing the transaction from two-party
exchanges. Still, the courts (and by and large the Commissioner), in reviewing these
transactions, have evinced awareness of business and economic exigencies.

Often the taxpayer and a prospective purchaser will enter into an exchange agreement
before acceptable like-kind property has been located. In Alderson v. Commissioner,
supra, as in Biggs v. Commissioner, 69 T.C. 905 (1978), on appeal (5th Cir., Oct. 23,
1978), the court approved tax-free exchange treatment since the properties were
designated before the date set for transfer of taxpayer's property even though the to-be-
received properties had not been identified as of the date of the agreement. [FN3] This
aspect of Alderson was approved in Rev. Rul. 77-297, 1977-2 C.B. 304, in which the
Commissioner also allowed the taxpayer to search for and select the property to be
received by him in the exchange. In fact, in Alderson, the Ninth Circuit was also satisfied
even though originally the taxpayer negotiated a sale and only later amended the escrow
agreement to provide for a "three corner" exchange in lieu of a cash sale. See also Coupe
v. Commissioner, 52 T.C. 394 (1969). Rev. Rul. 77-297 also cited this aspect of Alderson
with approval.

In W. D. Haden Co. v. Commissioner, 165 F.2d 588 (5th Cir. 1948), an individual
purchased property from a third party with the intent of exchanging this property for
property held by the taxpayer, but the individual never acquired legal title to the property.
Despite this, the court sanctioned tax-free exchange treatment, holding that the buyer may
direct the third party to deed this property directly to the taxpayer so long as the cash paid
to the third party is transferred directly from the buyer to the third party and not through
the taxpayer. See also Biggs v. Commissioner, 69 T.C. 905 (1978), where this Court
sustained tax-free exchange treatment, again notwithstanding the fact that the exchanging
party did not obtain legal title to the property to be exchanged.

In 124 Front Street, Inc. v. Commissioner, 65 T.C. 6 (1975), section 1031 treatment
was in order for a taxpayer where a corporation advanced funds to the taxpayer to permit
him to exercise an option he held on property. The taxpayer then exchanged the newly
acquired property for property held by the corporation. In Biggs v. Commissioner, supra,
a similar result ensued where the taxpayer advanced funds to a fourth party to enable it to
purchase the sought property (the taxpayer ultimately recovering his funds when the
several titles closed).

Notwithstanding those deviations from the standard multiple-party exchanges which


have received judicial approval, at some point the confluence of some sufficient number
of deviations will bring about a taxable result. Whether the cause be economic and
business reality or poor tax planning, prior cases make clear that taxpayers who stray too
far run the risk of having their transactions characterized as a sale and reinvestment.

For example, in Carlton v. United States, 385 F.2d 238 (5th Cir. 1967), the parties
intended to enter into an Alderson like-kind exchange (i.e., the person who wanted the
taxpayer's property was to temporarily acquire and hold the property wanted by the
taxpayer), but to avoid unnecessary duplication in the transfer of money and titles, the
third party conveyed his property directly to the taxpayer, and the buyer paid money to
the taxpayer, intending that the taxpayer pay this money to the third party. Focusing on
the taxpayer's receipt of cash rather than real property, the court held that the transaction
was a sale.

In Rogers v. Commissioner, 44 T.C. 126 (1965), affd. per curiam 377 F.2d 534 (9th
Cir. 1967), the taxpayer granted a purchase option to Standard Oil Co. of California prior
to his agreement with third parties to exchange the property subject to the outstanding
option. Standard Oil exercised its option and paid the purchase price into escrow just
before the exchange was completed. Therefore, the taxpayer was held to have sold his
property before the exchange took place, and section 1031 treatment was denied.

It is against this background that the present four-party, like-kind exchange must be
analyzed. At the outset, we note that this transaction is earmarked by several factors
characteristic of section 1031 exchanges. It is clear that the parties intended that there
would be an exchange of the properties. While intent alone is not sufficient (Carlton v.
United States, 385 F.2d 238 (5th Cir. 1967)), it is relevant to a determination of what
transpired. Biggs v. Commissioner, supra at 915.

Consonant with this intent, the essence of the agreements among the parties was that
petitioner would exchange the Demion property for the Casa El Camino property rather
than have petitioner sell the Demion property and reinvest the proceeds. This was
accomplished through contractual arrangements which were such that petitioner did not,
or could not, obtain actual or constructive receipt of the cash proceeds from the sale of
the Demion property to Goodyear.

Each of the contractual arrangements between the parties was a mutually


interdependent part of an integrated plan; each transaction was contingent upon the
successful completion of the other transactions; and the transactions were to be
completed simultaneously. Under the agreements, moneys paid into escrow were
earmarked for the Casa El Camino property; petitioner had no option of taking cash in
lieu of this property. Finally, title passage was consistent with the idea that this was an
exchange of properties. Title for the Demion property passed from the petitioner to
Covington Bros. and then to Goodyear; conversely, title for the Casa El Camino property
passed from the initial owner to Covington Bros. and then to petitioner.

There are, however, two features of this transaction which could be construed as
suspect under section 1031: Covington Bros.' transitory ownership of the properties and
the possibility that petitioner could have received cash rather than real estate.

At first blush, the transitory nature of Covington Bros.'ownership of the Demion


property on the one hand and the Casa El Camino property on the other seems to lend
itself to a step-transaction argument; that is, Covington Bros.' ownership of the properties
could be viewed as nothing more than an unnecessary and formalistic step of no legal or
economic significance which should be ignored in determining the character of the
transaction for tax purposes. But, as indicated above, the Commissioner accedes to
transitory ownership in the three-party context (Rev. Rul. 77-297, supra ), and we can
perceive no reason why the four-party context should be treated any differently. In other
four-party exchanges previously considered by the courts and decided in favor of the
taxpayer, the fourth party has held title to the properties for no longer than a transitory
period. We do not understand respondent's attack on four-party exchanges to be so broad-
based that he thinks none qualify for section 1031 treatment. See Coupe v.
Commissioner, supra; Biggs v. Commissioner, supra. [FN4] Indeed, respondent has not
made such an argument here. To the complaint that this treatment places undue emphasis
on a formalistic step of no substance, we repeat what we have already said: that the
conceptual distinction between an exchange qualifying for section 1031 on the one hand
and a sale and reinvestment on the other is largely one of form.

Respondent has chosen to focus his attack on those attributes of this transaction which
depart from the standard four-party exchange. Respondent's basic contention is that the
agreement providing for the transfer of the Demion property from petitioner to Goodyear
is separate and distinct from the agreement providing for the transfer of the Casa El
Camino property to petitioner. Respondent's view has it that escrow No. 4-2864-01
between petitioner as seller and Goodyear as buyer obligated petitioner to sell the
Demion property to Goodyear upon payment of an appropriate amount of cash into
escrow. He contends that petitioner could have taken the cash by paying a $50 penalty,
plus costs, after transferring the Demion property to Goodyear and withdrawing from the
agreements calling for her to acquire the Casa El Camino property. And respondent views
the provision for simultaneous escrow closings on the Demion and Casa El Camino
properties as an artifice through which petitioner avoids cash passing through her hands.
Respondent draws the conclusion that the transactions should be characterized as a sale
and reinvestment of funds which does not qualify as a section 1031 exchange.

The basic weakness in respondent's position is that it treats too cavalierly the language
in the escrow agreements providing that the successful closing of each transaction is
contingent upon the successful closing of all the other transactions. The mutual
interdependence of the Demion and Casa El Camino transfers could not have been made
more explicit. [FN5] In this context, the fact that the escrow agreement (No. 4-2864-01)
providing for the transfer of the Demion property to Goodyear listed Barker rather than
Covington as "seller" takes on less significance. [FN6] Indeed, there is plenty of evidence
that Goodyear received the property from Covington Bros. rather than Barker. There was
a separate escrow agreement providing for the transfer of the Demion property from
Barker to Covington Bros. The escrow ledger for escrow account No. 4-2864-01 listed
Covington Bros. as the seller rather than Barker. And at the Hall of Records there was
recorded the passage of title from Barker to Covington to Goodyear.

SAME PARTY AS TRANSFEROR AND TRANSFEREE:


PRIVATE LETTER RULING 8852031

The question in an exchange is often as to the structure of the transaction. In the Private
Letter Ruling that follows, the issue was whether a taxpayer can qualify within Code
§1031 if the taxpayer, as an example, transfers property to X, but receives like-kind
property from Y. In other words, the transfer is not made to and from the same party.
This Ruling examines this concern and allows the Code §1031 treatment. (See also the
Barker and Haden cases, noted in this Chapter.)

PRIVATE LETTER RULING 8852031

Dear _____:
This is in reply to a letter dated March 2, 1988, written on behalf of A by its authorized
representatives, in which a ruling is requested on whether a certain aspect of a transaction
involving an exchange of properties affects the application of section 1031 of the Internal
Revenue Code.

In the transaction A contracts to transfer real estate to B as part of an exchange that A


intends to qualify under section 1031 of the Code. B agrees to cooperate with A in
effecting an exchange that so qualifies. To accommodate the exchange, B transfers funds
to C, which will act as a trustee. Within certain time limits (specified in section
1031(a)(3) of the Code) C may apply the funds toward the purchase of property that
satisfies B's obligation to A. If such purchases fail to fully satisfy B's obligation, then C
will release the remaining funds to A.

The submission indicates that C is the party with whom A is exchanging properties.
The letter also states that C is not an agent of A. In order to avoid the state documentary
transfer taxes that would occur upon a transfer of A's real estate first to C and then to B,
A proposes to provide for a single transfer of the deed from A to B. Likewise, to avoid
the state documentary transfer taxes that would occur on the transfer of property first
from parties who contract to sell with C to C, and then from C to A, the proposed
transaction provides for a single transfer of the properties from the contracting parties to
A.

Section 1031(a) of the Code provides, in general, 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 a like kind which is to
be held either for productive use in a trade or business or for investment.

At issue is whether a taxpayer qualifies for section 1031 treatment if the other party to
the exchange does not have title to the property transferred to the taxpayer and does not
take title to the property received from the taxpayer. This is the sole issue on which we
are ruling. On the basis of the information submitted we make no determination as to
whether C is the party with whom A is exchanging properties or whether C is acting as an
agent in the exchange. We note that the treatment of A for purposes of section 1031 is the
same whether C is the party to the exchange or the agent of B. See, Mercantile Trust Co.
of Baltimore v. Commissioner, 32 B.T.A. 82, 85 (1935).

W.D. Haden Co. v. Commissioner, 165 F.2d 588 (5th Cir. 1948), addresses the effect
under section 1031 of the Code of not recording the name of the person with whom the
taxpayer made the exchange on the deeds to the properties exchanged. In Haden the
taxpayer transferred lot 18 to Goodwin in exchange for lot 17. Goodwin was a
middleman in the transfers of lot 16 and lot 17; he had also contracted to purchase lot 17
from Texas Company and to sell lot 16 to Beeley. When it came to recording title, at
Goodwin's request Texas Company conveyed lot 17 to the taxpayer and the taxpayer
conveyed lot 16 to Beeley. The taxpayer reported the exchange as a loss rather than under
the predecessor of section 1031, section 112(b)(1) of the Internal Revenue Code of 1939.
The Fifth Circuit affirmed the Tax Court's holding that section 112(b)(1) of the 1939
Code applied to the exchange. The fact that the party with whom the taxpayer made the
exchange was not recorded on the deeds to the properties exchanged was irrelevant.

Accordingly, we conclude that the applicability of section 1031 of the Code to A is not
affected by whether the party with whom A makes the exchange has title to the properties
transferred to A or takes title to the property received from A.

DIRECT DEEDING RECONSIDERED:WITH OTHER FACTS:


PRIVATE LETTER RULING 8923050

Under Private Letter Rul. 8923050, the Treasury has held that in a situation where a
taxpayer could qualify for nonrecognition under Code §1031, where the transferee did
not receive title directly from the party to whom he transferred his property under the
Code §1031 transaction, nevertheless this could qualify as a tax-deferred exchange
transaction. In other words, the fact that there was an indirect deeding did not eliminate
the Code §1031 treatment.

This prior position was under Private Letter Rul. 8852031. The Service revoked the
prior 1988 Ruling under this Private Letter Rul. 8923050. However, the revocation was
not because of the deeding. It was due to a relationship, as mentioned in the Ruling.

As to direct deeding, now see Rev. Rul. 90-34, supra, and the Final Regulations under
Code §1031, as to deferred exchanges, issued in 1991.

PRIVATE LETTER RULING 8923050

This is in reference to a ruling letter issued to you on b (PLR 8852031). PLR 8852031
considered whether a taxpayer qualifies for nonrecognition treatment under section 1031
of the Internal Revenue Code when the transferee does not receive title to the property
relinquished by the taxpayer and the transferee does not take title to the property received
by the taxpayer in the exchange.

This is to advise you that the Internal Revenue Service has reconsidered PLR 8852031.
Our cause for reconsideration of PLR 8852031 emanates from our concern about the
relationship between you and the transferee and not whether the transferee held or
acquired title to the property in question. Consequently, PLR 8852031 is hereby revoked
and may no longer be relied upon as of the date of this letter.

INTENT WHEN ACQUIRING PROPERTY: WAGENSEN

Fred S. Wagensen, a resident of Wyoming, owned a large ranch with his wife, previous
to her death in 1972. In the 1960s he negotiated with Carter Oil Co. to sell the ranch to it,
although Wagensen desired an exchange. Although earlier transactions were not
completed between the parties relative to a sale or an exchange, Carter and Wagensen on
September 19, 1973, entered a contract relative to the sale of the Wagensen ranch to
Carter.
The contract directed that the deed be placed in escrow until closing, at which time it
would be delivered to Carter. The contract obligated Carter to acquire and transfer to
Wagensen a maximum of five properties satisfactory to the taxpayer. If the total price of
the property transferred to petitioner was less than the value of the Wagensen ranch,
Carter would pay the difference in cash at closing. If it went the other way, Wagensen
would pay the difference. If no satisfactory lands were acquired within five years, Carter
would pay the cash price of $3 million.

Special arrangements allowed Carter to receive a pro rata portion of possession of the
Wagensen ranch upon each conveyance by Carter of lands to taxpayer. Carter was also
allowed to use other portions of the property, subject to a lease, which could be
terminated. There was also a ten-year leaseback to Wagensen, terminable by Carter,
relative to Wagensen's cattle ranch business.

On January 18, 1974, Carter, for Wagensen, executed deed to the property known as
Napier Ranch. It was valued at approximately $995,500. No additional property was
acquired, as none was found that was acceptable to Wagensen.

On September 21, 1974, the taxpayer informed Carter that he desired to take the
remaining balance, approximately $2 million, in cash. He then for the first time informed
his children, Donald and Opel, that he intended to give half of the Napier Ranch to
Donald and half to Opel, along with $500,000 to each. (This leads to part of the problem
in this case).

On October 15, 1974, Carter paid petitioner approximately $2 million, under the
agreement of September 19, 1973. On this same date, the Wagensen ranch deed was
delivered from escrow to Carter. On that date taxpayer transferred a total of $1 million,
half to Open and half to Donald and his wife.

On November 8, 1974, taxpayer executed deeds to Opel and Donald and his wife for
the Napier Ranch.

The question was whether the Napier Ranch qualified as a tax-deferred exchange. The
government took the position that Section 1031 did not apply inasmuch as the taxpayer
acquired the Napier property with the intent to transfer the same as a gift and, therefore, it
was disqualified.

The taxpayer was not challenged on the question as to whether there was like-kind
property, the issue on cash, or other arguments. Rather, the thrust of the argument by the
government was that the transaction did not qualify under Section 1031 inasmuch as the
Napier ranch was acquired with the intent to immediately make a gift of the same, and
therefore the requisite intent under Section 1031 was not met.

The Court held for the taxpayer, holding that the Court will look to the substance of the
transaction rather than to its form in analyzing the purported 1031 transaction. A number
of cases, including Biggs, were cited.
This type of case illustrates the flexibility that apparently exists for taxpayers. It also
shows an additional approach where the facts will support the position for a transaction
similar to Starker, but having the deed out of escrow on a simultaneous basis.

FRED S. WAGENSEN, PETITIONER


v.
COMMISSIONER of INTERNAL REVENUE, RESPONDENT
74 T.C. 653 (1980)

FEATHERSTON, Judge:
In these consolidated cases, respondent determined deficiencies of $353,881, $1,806,
and $1,444 in petitioner's Federal income taxes for 1974, 1975, and 1976, respectively.
The issues for decision are:

(1) Whether section 1031 [FN1] applies to an exchange of


petitioner's ranch for another ranch and cash where he
subsequently gave the ranch and some of the cash to his
children.
(2) Whether a partnership in which petitioner is a partner is
entitled to investment credit on livestock that the partnership
included in inventory.

FINDINGS OF FACT

Petitioner FRED S. WAGENSEN was a legal resident of Gillette, Wyo., when he filed
his petition. He filed his individual Federal income tax returns for 1974, 1975, and 1976
with the Internal Revenue Service Center, Ogden, Utah.

Petitioner, age 83 at the time of trial, was involved in ranching in Campbell County,
Wyo., for over 50 years. Since at least 1956, petitioner operated a cattle ranching
business in partnership with his son, Donald. The partnership, known as the Wagensen
Ranch partnership, filed returns for 1974, 1975, and 1976. All of the real property used
by the partnership was owned by petitioner and his wife as joint tenants until her death in
1972. Thereafter, until November 8, 1974, the property was owned solely by petitioner.
The partnership paid the property taxes on the real property used by it. During 1974
through 1976, petitioner continued to operate the cattle-ranching business in partnership
with his son.

During the late 1960's, the Carter Oil Co. (Carter) purchased at auction from the
Federal Government a 20-year lease covering coal underlying one of the ranches owned
by petitioner known as the Wagensen or Rawhide Ranch. During the period 1970 to
1973, petitioner negotiated with Carter and other companies for the sale of petitioner's
ranch. Consistently throughout the negotiations, Carter indicated its willingness to pay
cash, but petitioner made it clear that he wanted to receive, in exchange, other property
on which to continue his ranching business. In early 1973, petitioner and Carter agreed
that petitioner would transfer the Wagensen Ranch to Carter in exchange for another
designated ranch if Carter could acquire that ranch. Carter was unable to acquire that
ranch, however, and the agreement terminated.

On September 19, 1973, petitioner entered into a contract with Carter setting forth the
terms on which Carter would acquire the Wagensen Ranch. Under the contract, petitioner
executed a deed to Carter for the ranch. The value placed on the ranch by the contract
was $3 million. The contract directed that the deed be placed in escrow until the date of
closing, at which time it would be delivered to Carter. The contract obligated Carter to
acquire and transfer to petitioner a maximum of five properties which were satisfactory to
him. If the total purchase price of the properties transferred to petitioner was less than the
value of the Wagensen Ranch, Carter would pay the difference in cash at closing. If the
purchase price exceeded the Wagensen Ranch's value, petitioner would pay the
difference. If no lands satisfactory to petitioner were acquired within 5 years, then Carter
would pay cash of $3 million to petitioner.

The contract further provided that, upon each conveyance of lands by Carter to
petitioner, Carter would be entitled to possess, for purposes of coal mining, a portion of
the Wagensen Ranch approximately equal in value to the land transferred to petitioner.
To the extent that Carter used portions of the Wagensen Ranch prior to the transfer of
property to petitioner, Carter was obligated to pay rent of $5 per acre per year. To avoid
disrupting petitioner's cattle operations until new property was acquired, the agreement
also granted petitioner a 10-year renewable lease on the ranch subject to Carter's rights.
The lease was terminable at will by Carter.

On January 18, 1974, Carter executed a deed to property, known as the Napier Ranch,
to petitioner. The deed was recorded on January 31, 1974. The cost of the Napier Ranch
was $995,487. After the purchase of the Napier Ranch, petitioner and Carter continued to
search for additional ranching properties through September 1974. No ranches
satisfactory to petitioner, however, were found, and thus, Carter did not purchase any
more property for petitioner.

Subsequent to the Napier Ranch acquisition, petitioner discussed with his accountant
the amount of gift tax that would be due if he transferred his property to his children. In
early fall 1974, petitioner decided not to seek additional land but instead to accept the
cash due in order to pay taxes and ensure solvency in case of difficult times such as a
drought. On September 21, 1974, petitioner informed Carter of his decision to take the
remaining cash. Shortly thereafter, he also informed his children, Donald and Opel, that
he intended to transfer one-half of the Napier Ranch and $500,000, subject to their
obligation to pay the gift tax thereon, to each of them. At no time had the children taken
part in the negotiations with Carter.

Petitioner, prior to his wife's death, had discussed with her the possibility of
transferring their property to their children to reduce their estate taxes. Throughout the
negotiations with Carter, petitioner intended eventually to transfer his property to his
children. Nevertheless, at no time prior to petitioner's announcement did his children
have any indication that the gift would be made.
On October 15, 1974, Carter paid petitioner $2,004,513.76, representing the balance
due petitioner under the September 19, 1973, agreement, and Carter received the
Wagensen Ranch deed from escrow. On that same day, petitioner transferred $1 million
to Opel and Donald and his wife. On November 8, 1974, petitioner executed deeds to
Opel and Donald and his wife conveying approximately one-half of the Napier Ranch to
each.

Petitioner filed a gift tax return for the calendar quarter ended December 1974
reflecting payment of gift tax by the donees on the transfer of the cash and property in the
amount of $419,068.08. Petitioner, in his 1974 income tax return, reported a capital gain
of $2,000,902, consisting of the cash received less cost or other basis and expense of sale,
on the exchange.

During 1974 through 1976, all of the Wagensen Ranch partnership livestock, including
the breeding livestock, was included in the inventory of the partnership. No depreciation
was claimed by the partnership on its livestock.

OPINION

1. Like-Kind Exchange
Section 1031 [FN2] provides that an exchange of like-kind property (not including
stock in trade or other property held primarily for sale) held for use in a trade or business
or investment is a nontaxable event. If cash or other property which does not qualify as
like-kind property is included in the exchange, gain is recognized to the extent of the cash
or other property received.

Respondent does not contend that the properties exchanged are not like kind, that the
receipt of cash disqualifies the transaction, or that the property was held primarily for
sale. [FN3] Rather, respondent argues that the transaction fails to qualify under section
1031 on the theory that petitioner intended to make a gift of the acquired property and
thus did not hold it for investment or use in trade or business as is required by the statute.
We hold for petitioner.

One of the primary purposes for allowing the deferral of gain in a like-kind exchange is
to avoid imposing a tax upon a taxpayer who, while changing his form of ownership, is
continuing the nature of his investment. H. Rept. 704, 73d Cong., 2d Sess. (1934), 1939-1
C.B. (Part 2) 554, 564. Jordan Marsh Co. v. Commissioner, 269 F.2d 453, 455 (2d Cir.
1959), revg. a Memorandum Opinion of this Court on another point; Biggs v.
Commissioner, 69 T.C. 905, 913 (1978). In Koch v. Commissioner, 71 T.C. 54, 63-64
(1978), we explained:

The basic reason for allowing nonrecognition of gain or loss on the exchange of like-
kind property is that the taxpayer's economic situation after the exchange is
fundamentally the same as it was before the transaction occurred. "(I)f the taxpayer's
money is still tied up in the same kind of property as that in which it was originally
invested, he is not allowed to compute and deduct his theoretical loss on the exchange,
nor is he charged with a tax upon his theoretical profit." * * * The rules of section 1031
apply automatically; they are not elective. * * * The underlying assumption of section
1031(a) is that the new property is substantially a continuation of the old investment still
unliquidated. * * *

In the present case, the exchange did not constitute a cashing in on petitioner's
investment except to the extent of the approximately $2 million which he reported as
capital gain. To the contrary, the exchange actually increased petitioner's ranching
property acreage. The Wagensen Ranch had approximately 5,000 acres, and the Napier
Ranch had approximately 18,000 acres. The value of the Wagensen Ranch in excess of
the approximately $2 million which petitioner ultimately received in the deal with Carter
continued to be "tied up" in ranch land, i.e., the Napier Ranch.

From January 18, 1974, when petitioner acquired title to the Napier Ranch, until
November 8, 1974, when he conveyed the ranch to his son and daughter, a period in
excess of 9 months, petitioner held the Napier Ranch for use by the ranching partnership
of petitioner and his son. During that period, the ranch was owned by petitioner and was
held for use by the same parties and for the same purposes as was the Wagensen Ranch.
Petitioner's goal from the outset of his negotiations with Carter was to obtain other ranch
land to replace the Wagensen Ranch, and Carter's representatives made extensive efforts
to locate Wyoming ranch land, in addition to the Napier Ranch, that could be exchanged
for other portions of the Wagensen Ranch. Thus, during this 9-month period, petitioner
held the Napier Ranch "for productive use in trade or business or for investment" within
the meaning of section 1031. After petitioner gave the Napier Ranch to his children, the
partnership of petitioner and his son continued to use the ranch through the date of trial.

Respondent's argument that petitioner acquired the Napier Ranch in order to give it to his
children and, therefore, section 1031 is inapplicable, is without merit. It is true that
petitioner, a parent of advanced years, contemplated eventually passing his property to
his children. He frankly testified that he and his wife, prior to her death, had discussed
that possibility. Nevertheless, the record shows that he had no concrete plans to do so
when he acquired the Napier Ranch. Indeed, Carter and petitioner continued to search for
additional ranch properties to replace the Wagensen Ranch, and petitioner continued to
hold the Napier Ranch for the partnership's cattle business. Petitioner did not inform
Carter of his decision to take the remaining cash rather than additional ranch lands until
September 21, 1974. He also did not inform his children of his plan to give them the
Napier Ranch until after that date.

Not until after petitioner had received the deed to the Napier Ranch in January 1974 did
he initiate discussions with his accountants on the income and gift tax implications of
giving his son and daughter the Napier Ranch and cash. He learned that the taxes would
approximate $1 million and that he might not have enough cash to pay them if he took
another large parcel of land from Carter. In light of these facts, he made his decision to
divide the Napier Ranch and give one-half of it to each of his children. After making that
decision, he worked out an equitable division of the ranch between his son and daughter.
In no sense, therefore, can it be said that the exchange with Carter was part of the gift
transaction. Petitioner's general desire on January 18, 1974, when he received the deed to
the Napier Ranch, eventually to transfer his property to his children, is not inconsistent
with his intent at that time to hold the ranch for productive use in business or for
investment.

Respondent relies upon Regals Realty Co. v. Commissioner, 127 F.2d 931 (2d Cir. 1942),
affg. 43 B.T.A. 194 (1940), to support his theory that petitioner intended to transfer the
acquired ranch as a gift, and thus it would not be held for investment or use in his trade or
business as section 1031 requires. In that case, the court upheld a Board of Tax Appeals
decision that the transaction under consideration failed to qualify as a tax-free like-kind
exchange because the petitioner held the received property for sale rather than for
investment (127 F.2d at 933-934). Respondent, however, does not contend that petitioner
held the Napier Ranch for sale. Thus, Regals Realty Co. v. Commissioner, supra, is
inapposite here. Cf. Griffin v. Commissioner, 49 T.C. 253 (1967).

Generally, courts look to the substance of the transaction rather than to its form when
analyzing a purported section 1031 exchange of property. Crenshaw v. United States, 450
F.2d 472, 475 (5th Cir. 1971), cert. denied 408 U.S. 923 (1972); Biggs v. Commissioner,
supra at 914. In the instant case, if the form of the transaction had been altered so that
petitioner had given an interest in the Wagensen Ranch to his children prior to the
exchange with Carter, the children's subsequent exchange of the property with Carter
would have qualified under section 1031. The substance of that transaction, however, is
essentially the same as the substance of the transaction here. [FN4] Thus, to hold that the
exchange in the instant case fails to qualify for nonrecognition treatment merely because
the gift was made after the exchange rather than before it would exalt form over
substance. See Biggs v. Commissioner, supra at 914-918.

Decisions will be entered under Rule 155.

FN3. Nor has respondent challenged the applicability of sec. 1031 on the ground that
Carter did not own the Napier Ranch at the time the overall exchange plan was adopted
on Sept. 19, 1973. As to the so-called "three corner" exchanges, see, e.g., Coastal
Terminals, Inc. v. United States, 320 F.2d 333 (4th Cir. 1963); Alderson v.
Commissioner, 317 F.2d 790 (9th Cir. 1963), revg. 38 T.C. 215 (1962); W. D. Haden Co.
v. Commissioner, 165 F.2d 588, 590 (5th Cir. 1948), affg. on this issue a Memorandum
Opinion of this Court; Biggs v. Commissioner, 69 T.C. 905, 913 (1978); Coupe v.
Commissioner, 52 T.C. 394, 405 (1969); J. H. Baird Publishing Co. v. Commissioner, 39
T.C. 608 (1962).

MAXWELL

This case examined the basic point of the requirement of a proper format for the
exchange. Use of a trust, where control exists over the money, will result in constructive
receipt.
Mark T. MAXWELL and Gertrude Maxwell, Plaintiffs,
v.
UNITED STATES of America, Defendant.
Larry S. BELL and Nancy Bell, Plaintiffs,
v.
UNITED STATES of America, Defendant.

Nos. 86-8446-CIV-ZLOCH, 86-8447-CIV-ZLOCH.


United States District Court, S.D. Florida.
88-2 USTC Para. 9560
62 A.F.T.R.2d 88-5406 (1988)

REPORT AND RECOMMENDATION VITUNAC,


United States Magistrate:

The Plaintiffs in this case, Mark T. Maxwell, Gertrude Maxwell, and Nancy Bell, were
beneficiaries of a certain land trust designated as "Trust No. 665" for which the Southeast
Bank of Riviera Beach acted in the capacity of trustee. The Seminole Building in Palm
Beach, Florida was acquired by the trust in 1980, as investment property.

There came a point in time when a Mr. James Skeffington on behalf of Seminole
Associates approached the Plaintiff, Mark Maxwell and proposed that Seminole
Associates buy the Seminole Building. The Plaintiff, Maxwell, referred Skeffington to his
attorney, H. Gordon Brown. (Brown later became involved with the escrow agreement,
which is the subject matter of this litigation.)

At the same time Maxwell was interested in acquiring two parcels of real property
located in Fort Lauderdale and in Michigan. According to the deposition of Maxwell, H.
Gordon Brown advised the parties that they should make a like-kind exchange of the
properties under Section 1031 of the Internal Revenue Code to avoid paying on the gain
at that time.

In February of 1981, H. Gordon Brown, on behalf of the Beneficiaries and Trust No.
665, assisted in drafting the purchase and sale agreement for the Seminole Building. On
February 21, 1981, Skeffington, on behalf of the purchasers, and John C. Patten, Jr., on
behalf of Trust No. 665, for the sellers, executed a purchase and sale agreement for the
acquisition of the Seminole Building. Both sides agree that the agreement provided for a
total purchase price of two million five hundred thousand ($2,500,000.00) dollars less
assumed mortgages and a one hundred thousand ($100,000.00) dollar earnest money
deposit.

The agreement provided in pertinent part:

Upon prior written request of Seller, less than fifteen (15) days prior to the Closing
Date, Purchaser agrees to comply with the reasonable requests of Seller with respect to
Seller's election to execute a Section 1031 I.R.C. exchange (referred to as a "Third Party"
exchange) of the Premises for real estate to be acquired by the Purchaser, provided,
however, that the Closing Date is not to be extended or delayed beyond April 2, 1981.

On April 8, 1981, an escrow agreement was entered into between the parties wherein
they agreed to place the cash proceeds of the sale of the Seminole Building into an
escrow fund for the purpose of facilitating a future contemplated purchase of real
property. That real property was then to go to the Plaintiffs. The Escrow Agreement
provided in pertinent part:

The Seller alone shall have the right to terminate this escrow prior to the use thereof for
purchasing the contemplated real property, but in any event this escrow shall terminate
one (1) year from date, and on termination, all assets on deposit shall be transferred to the
Southeast Bank, Trustee of Land Trust Number 665, and the Buyer and Escrow Agent
Shall thereafter be relived [sic] of this agreement

The Government points out in its memorandum of law that there is no explicit mention
in the Escrow Agreement of an intention to effectuate a Section 1031 like-kind exchange.

On or about April 13, 1981, the parties "closed" on the Seminole Building and title to
the property was transferred to Seminole Associates. From the proceeds of the sale one
million nine hundred eighty three thousand ($1,983,000.00) dollars was transferred into
the escrow account at Southeast Bank in accordance with the escrow agreement. At this
point in time, no property had been identified by the seller or purchaser as property to be
exchanged for the Seminole Building.

In June of 1981, H. Gordon Brown on behalf of the Trust offered to purchase the Grand
Union Supermarket in Fort Lauderdale, from an Alvin B. Lowe. The real estate
transaction closed on September 1, 1981. At the closing of the Grand Union property,
Trust No. 665, paid one hundred thousand ($100,000.00) dollars in cash to Lowe and
executed a purchase money mortgage for the remaining purchase price of nine hundred
thousand ($900,000.00) dollars. (It was stipulated to at the hearing for the motion for
summary judgment that the $900,000.00 cash which had been in escrow had been used to
purchase money market certificates).

In October of 1981, the Trust offered to buy and in November of 1981, did buy K-Mart
Property in Kingsford, Michigan, for a price of one million one hundred ninety-two
thousand ($1,192,000.00) dollars. The Southeast Bank disbursed fifty thousand
($50,000.00) dollars to assist in the purchase of that property. Beneficiaries to the Trust
took title to the K-Mart Property on either December 31, 1981, or sometime prior to
January 1, 1982.

Plaintiffs filed tax returns for the year 1981, and failed to report any gain realized on
the sale of the Seminole Building and it is the Plaintiff's contention that the transfers of
property qualified as like-kind exchange for which any tax on gain would be deferred
until a later time. The Internal Revenue Service assessed deficiencies which were paid by
the Plaintiffs in this case and the present litigation ensued.

STATEMENT OF THE LAW

Section 1031(a) of the Internal Revenue Code of 1954, states in pertinent part:

No gain or loss shall be recognized if property held for productive use in trade or
business or for investment * * * is exchanged solely for property of a like kind to be held
either for productive use in trade or business or for investment.

As pointed out in the Government's memorandum of law, the reason for the deferment
stems from the congressional recognition that in an exchange of like- kind property,
where the newly acquired property is used in a trade or business or is held for investment,
the taxpayer has not received a gain or suffered a loss in an economic sense. Rather, the
new property can be considered as substantially a continuation of the old investment
which has never been liquidated.

With the facts as previously stated and with that statement of law, the question before
the Court is whether or not an exchange took place within the meaning of Section 1031 or
whether the transaction which occurred was actually a sale and not a like-kind exchange.
Various factors must be looked at by the Court to determine whether or not there was, in
fact, a like-kind exchange or in actuality a sale of property which would then subject the
property owners to payment on taxable gains.

"The very essence of an exchange is the transfer of property between owners, while the
mark of a sale is the receipt of cash for property." Carlton v. United States [67-2 USTC P
9625], 385 F.2d 238, 242 (5th Cir.1967). The contemplated receipt of cash, however, is
not dispositive of the issue of the distinction between sale or exchange of property. While
there can be receipt of cash as a contingency in a like-kind exchange, there cannot be a
sale with receipted cash and then a future purchase of property unless there is an
integrated plan for purchase involving what has been termed as a "bullet-proof escrow
agreement". See Carlton, id.; Briggs v. Commissioner [81-1 USTC P 9114], 632 F.2d
1171 (5th Cir.1980); Swaim v. United States [81-2 USTC P 9575], 651 F.2d 1066 (5th
Cir.1981).

The wording of Section 1031 seems also to require simultaneity of the transfer of
property. This, however, is also not the case. Courts have granted leeway to the parties to
a like-kind exchange for the transfer of those properties to take place and in Starker v.
United States [79-2 USTC 9541], 602 F.2d 1341 (9th Cir.1979) it appears that the second
parcel of property was not exchanged until some five years later. In Starker, the Ninth
Circuit Court of Appeals approved the transaction of the tax free exchange in spite of a
lack of identification of the exchange property, nonsimultaneous acts and the fact that the
seller might receive cash. This Court finds that the Plaintiff's reliance on Starker is
misplaced. The pivotal point upon which this Court makes its recommendation to the
District Court, with respect to the case at bar, is the escrow account. The seller, in the
case at bar, had by virtue of the escrow agreement, unbridled discretion to terminate the
escrow prior to the use thereof for purchasing the "contemplated" real property. In
Starker, there was no escrow account to which the taxpayer had unrestricted access. In
addition, this Court finds from the stipulated facts that the funds in the escrow were not
actually used to acquire the Grand Union property. The Grand Union property was
purchased from cash in the form of a purchase money mortgage. This Court is not
persuaded by the Plaintiff's argument that the lawyer H. Gordon Brown "would not
permit the Beneficiaries of the Trust No. 665 to obtain any of the escrowed proceeds for
any reason other than obtaining exchange properties unless the tax purposes of the
transactions were totally frustrated". It appears from the written document in evidence in
this case that Brown could not have stopped the Beneficiaries of the Trust from
demanding the funds to be paid over to them from the escrow account without having
purchased like-kind property. The failure to make the escrow agreement "bullet proof" is
fatal to Plaintiffs' case.

Both parties, at oral argument, state that the best case in their respective favor is the
case of Earlene T. Barker, Petitioner, v. Commissioner of Internal Revenue, Respondent
[CCH Dec. 37,002], 74 T.C. 555 (June 1980). The facts of that case are very similar to
the facts of the case at bar. In Barker the Court states that:

The "exchange" requirement poses an analytical problem because it runs headlong into
the familiar tax law maximum that the substance of a transaction controls over form. In a
sense, the substance of a transaction in which the taxpayer sells property and immediately
reinvests the proceeds in a like-kind property is much different from the substance of a
transaction in which two parcels are exchanged without cash. Bell Lines, Inc., v. United
States [73-2 USTC P 9524], 480 F.2d 710, 711 (4th Cir.1973). Yet, if the exchange
requirement is to have any significance at all that perhaps formalistic difference between
two types of transactions must, at least on occasions engender different results. [emphasis
added] This Court cites with approval Starker v. United States, 602 F.2d 1341 [79-2
USTC P 9541], 1352 (9th Cir.1979).

The Barker Court goes on to say that:

... at some point the confluence of some sufficient number of deviations will bring
about a taxable result. Whether the cause be economic and business realities or poor tax
planning, prior cases make clear that taxpayers who stray too far, run the risk of having
their transactions characterized as a sale and reinvestment. At para. 74.42 P-H T.C. 74-
306.

The crucial language of Barker is that the parties must intend that there be a like-kind
exchange. Barker goes on to state:

Consonant with this intent, the essence of the agreements among the parties was that
petitioner would exchange the Demion property for the Casa El Camino property rather
than have the petitioner sell the Demion property and reinvest the proceeds. This was
accomplished through contractual arrangements which were such that petitioner did not
nor could not obtain actual or constructive receipt of the cash proceeds from the sale of
the Demion property to Goodyear.

The Barker case also requires mutually interdependent contracts which are part an
integrated plan to specifically earmark funds for particular like-kind exchangeS of
property. This airtight escrow agreement is totally lacking in the case at bar and for that
reason this Court finds that the exchange which took place was such as to render the
transaction a sale of property and not a like-kind exchange. Again citing Barker: Under
the Commissioner's administrative position, an exchange can be effected through an
escrow account as long as the taxpayer cannot obtain use of the escrow monies. Rev.Rul.
77-297. Since the money paid into escrow here was earmarked for the Casa El Camino
property and could never be made available to petitioner under the terms of the escrow
agreements, this transaction meets the requirements of like-kind exchange.

Based on the foregoing finding of facts and the conclusions of law, this Court
respectfully recommends to the District Court that judgment be entered for the
Defendant, the United States of America.

ESCROWS
HAYDEN

Escrows with multiple parties, not necessarily non-simultaneous, are illustrated by the
following cases.

DICK R. HAYDEN and Yvonne I. Hayden, Plaintiffs


v.
United States of America, Defendant.

82-2 USTC Para. 9604 (1981)


KERR, District Judge.

Findings of Fact and Conclusions of Law

The above-entitled matter coming on regularly for hearing before the Court, plaintiffs
appearing by and through their attorneys, Lawrence A. Yonkee and Thomas C. Toner,
and defendant appearing by and through its attorney, Bruce I. Crocker, and the Court
having heard the evidence adduced for and on behalf of the plaintiffs, and the evidence
offered for and on behalf of the defendant, and having taken said matter under
advisement, and having carefully considered the pleadings, testimony and exhibits
relevant and material to the matters in dispute, and the memoranda submitted by counsel
in support of their respective theories of the case, and the Court being fully advised in the
premises makes the following Findings of Fact and Conclusions of Law:

Findings of Fact

1. This case comes before the Court upon a denial of a tax refund
claim by the Internal Revenue Service in the amount of
$30,782.66.
2. DICK R. HAYDEN (HAYDEN) and Yvonne I. Hayden are
husband and wife and are residents of Gillette, Wyoming. Prior
to 1974, Hayden's father conveyed an undivided one-seventh
remainder interest to Hayden and his six brothers and sisters in
some grazing land in Campbell County, Wyoming. The
remainder interests of the children were subject to the life estate
of the father.
3. The lands above-described were part of the Hayden family
ranch. The ranch was rented to one of Hayden's brothers, who
raised livestock on the ranch. Several members of the Hayden
family, including the plaintiff, engaged in farming and ranching.
4. Sun Oil Company (Sun) owned property which was contiguous
to the property owned by the seven children subject to their
father's life estate. In 1974, Sun began to negotiate with the
Hayden family to purchase their property. Sun was interested in
mining coal on the property.
5. On December 26, 1974, a Contract for Deed for 1,825 acres was
executed between Sun and the Hayden family. The total sale
price was $2,190,000.00. Of that amount, $68,606.00 was paid
to the father as the holder of the life estate and each child
received $21,484.00 as a down payment.
6. The contract further provided for a balance due and owing to
each of the children in the sum of $193,364.00. Options were
available to each seller regarding the balance. Specifically the
contract provided that:
Each Seller shall individually have the right to independently
elect one of the options contained in this paragraph for the
payment of his or her respective share of the balance of the
purchase price. The election for payment can be made after
February 1, 1975, or forty-five (45) days after the abstracts are
furnished to Buyer as provided in Article VIII hereof,
whichever date is later, by giving written notice to the Buyer.
The notice shall be given by registered mail, return receipt
requested on or before January 1, 1976. Each Seller shall have
the option to individually elect one of the following plans, to-
wit:
a. If said Seller should find another parcel or parcels of real
property that said Seller desires to acquire and that the owner
is willing to sell, then Seller shall make all arrangements
necessary for the purchase of such property for cash
including, but not limited to, approval of title by Seller and
closing through a licensed real estate broker or attorney and
upon not less than fifteen (15) days' notice by registered mail,
at the time of closing Buyer agrees to acquire such property
and to convey the interest thus acquired by Buyer to Seller in
exchange for the land the Buyer is purchasing under this
agreement, in lieu of the balance hereinabove provided, and
in the event there is a difference between the price that the
Buyer must pay to obtain the parcel of real property from the
third party, and the balance owing by Buyer to said Seller
under this agreement, then a proper cash adjustment shall be
made between the parties at the time of closing. It is the
intent of the parties that necessary and reasonable costs
incurred by Buyer with respect to the purchase of such real
property shall be charged against said balance.
b. A Seller shall have the right to demand cash payment of the
balance of the purchase price and Buyer shall make cash
payment within thirty (30) days of the date of such demand,
said demand to be made by registered mail, return receipt
requested, and
c. If any Seller does not make an election in writing on or
before the first day of January, 1976, then the Buyer shall pay
the balance of the purchase price owed to said Seller in cash
on or before January 31, 1976, and
d. The unpaid balance of the purchase price due each Seller
shall bear interest at the rate of seven percent (7%) per
annum, said interest to commence as of the date of this
agreement, and thereafter and said interest shall be paid on
the date of settlement with each Seller.
7. Hayden requested that his portion of the contract contain the
option to have other parcels of land purchased for him. It is clear
and the government concedes that Hayden's intent was to qualify
for a like-kind exchange under s 1031 of the Internal Revenue
Code.
8. A warranty deed was also signed on December 26, 1974. The
deed was deposited at the Stockmens Bank in Gillette, Wyoming
in an escrow account. The instructions were clear that the deed
was to remain in escrow until all of Sun's obligations to the
Sellers were satisfied. The instructions read in pertinent part as
follows:
3. The parties have agreed that Stockmens Bank, Gillette,
Wyoming, shall be the agent of the Sellers to receive all
payments to be made by the Buyer to Sellers, and upon
receipt of such payments, you are directed to deposit the
same to the credit of the respective Seller, and to notify the
Seller of the receipt of such payment.
4. If any Seller elects to accept a transfer of real estate, as herein
mentioned, the parties do agree that immediately after such
transfer is completed, they shall notify the escrow agent in
writing of the satisfaction and discharge of Buyer's obligation
to such Seller.
5. You are directed to hold the Warranty Deed in your
possession and upon final payment of all the purchase money
due and owing by Buyer to Sellers, and upon satisfaction and
discharge of Buyer's obligation to each Seller for the
purchase price then, you are authorized and instructed to
deliver the Warranty Deed to the Buyer or its successors in
interest.
9. After the execution of the contract, Hayden examined several
properties in Campbell, Johnson and Platte counties with the
intent to have Sun buy them under the contract. For various
reasons none of the properties were satisfactory to Hayden.
10. On March 24, 1975, Hayden sent a letter to Sun requesting
payment of $93,364.00. The remaining balance due and owing to
Hayden was $100,000.00.
11. For years Hayden had been in a business partnership with
Donald Wagensen (Wagensen). The partnership was engaged
primarily in the livestock business. One of the assets of the
partnership was a 19-acre tract of land in the city of Gillette.
12. Wagensen retired from the partnership, valuing his half of the
19-acre tract at $75,000.00. On December 31, 1975, Hayden
wrote a letter to Sun requesting that Sun buy the property from
Wagensen pursuant to the contract between Hayden and Sun.
13. On January 26, 1976, a deed conveying the Wagensen undivided
one- half interest to Sun was executed. Sun then conveyed the
deed to Hayden, who recorded it on January 29, 1976. Sun also
paid Hayden the remaining $25,000.00 plus interest after the
Wagensen interest was conveyed.
14. On January 29, 1976, Hayden notified the escrow agent at the
Stockmens Bank in Gillette, Wyoming that $75,000.00 of the
obligation due and owing from Sun to Hayden had been satisfied
by the transfer of the Wagensen property.
15. All of Sun's obligations to the Hayden family were satisfied in
1976. The deed to the Hayden property was delivered by the
escrow agent to Sun and Sun recorded it on June 4, 1976.
16. After an audit of the Haydens' 1976 tax return, the Internal
Revenue Service made an assessment against the Haydens in the
amount of $26,410.00 together with accrued interest and
penalties. On October 12, 1979, the Haydens paid the full
amount, totalling $30,782.66 at that time.
17. On December 24, 1979, the Haydens filed a claim for a refund.
The claim was based upon s 1031 of the Internal Revenue Code,
the like-kind exchange provision. The claim for refund was
disallowed in full on July 18, 1980. A Complaint was then filed
in this Court on August 13, 1980.

Conclusions of Law

2. In analyzing a transaction that is potentially covered by s 1031,


the transaction is to be viewed as a whole. Consideration is to
be given to the question of whether or not the transactions are
mutually dependent upon each other or if they are separate.
Bell Lines, Inc. v. United States [73-2 USTC P 9524], 480 F.
2d 710 (4th Cir. 1973); Red Wing Carriers, Inc. v. Tomlinson
[68-2 USTC P 9540], 399 F. 2d 652 (5th Cir. 1968).
3. The transactions in this case, the sale of the Hayden ranch
property in exchange for the Wagensen property plus cash,
were mutually dependent transactions. One would not have
occurred without the other.
4. The intent of the taxpayer to qualify for s 1031 is irrelevant.
The issue is strictly whether the transactions in question
qualify for the section. Biggs v. C. I. R. [81-1 USTC P 9114],
632 F. 2d 1171 (5th Cir. 1980); Halpern v. United States [68-1
USTC P 9308], 286 F. Supp. 255 (D. C. Ga. 1968); Carlton v.
United States [67-2 USTC P 9625], 385 F. 2d 238 (5th Cir.
1967).
5. The contract between Sun and Hayden contained a provision
that the option to take either real estate or cash expired 2 years
after the contract was signed. The transaction in question took
place well within that time frame.
6. None of the $75,000.00 in question was received by Hayden in
the form of cash. Taxes were paid on all cash received.
7. Sun Oil Company received legal title to the Wagensen
property. The company then transferred its legal title to the
property to Hayden. Alderson v. C. I. R. [63-2 USTC P 9499],
317 F. 2d 790 (9th Cir. 1963).
8. This case is factually similar to Mercantile Trust Co. v. C. I. R.
[CCH Dec. 8888], 32 B. T. A. 82, and to Alderson v. C. I. R.,
supra. In the former case, the taxpayer was to receive cash in
the event that the exchange of property for property could not
take place. The exchange did take place and a title company
took the role that Sun took in the current action. The tax court
held that a s 1031 transaction had occurred. In Alderson, the
agreement between the parties was amended to contain an
option similar to the one in the Hayden-Sun contract. The
Court held that a s 1031 exchange had taken place.
10. The transaction in question does not entail a sale and
repurchase. Viewed as a whole, with a close inspection of
what really transpired, the transaction was a like-kind
exchange as described in s 1031.

Judgment will be entered in accordance with these Findings of Fact and Conclusions of
Law.

GIBSON

The question in this case was to review whether a transaction by the taxpayers
involving a sale and reinvestment could come within Code §1031.

Factually, the taxpayers and others had a partnership involved in investment lots at
Snowmass, Colorado. This property was sold on May 1, 1976, for cash. Magic Lands
partnership purchased, also for investment purposes, an improved piece of ground in
California. This property was paid for with cash and a note.

Upon the sale of the Snowmass property, the purchasers paid the purchase price to an
escrow agent in Colorado. This money was transferred by that agent to a wholly different
escrow agent in California, through which the property in California was purchased.
These monies in escrow, which were moved out of Colorado and moved into California,
were used as a down payment by Magic Lands for the California property.

The Court held that the record does not show that the cash transferred by the Colorado
escrow agent to California escrow was not available to Magic Lands, or was not subject
to Magic Lands' full control prior to the transfer. Therefore, the Court held that such
activity was actually a sale and a reinvestment and not an exchange within Code §1031.
The escrow did not save the situation. The use of Code §1031 was denied, and the
taxpayers were forced to recognize the gain. This was true even though the reinvestment
in the California property followed very quickly relative to the Snowmass transfer.

STUART L. GIBSON and GRETCHEN B. GIBSON, Petitioners


v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
T. C. Memo. 1982-342

MEMORANDUM FINDINGS OF FACT AND OPINION

RAUM, Judge:
The Commissioner determined income tax deficiencies against petitioners Stuart and
Gretchen Gibson in the amounts of $1,716 and $985 for 1976 and 1977, respectively.
After concessions, the issues for decision are: (1) Whether a disposition of one
investment property in 1976 and acquisition of another such property in 1976, by a
partnership in which petitioners had a one-half interest, qualifies as an "exchange" under
section 1031, I.R.C. 1954, with the result that petitioners may defer recognition of a
portion of their share of the gain realized on the disposition.
FINDINGS OF FACT

Some of the facts have been stipulated. The stipulation of facts and attached exhibits
are incorporated herein by this reference.

At the time the petition was filed, petitioners, husband and wife, resided in Irvine,
California. They timely filed joint Federal income tax returns for the taxable years ended
December 31, 1976, and December 31, 1977.

In 1972, petitioners and another couple formed an equal partnership called


"Magiclands", and on November 1, 1972, Magiclands purchased for investment purposes
a lot at Snowmass, Colorado (the Snowmass property), which was improved only by
utility connections and a paved road. This property was sold, on May 1, 1976, to Stewart
and Romayne Dixon (the Dixons) entirely for cash. On July 21, 1976, Magiclands
purchased, also for investment purposes, an improved parcel in Irvine, California (the
Irvine property), from the Standard Pacific Corporation. This property was paid for with
cash and a note.

Upon sale of the Snowmass property, the Dixons paid $14,000 of the $49,700 purchase
price to an escrow agent in Colorado. This money was transferred by that escrow agent to
a wholly different escrow agent in California, through which the Irvine purchase was
being consummated, and was used as the down payment by Magiclands on the Irvine
purchase. When the latter escrow account was closed, $1,530.35 of this amount was
refunded to Magiclands.

The Dixons and Standard Pacific Corporation were not shown to have any connection
with one another, nor was there any agreement between them or any other parties
(including the escrow agents) to cast the sale of the Snowmass property and the purchase
of the Irvine property in the form of an exchange rather than a sale and a wholly
independent subsequent purchase. The record does not show that the cash transferred by
the Colorado escrow agent to the California escrow was not available to Magiclands or
was not subject to Magiclands' full control prior to such transfer.

On their 1976 income tax return, petitioners excluded from income their entire share of
Magiclands' gain on the disposition of the Snowmass property. In the statutory notice of
deficiency, the Commissioner determined that this gain must be included in petitioners'
income in 1976.

On January 31, 1977, petitioners leased a new 1977 Volvo automobile from Cenval
Leasing (Cenval) for a period of 36 months. It was stipulated at trial that the automobile
was used 80 percent for business purposes. The lease agreement identified Cenval as the
"Assignee" of Earle Ike Imports, which in turn was identified as the "Dealer/Lessor".
While the agreement does not clarify these terms, it appears that Cenval purchased the
automobile from Earle Ike Imports and leased it to petitioners, whose payments under the
lease were made to Cenval. By the due date of petitioners' 1977 Federal income tax
return, neither Cenval nor Earle Ike Imports had issued a statement to petitioners electing
to treat petitioners as the first users of the automobile for purposes of the investment tax
credit. No credit was claimed on petitioners' 1977 tax return in respect of this lease, and
the issue was not raised in the original petition in this case. Instead, petitioners claimed
entitlement to this credit in an amendment to their petition, which amendment was
permitted pursuant to Rule 41(a), Tax Court Rules of Practice and Procedure.

OPINION

1. Section 1031 Exchange. As a general rule, all gain or loss on the sale or exchange of
property must be recognized. Section 1002, I.R.C. 1954. [FN2] Under section 1031(a),
[FN3] gain or loss is not recognized if property is exchanged solely for other property of
a "like kind". If the exchange is not solely for like kind property, but includes other
property or money, then gain is recognized to the extent of the money and the fair market
value of the other property received. Section 1031(b). [FN4]

No issue is raised here as to whether the Snowmass and Irvine properties were of a like
kind; instead, we have only to consider whether the transaction in question was an
"exchange", as opposed to a sale of one property and purchase of another. Petitioners
apparently concede that to the extent Magiclands retained the cash received from the
Dixons for Snowmass, they must recognize their gain on the disposition. It is their
position, however, that the transfer of a portion of the sales proceeds directly from the
sales escrow agent to the purchase escrow agent transformed the transactions into a
section 1031(b) exchange, with the result that a corresponding portion of their gain on the
disposition is not recognized.

It is true that taxpayers have been allowed a great deal of flexibility in structuring a sale
and an otherwise unrelated purchase as an "exchange" which may receive nonrecognition
treatment under section 1031. * * * * Nevertheless, a prerequisite for qualification as a
like kind exchange is the presence of an exchange; it is not enough that property is sold
and the proceeds rapidly reinvested in comparable property. See Barker v. Commissioner,
74 T.C. 555, 560-561 (1980). In Carlton v. United States, 385 F.2d 238 (5th Cir. 1967),
the transaction in question was planned as an exchange, but was executed as a sale of the
taxpayer's property with reinvestment of the proceeds by the following day. The court
held that section 1031 was inapplicable, saying (385 F.2d at 242):

The very essence of an exchange is the transfer of property between owners, while the
mark of a sale is the receipt of cash for the property, * * * Where, as here, there is an
immediate repurchase of other property with the proceeds of the sale, that distinction
between a sale and exchange is crucial.

In this case, the record fails to show that the disposition of one property and acquisition
of another was even contemplated as an exchange. Instead, it seems apparent that the
Snowmass property was simply sold to the Dixons for cash. For reasons not made clear
by the record, a portion of the sales proceeds was paid into escrow by the Dixons. The
taxpayers have introduced no evidence in respect of the terms of the escrow agreement;
in particular, there has been no convincing showing that the taxpayers, through
Magiclands, could not have received the escrow money at their discretion. Compare
Barker v. Commissioner, supra, 74 T.C. at 564. The escrow money was in fact transferred
directly from the Snowmass escrow agent to the Irvine escrow agent and most of it was
used as a deposit on the Irvine property. This fact, however, standing alone, is insufficient
to convert into an exchange what was clearly a sale of one property followed by a
purchase of another property. As far as we know, petitioners' control over this money was
"unfettered and unrestrained", and this characterization of the transaction is unaffected by
the decision to reinvest the money in other property. Carlton v, United States, supra, 385
F.2d at 243.

In support of their contention that they are entitled to section 1031 treatment,
petitioners rely upon Rev. Rul. 77-297, 1977-2 C.B. 304, in which, they claim, the
Commissioner has ruled "that an exchange can be effected through an escrow account as
long as the taxpayer cannot obtain use of the escrow monies that are to be transferred to
another escrow". Regardless of whether petitioners correctly interpret Rev. Rul. 77-297,
but cf. Barker v. Commissioner, supra, 74 T.C. at 567-568, this argument does not further
their cause, for, as noted above, they have not demonstrated that the money held in
escrow was unavailable to them. Moreover, in Rev. Rul. 77-297, the potential purchaser
of the taxpayer's property actually acquired the property which the taxpayer desired to
obtain, and then in fact exchanged it for the taxpayer's property. That situation stands in
sharp contrast to the instant case, where funds which were clearly sale proceeds were
simply paid into one escrow and later transferred to an entirely different escrow to be
used in the purchase of other property.

We hold that section 1031 is inapplicable to the sale of the Snowmass property and
purchase of the Irvine property. [FN5] Petitioners must therefore include their entire
distributive share of the gain from the Snowmass sale in their gross income for 1976.

FN5. We note that the facts in this case are strikingly similar to those in Meadows v.
Commissioner, T. C. Memo. 1981-417. In that case, we also held that sec. 1031 does not
apply simply because some sale proceeds are transferred directly from the sale escrow
account to the purchase escrow account.

GARCIA

In the Phillip Garcia case, a 1983 Tax Court decision, the Court was asked to address
the issue as to whether Code §1031 would apply where there were integrated exchange
plans and cash involved.

Factually, the Taxpayers, the Garcias, resided in California and were undertaking the
possibility of exchanges of property in California. There were a series of transfers made
through the use of escrow arrangements. There was also cash involved in the
transactions.

Inasmuch as the closings were simultaneous in nature, interdependent, and there was no
constructive receipt of cash by the taxpayers, there was no boot received. In addition,
there was an assumption of debt which had independent economic substance, stated the
Court, notwithstanding that the debt was created at Petitioner's request. Therefore, the
Court held that there was no boot because of debt relief and no constructive receipt of
cash.

PHILLIP M. GARCIA and DEBORAH H. GARCIA, PETITIONERS


v.
COMMISSIONER of INTERNAL REVENUE, RESPONDENT
80 T.C. 491, 80 T.C. 80

HAMBLEN, Judge:

(1) Whether petitioners' disposition of one parcel of real property


and acquisition of another qualified as a like-kind exchange
under section 1031(a). [FN1]
(2) If so, whether petitioners must recognize any gain on the
exchange under section 1031(b).

FINDINGS OF FACT

All of the facts have been stipulated and are found accordingly.

Petitioners Phillip M. GARCIA and Deborah H. GARCIA, husband and wife, resided
in Long Beach, Calif., when they filed their 1977 joint Federal income tax return with the
Internal Revenue Service Center, Fresno, Calif., and when they filed their petition in this
case.

As of July 1977 and prior thereto, petitioners owned residential real property located at
163 and 1631;2 St. Joseph in Long Beach, Calif. (hereinafter referred to as the St. Joseph
property), which they held as rental property. In 1977, they decided to dispose of the St.
Joseph property and discovered that Nicholas Farnum and Peter O. Philpott (hereinafter
referred to as Farnum and Philpott) were interested in purchasing the property. Rather
than selling the property to Farnum and Philpott, however, petitioners wanted to effect an
exchange of the St. Joseph property for other like-kind property so as to qualify for
nonrecognition of gain under section 1031. Since Farnum and Philpott did not own any
property petitioners were interested in acquiring, the parties had to locate property for
which petitioners would be willing to exchange the St. Joseph property. Consequently,
petitioners and Farnum and Philpott established escrow No. 1285-ST with the
Transpacific Escrow Corp. (hereinafter referred to as Transpacific). Pursuant to the
escrow agreement, petitioners agreed to sell, and Farnum and Philpott agreed to purchase,
the St. Joseph property for $140,000. In addition, Farnum and Philpott promised to
cooperate with petitioners in structuring a tax-deferred exchange of properties under
section 1031. The escrow agreement gave Farnum and Philpott the option to cancel the
escrow if a suitable exchange property was not located within 60 days of the date thereof.
Suitable property for the exchange was found at 2042 Pine (hereinafter referred to as
the Pine property) in Long Beach, Calif. Such property was residential real property
owned by Barton H. Colombi and Hoyte E. Hayden (hereinafter referred to as Colombi
and Hayden). To accomplish the petitioners' exchange of the St. Joseph property for the
Pine property, a series of transfers was made through the use of escrow agreements.
These transfers involved not only the St. Joseph and Pine properties, but also a third
property located in Hollydale, Calif. (hereinafter referred to as the Garfield property),
owned by Domino, Eleana, Salvatore J., and Alice E. Grillo (hereinafter referred to as the
Grillos). The Garfield property was included in the transaction because Colombi and
Hayden wanted to acquire such property. [FN2]

In addition to escrow No. 1285-ST, two other escrows (escrow No. 1308-ST and
escrow No. 1406-ST) were established with Transpacific in order to consummate the
transaction. Pursuant to escrow No. 1308-ST, dated August 3, 1977, petitioners agreed to
transfer the St. Joseph property to Colombi and Hayden in exchange for the Pine
property. Thereunder, petitioners were listed as the buyers, and Colombi and Hayden
were listed as the sellers. The escrow agreement stated that the St. Joseph and Pine
properties had a value of $140,000 and $143,000, respectively, and were subject to
encumbrances of $107,000 and $75,000, respectively. [FN3] In addition, it provided that,
when Colombi and Hayden transferred the Pine property to petitioners, it would be
subject to a new deed of trust in the amount of $107,200. Any difference between each
party's equity in his respective property prior to closing would be satisfied by a cash
payment. The escrow was scheduled to close on or before November 1, 1977. Its closing,
however, was made contingent upon the concurrent closing of escrow No. 1285-ST.

With respect to the participation of Colombi and Hayden in the exchange, escrow No.
1308-ST stated as follows:

The Second party agree [sic] to execute all instructions and documents necessary to
close escrow No. 1285 as Seller although all costs that are charged to the second party as
seller shall be credited to second party in this escrow No. 1308. It is understood that the
second party (Colombi and Hayden) shall be at no additional expense due to the
exchange other than normal fees to seller on the second property (2042 Pine).

The first party agrees to pay all fees incurred in the sale of the first property [St. Joseph
property].

To comport with the transfer of the St. Joseph property to Colombi and Hayden under
escrow No. 1308-ST, escrow No. 1285-ST was amended to substitute Colombi and
Hayden for petitioners as the sellers of the St. Joseph property thereunder. The
amendment was dated August 5, 1977, and provided as follows:

Due to the exchange escrow No. 1308-ST, it is understood that you will record a grant
deed on this subject property from Phillip M. GARCIA and Deborah H.GARCIA to
Barton H. Colombi, a single man and Hayt [sic] Hayden, an unmarried man and the
following parties shall be shown as seller of this property:
Barton H. Colombi and Hayt [sic] Hayden

It is understood that Colombi and Hayden shall be at no additional expense as seller of


this property and is only to accomodate [sic] the exchange escrow. Any fees shown as a
charge in this escrow to Colombi and Hayden shall be credited back to said party in
Escrow No. 1308-ST.

Sometime prior to the closing, Colombi and Hayden decided that they wanted to
acquire the Garfield property and attempted to structure the acquisition of that property as
an exchange of the Pine property for the Garfield property which would qualify for
nonrecognition of gain under section 1031. Therefore, pursuant to escrow No. 1406-ST,
dated September 17, 1977, Colombi and Hayden agreed to transfer the Pine property and
$40,000 in cash to the Grillos in exchange for the Garfield property. The escrow
agreement provided that the Pine and Garfield properties would be transferred subject to
deeds of trust in the amounts of $107,200 and $78,526, respectively. In addition, the
agreement provided that the Garfield property would be transferred subject to a land
contract executed by Colombi and Hayden to the Grillos in the amount of $180,000 with
an unpaid principal balance of $140,000. The escrow provided that it would close and the
properties would be exchanged on or before November 1, 1977. Its closing, however, was
made contingent upon the concurrent closing of escrow No. 1285-ST and escrow No.
1308-ST.

With respect to the exchange of the Pine property for the Garfield property, escrow No.
1406-ST stated as follows:

The parties are entering into this escrow for the purpose of the second party [Colombi
and Hayden] obtaining [the] benefit of Section 1031 of the Internal Revenue Code.
Escrow holder is released of all liability of said escrow qualifying for said Section. The
Third party [Grillos] agrees to execute all documents pertaining to the Second property
[Pine property] which is sold in escrow No. 1308 as the seller of said property and is to
be at no additional expense other than the sale of the third property which is 12001 to
12017 Garfield, Hollydale, California.

On the same date that they established escrow No. 1406-ST, September 17, 1977,
Colombi and Hayden and the Grillos entered into an installment sale land contract.
Thereunder, Colombi and Hayden agreed to pay a purchase price of $180,000 for the
Garfield property as follows: $40,000 downpayment and the balance of the purchase
price of $140,000, with interest on any unpaid balance at a rate of 9.5 percent per annum,
payable in installments of $1,200 per month from December 1, 1977, until November 1,
1992, at which time the principal balance and interest thereon would be due. The Grillos
agreed to make the payments on the existing first deed of trust on the property.

On November 1, 1977, all three escrows closed simultaneously and the following grant
deeds were recorded:
Therefore, once the terms of the escrow agreements were fulfilled, petitioners received
title to the Pine property, and Farnum and Philpott received title to the St. Joseph
property. When petitioners took title to the Pine property, it was subject to a first deed of
trust in the amount of $100,000 and a second deed of trust in the amount of $7,250, for a
total of $107,250. [FN5] Petitioners transferred the St. Joseph property subject to total
liabilities in the amount of $106,463.33. [FN6]

The total purchase price of the St. Joseph property was $140,000. Prior to closing,
Farnum and Philpott deposited $32,400 in escrow No. 1285-ST and obtained a $112,000
loan from American Savings & Loan Association, Huntington Beach, Calif. [FN7] After
paying the first and second mortgages on the St. Joseph property, closing costs, and other
miscellaneous expenses, the proceeds due to the seller from escrow No. 1285-ST equaled
$31,086.43. These proceeds were transferred by a draft from Transpacific dated
November 2, 1977, drawn from escrow No. 1285-ST and payable to the order of
"Transpacific Escrow Corporation credit Escrow No. 1308-GARCIA." A voucher
attached to the draft stated only the following: "Transfer of funds to Escrow 1308 for
account of GARCIA exchange escrow."

OPINION

We must decide whether petitioners' disposition of the St. Joseph property and
acquisition of the Pine property constituted an exchange which qualifies for
nonrecognition of gain under section 1031. [FN9]

Petitioners maintain that the substitution of the Pine property for the St. Joseph property
constituted a qualified exchange. Respondent asserts that the transactions must be instead
classified as an unqualified sale of the St. Joseph property coupled with a reinvestment of
the proceeds therefrom in the Pine property. We find that a qualified exchange occurred
here.

In making this determination, the steps taken to accomplish the end result must be
considered as well as the result itself. The substance of the transaction, rather than its
form, must govern the tax consequences.

The parties' intent often has been considered in evaluating the true substance of a
purported exchange transaction. Intent alone does not determine tax consequences, and
the bare fact that a taxpayer desires to fall within a particular section of the Internal
Revenue Code is not controlling where actions belie expressed intent. See Smith v.
Commissioner, 537 F.2d 972 (8th Cir. 1976); Carlton v. United States, 385 F.2d 238 (5th
Cir. 1967). Nonetheless, stated intent has received deference where parties have acted
consistently therewith. The possibility that intent may be thwarted has not deterred a
finding of section 1031 application where, in fact, such possibility did not materialize and
an exchange actually occurred.

Thus, in Mercantile Trust Co. of Baltimore v. Commissioner, 32 B.T.A. 82 (1935), a


qualified exchange was found despite a taxpayer's retention of the right to require cash
payment if the other party to the exchange was unable to acquire for exchange an
identified property desired by the taxpayer. The Board did not deem the possibility of a
sale fatal to a finding of an exchange where the conditions required to animate an intent
to exchange had been met. The Board stated:

The * * * agreement * * * evidenced an intention to exchange the [taxpayer's] property,


if certain conditions were met, and to sell it, if those conditions were not met. Those
conditions were met The property was, in fact, exchanged. That fact is controlling here *
* * [32 B.T.A. at 87.]

Cases decided since Mercantile Trust Co. of Baltimore have followed the pattern of
ignoring alternative sales possibilities where a preference for exchange was manifest and
exchange actually occurred. E.g., Starker v. United States, 602 F.2d 1341 (9th Cir. 1979);
Smith v. Commissioner, supra; Coastal Terminals, Inc. v. United States, 320 F.2d 333
(4th Cir. 1963); Carlton v. United States, supra (agreement with principle, although result
to contrary due to form of payment).

The facts of the instant case fit squarely within this expression of a qualified exchange.
Both "before and throughout the executory period," the petitioners "preferred property to
cash." This is clear from the language of the original escrow agreement for the sale of the
St. Joseph property which contained the provision that "Buyer[s] [were] to cooperate with
seller[s] for a tax deferred exchange under Section 1031 of the Internal Revenue Code."
The location of the Pine property and the entry by the petitioners into the subsequent
escrow agreement, which required the conveyance of this property to them, were
consistent with their expressed intent.

However, notwithstanding petitioners' intent, the second clause of the Starker standard,
i.e., that "only like-kind property is ultimately received," is in dispute. Respondent argues
that, in addition to the Pine property, cash has been received by the petitioners due to
Farnum and Philpott's deposit into escrow No. 1285-ST of $32,400 in earnest money and
that these funds, $31,086.43 of which was transferred by the escrow agent to the
petitioners' account in exchange escrow No. 1308-ST, were constructively received by
the petitioners.

BRAUER

In Brauer, the Tax Court was faced with the issue of whether multiple parties can be
involved in interdependent transactions, meeting the substance of Section 1031, without
necessarily meeting the form, and qualifying under §1031(a).

In summary, the taxpayer, Brauer, owned the property known as the St. Charles farm.
This was purchased in 1968 and was available for sale by the taxpayer in 1974. Stealey
Realty listed the St. Charles farm in 1974.

Tochtrop owned a 10-acre piece of property, known as the Commercial (C) property in
this case. Tochtrop agreed to transfer his 10-acre parcel to a real estate company, who
was really the commissioned party involved, Milor Realty of St. Louis. The taxpayer,
Brauer, did not have an interest in acquiring the 10-acre tract.

Milor also agreed to buy the St. Charles property from the taxpayer. Tochtrop was
interested in acquiring the St. Charles property.

The revisions occurred when the taxpayer, Brauer, was to transfer his property. He
determined that an exchange would be beneficial to him and set about negotiating this
change in circumstances.

Brauer then determined that there was a property in Missouri, known as the Gasconade
property, owned by Franz. Brauer desired to exchange for this property.

To facilitate the transaction, Milor Realty was to acquire the Gasconade property and
exchange it with the taxpayer for the St. Charles property. However, Milor did not act at
this time because of a death of a party in that firm. Oney, an employee of Stealey Realty,
agreed to acquire the Gasconade property and to facilitate the transaction. However,
Oney hesitated in acquiring the property because of questions as to title of the same.
Therefore, Oney assigned his Gasconade contract to Milor Realty, Milor now agreeing to
act. However, with certain title issues, Milor assigned its contract to the taxpayer. Milor
did not receive the deed from Franz on the Gasconade property. Franz then conveyed that
property to the taxpayer. The taxpayer conveyed the St. Charles property to Milor. Milor
in turn conveyed that property to Tochtrop for the 10-acre commercial property.

There was a title company acting as disbursing agent and issuing a number of checks on
the transaction.

The government's position was that the transactions were not interdependent
transactions, and Section 1031 was not met.

Judge Drennen held that the intent was clear, and that substance, and not the form,
should control. The Court cited the recent cases of Biggs and Barker and held for the
taxpayer on a Section 1031 transaction.

The Court addressed a number of questions, such as the assigning of the contract right
to purchase, as opposed to the legal title. Citing Biggs, the Court held that this did not
create a problem for the taxpayer. Further, the Court held that it did not matter that the
taxpayer had initially helped finance the acquisition of the property which he ultimately
received.

The Court particularly emphasized that the taxpayer endorsed certain checks but never
had control and dominion over the checks and monies; there was no boot received by the
taxpayer, even though a number of checks and monies were involved in the escrow
agent's closing of the transaction.
ARTHUR E. and GLENDA BRAUER, PETITIONERS
v.
COMMISSIONER of INTERNAL REVENUE, RESPONDENT
74 T.C. 1134 (1980)

DRENNEN, Judge: Respondent determined a deficiency of $19,385 in petitioners'


income tax for the taxable year ended December 31, 1974.

Due to concessions, the only issue for decision is whether petitioners' transfer of their
interest in a 239-acre farm and acquisition of a 645-acre farm constituted an exchange
which qualifies for nonrecognition of gain, except to the extent of boot, under section
1031, I.R.C. 1954. [FN1]

FINDINGS OF FACT

Some of the facts were stipulated and are so found. The stipulation of facts, together
with the exhibits attached thereto, is incorporated herein by this reference.

Petitioners ARTHUR E. BRAUER and Glenda Brauer (hereinafter petitioners),


husband and wife, resided in St. Louis, Mo., when they filed their petition in this case.
They filed a joint Federal income tax return for 1974 with the Internal Revenue Service
Center, Kansas City, Mo.

In 1968, petitioners purchased, as tenants by the entirety, 239 acres of farmland located
in St. Charles County, Mo. (hereinafter St. Charles farm).

On February 22, 1974, petitioners entered into a 6-month exclusive-listing agreement


with Stealey Building & Realty Co. (hereinafter Stealey Realty) for the sale of the St.
Charles farm at a total purchase price of $298,750 ($1,250 per acre). In the event the
property was sold, Stealey Realty was to receive a 6-percent commission.

Stealey Realty located a group of individuals, Henry Tochtrop, Walter Tochtrop, and
Geraldine Kerkemeyer (hereinafter Tochtrop group), who were interested in acquiring the
St. Charles farm. The Tochtrop group owned a commercially zoned 10-acre tract which it
wanted to exchange for petitioners' farm. Milor Realty Co. of St. Louis (hereinafter Milor
Realty) was interested in acquiring the 10-acre tract owned by the Tochtrop group.
Petitioner had no interest in acquiring this 10-acre tract. The Tochtrop group and Milor
Realty, therefore, executed a contract under which the Tochtrop group agreed to transfer
its 10-acre tract, plus cash, to Milor Realty in exchange for the St. Charles farm, which
Milor Realty agreed to acquire from petitioners.

On March 15, 1974, petitioners entered into an unconditional contract to sell the St.
Charles farm to Milor Realty for the price of $298,750, payable $5,000 as an earnest
deposit, $248,900 in cash at closing, and by Milor Realty's assumption of a $44,850 deed
of trust on the property. Closing was set for May 8, 1974. The contract specified that a
commission of $15,425 was to be paid to Stealey Realty, and one of $2,500 was to be
paid to Sandfam Corp. (a corporation owned by an agent of Milor Realty). This contract
was expressly approved by the Tochtrop group.

The earnest money deposit of $5,000 was paid by Milor Realty to Stealey Realty and
was deposited by the latter corporation in an escrow account.

Subsequent to March 15, 1974, petitioner ARTHUR E. BRAUER (hereinafter


BRAUER) decided that, due to the capital gains tax consequences which would result
from the sale of the St. Charles farm, he wanted to acquire another tract of land, in a
nontaxable exchange, for the St. Charles farm.

Brauer was familiar with a 645-acre farm in Gasconade County, Mo. (hereinafter
Gasconade farm), owned by Chester B. Franz, Inc. (hereinafter Franz). Prior to March 15,
1974, Brauer was under the impression that this property was not available for
acquisition. Shortly after March 15, 1974, when he learned that the Gasconade farm was
available at a cost of approximately $300 per acre, Brauer decided to acquire the
property.

After he learned that the Gasconade farm was available, Brauer met with
representatives of Stealey Realty concerning the possibility of an exchange [FN2] of the
St. Charles farm for the Gasconade farm. Brauer was informed that an exchange was
possible, although it would cost an additional $6,000 in commissions for Stealey Realty
and Milor Realty. Brauer agreed to pay this sum.

Stealey Realty thereafter entered into discussions concerning an exchange of the two
farm properties with an officer of Milor Realty and with N. B. Sandbothe, who was both
an agent of Milor Realty and president of Sandfam Corp. Following these discussions,
Stealey Realty, Milor Realty, Mr. Sandbothe, and Brauer orally agreed to have Milor
Realty acquire the Gasconade farm and exchange it with petitioners for the St. Charles
farm. It was also agreed that the additional $6,000 commission to be paid by Brauer
would, after the payment of attorney's fees, be evenly split between Stealey Realty and
Mr. Sandbothe.

On May 30, 1974, William Oney (hereinafter Oney), an employee of Stealey Realty,
and Franz executed a real estate contract for the purchase and sale of the Gasconade farm.
The contract provided for a purchase price of $193,572, payable $2,000 as earnest money
upon execution of the contract, with the balance due upon delivery of the deed. The
contract specified that the buyer was "William Oney or assignee" and that closing was to
take place on or before June 14, 1974. The contract also provided:

This sale contingent on the trade of the Braur (sic) farm in St. Charles County Missouri
with Milnor (sic) Realty Corporation.

To be deed as directed by buyer.


This purchase is made with the understanding of the parties that this farm will be traded
to * * * (petitioners) by buyer.

The $2,000 in earnest money was paid by Stealey Realty from the $5,000 escrow fund
which had been established following Milor Realty's payment of earnest money under the
contract of March 15, 1974, for the purchase of the St. Charles farm.

Oney, rather than Milor Realty or one of its employees, entered into the contract for the
purchase of the Gasconade farm because, during the time period concerned, the Milor
Realty officer originally involved in this transaction died and no other officer or
employee of Milor Realty was sufficiently familiar with the transaction so that Milor
Realty was willing to execute the contract. Due to these circumstances, it was decided
that Oney would execute the real estate contract in order to keep the transaction on track.
It was still intended, however, that Milor Realty would receive the warranty deed on the
Gasconade farm. This was to be accomplished by Oney's assignment of the contract to
Milor Realty, with Milor Realty then purchasing the farm.

Closing for the transfer of each of the properties involved, namely, the St. Charles farm,
the Gasconade farm, and the 10 acres owned by the Tochtrop group, was scheduled for
June 13, 1974.

At some point prior to the date set for closing, it was discovered during a title search on
Gasconade farm that a dispute existed concerning the boundaries of the property. The
boundary dispute was not resolved prior to the closing date. Because of this dispute,
Milor Realty indicated that it did not want to take title to, nor give a warranty deed on,
Gasconade farm.

We do not believe that a result in this case grounded on Biggs, namely, that the instant
transaction qualifies under section 1031, is undercut by the recent case of Barker v.
Commissioner, 74 T.C. 555 (1980). In Barker, greater emphasis was placed on form than
was the case in Biggs because "the conceptual distinction between an exchange
qualifying for section 1031 on the one hand and a sale and reinvestment on the other is
largely one of form." Barker v. Commissioner, supra at 566. The taxpayer in Barker
owned certain property which a second party wanted to acquire. A third party owned
like-kind property which taxpayer wanted to acquire in a nontaxable exchange. Taxpayer,
the second party, and an escrow agent entered into a series of interdependent escrow
agreements whereby the escrow agent agreed to (1) purchase from the third party the
property which taxpayer desired to acquire, (2) exchange this property for the property
owned by taxpayer, and (3) sell taxpayer's property to the second party. Pursuant to the
escrow agreements, the various transfers occurred.

Although the Court held that the transaction at issue in Barker qualified under section
1031, it did so only after noting that the contractual arrangements between the parties
were mutually interdependent parts of an integrated plan with each transaction covered
thereunder being contingent on the simultaneous and successful completion of the other
transactions. [FN8] Furthermore, care was taken to see that the taxpayer did not obtain or
control cash and that title to the various properties involved passed in accordance with the
idea that an exchange was being effected.

While the transaction in the instant case was not as artfully done as that in Barker, we
do not believe that Barker requires a different result than that engendered under Biggs.
The real estate contract between Franz and Oney for sale of the Gasconade farm was
"contingent on the trade of the Brauer Farm * * * with Milor. . . ." Franz's transfer of
Gasconade farm to petitioners by warranty deed and the contemporaneous closing of the
remaining transfers effectively resulted in an exchange by petitioners of the St. Charles
farm for the Gasconade farm. The fact that petitioners did not receive title to the
Gasconade farm from Milor Realty is not dispositive. W. D. Haden Co. v. Commissioner,
supra. Furthermore, although petitioners may have endorsed all the checks used to
equalize the various transfers, it is clear that they never exercised control over them since
the circumstances of the closing required that the checks be endorsed to the escrow agent.
Petitioners did not withhold from the endorsed checks the amount which they would
receive in the transaction. It was only from the escrow agent that petitioners received this
amount.

In summary, we conclude that petitioners' transfer of the St. Charles farm and their
receipt of the Gasconade farm qualifies for nonrecognition treatment under section 1031.
Both the substance and form of the transaction were that of a qualifying exchange.

FN8. The Court noted, however, in note 5, that contractual interdependence was not
required as a condition to the finding that an exchange has taken place, citing Biggs. The
Court did note that the existence of contractual interdependence supported its conclusion
that a qualifying exchange had occurred.

REVENUE RULING 73-476


1973-2 C.B. 301

In Rev. Rul. 57-244, advice was desired with regard to an exchange of lots by three
taxpayers. In 1950, the three taxpayers, A, B and C, acquired from another individual a
tract of 25 acres. After the property was divided into three separate lots, the parties
entered into an agreement among themselves that the lots could not be subdivided in the
future.

Shortly after the acquisition of the property, the three individuals abandoned their plans
to construct homes and desired to undertake steps to dispose of the property. In
subsequent years, the three individuals agreed to exchange lots with each other. C
acquired the lot owned by B, B acquired the lot owned by A, and A acquired the lot
owned by C. After the exchange, A sold the lot acquired from C to another individual.

Assuming that the property was otherwise qualified under Section 1031, Rev. Rul. 57-
244 holds that these transactions constituted valid §1031 exchanges. If any gain was to be
recognized, it would only be recognized under the general rules with regard to boot.
Taking this same concept a step further, Rev. Rul. 73-476 examined the question as to
whether three individual taxpayers who each own an undivided interest as a tenant-in-
common in three separate parcels of real estate could be involved in a §1031 transaction.
Each of the taxpayers would exchange his undivided interest in three separate parcels for
a 100 percent ownership of one parcel.

The Ruling is very short and holds that if otherwise qualified, the taxpayers could
transfer their undivided interests as tenants-in-common for a separate parcel ownership.

REVENUE RULING 73-476


1973-2 C.B. 301

Three individual taxpayers, who are not dealers in real estate, each owned an undivided
interest as a tenant in common in three separate parcels of real estate. The parcels were
held by the taxpayers for investment purposes. None of the properties were subject to
mortgages.

Each of the taxpayers exchanged his undivided interest in the three separate parcels for
a 100 percent ownership of one parcel. None of the taxpayers assumed any liabilities of
the other taxpayers or received money or other property as a result of the exchange. Each
taxpayer continued to hold the single parcel of land as an investment.

Held, Pursuant to section 1031(a) of the Internal Revenue Code of 1954, any gain or
loss realized by the taxpayers as a result of the exchange of their property interests is not
recognized and, thus, is not includible in gross income.

[Tax-Deferral of Multiple Exchanges Under Code Sec. 1031 (page 1)]


[Tax-Deferral of Multiple Exchanges Under Code Sec. 1031 (page 2)]
[Tax-Deferral of Multiple Exchanges Under Code Sec. 1031 (page 3)]
[Tax-Deferral of Multiple Exchanges Under Code Sec. 1031 (page 4)]

TENANCY IN COMMON AS AN EXCHANGE:


PRIVATE LETTER RUL. 8933019

The following Private Letter Rul. reaffirms the concept of Rev. Rul. 73-476, allowing
exchange treatment under Code §1031 where there is a division of property held by
tenants in common.

PRIVATE LETTER RULING 8933019

Dear ____:
This letter responds to your request of April 6, 1989, and previous correspondence, in
which you inquired as to the federal tax consequences of a proposed transaction.

As the submitted facts indicate, A died on September 9, 1983. When A died, B, Trust 1,
and Trust 2 were tenants in common, without right of survivorship, in a farm. B
possessed a one-half interest in the farm, and Trust 1 and 2 each possessed a one-fourth
interest. After A's death, B became the income beneficiary of Trust 1. B also possesses a
limited power of appointment under Trust 1. Trust 2, which was created by A on March
11, 1983, provides that A is the primary beneficiary during her life, and that C is the
remainder beneficiary. When A created Trust 2, she transferred her one-fourth interest in
the farm to Trust 2. B is the trustee of both Trust 1 and Trust 2.

You represent that, when A died, Trust 2's undivided one-fourth interest in the farm
was included in A's gross estate under section 2035(d)(2) of the Internal Revenue Code.
B as the executor of A's estate, elected to specially value Trust 2's one-fourth interest in
the farm under section 2032A. In accordance with section 2032A and the regulations
thereunder, C as qualified heir and B individually, as trustee of Trust 1 and 2, and as
holder of Trust 1's limited power of appointment, consented to having the 2032A special
use valuation election for Trust 2's undivided one-fourth interest in the farm. B
individually as trustee of Trust 1 and 2 and as the holder of Trust 1's limited power of
appointment, along with C as the qualified heir, inter alia, consented to a lien under
section 6324B on the farm. The Internal Revenue Service filed a special lien against the
entire farm in accordance with the agreement and section 6324B. You state that, since A's
death, the entire farm has been continuously used as a farm by A, and/or C's husband, or
by corporation's wholly owned by them.

Trust 2 terminated in December of 1986. B as trustee distributed the undivided one-


fourth interest in the farm that was owned by Trust 2 outright to C. It is represented that
there have been no other changes in the ownership of the farm since A's death.

You represent that B, individually, as trustee of Trust 1 and as holder of Trust 1's
limited power of appointment, proposes to partition the tenancy in common so that he
receives a fee simple interest in the farm having a fair market value of at least as great as
the fair market value of the undivided one-half interest that he relinquishes, and Trust 1
and C will each receive a fee simple interest in the farm property having a fair market
value of at least as great as the fair market value of the undivided one-fourth interest that
they each relinquish. It is represented that no liabilities will be assumed and that no
money or other property will be transferred in connection with the partition. It is also
represented that the property will continue to be held by the taxpayers for productive use
as a farm.

Based on the foregoing, we rule as follows:

ISSUES 1 and 2:

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.
In Revenue Ruling 73-476, 1973-2 C.B. 300, three individual taxpayers each owned an
undivided interest as a tenant in-common in three separate parcels of real estate held for
investment. Each taxpayer exchanged the undivided interest solely for a 100 percent
interest in one parcel. The ruling held that section 1031 of the Code applied to the
exchange.

We conclude that section 1031(a) of the Code applies to the proposed partition because
(1) the property exchanged is held by the taxpayers for productive use as a farm, (2) the
property exchanged and the property received are like-kind property under section
1.1031(a)-1(b) of the Income Tax Regulations, and (3) the property received in the
exchange is to be held for productive use as a farm.

SIMULTANEOUS EXCHANGE:
RELATED PARTIES:TENANTS IN COMMON:
PRIVATE LETTER RULING 9535030
(See also Private Letter Ruling 9535031, 9535032, 9535033)

This exchange was held to qualify within Code §1031, assuming the facts related by the
taxpayer. This involved a simultaneous exchange with property owned by two (2) or
more parties as tenants in common.

Subject to the assumptions in the Ruling, the transaction qualified under Code §1031.
This Ruling, along with the subsequent Rulings under Private Letter Rulings 9535031,
9535032 and 9535033 involved the same parties for the most part, with the taxpayers,
their three (3) sons and certain other interests, such as trusts. Given the assumptions in
the Ruling as to like-kind property, there was trade or business or investment property,
along with statements as to limited debt relief, etc., and the exchanges qualified under
Code §1031.

PRIVATE LETTER RULING 9535030

Section 1031 --
EXCHANGE of Property Held for Productive Use or Investment
June 1, 1995
Publication Date: September 1, 1995

Dear____:
This responds to the letter dated January 24, 1995 (and previous correspondence dated
April 15, 1994, August 30, 1994, December 21, 1994, January 12, 1995 and January 18,
1995) concerning the application of the like- kind EXCHANGE rules to proposed
transactions. Taxpayer is B Corp. The following facts are represented:

M and G were married in 1929 and had three sons, X, Y and Z. M accumulated
substantial holdings in real estate. In 1937, M established a trust (the 1937 Trust) for the
benefit of G for life with the remainder to be distributed to the sons, per stirpes, 21 years
after the death of G. The 1937 Trust holds various interests in real property. In 1948, M
established the Foundation, an entity exempt from income tax under section 501(c)(3) of
the Internal Revenue Code and a private foundation within the meaning of section 509(a)
of the Code. [FN1] M died on 1964. M's will bequeathed one-half of his residuary estate
to the Foundation, one-quarter to the Marital Trust (established under the will of M) and
the balance to the sons in equal shares.

M's will also granted G a general power of appointment over the corpus of the Marital
Trust exercisable by will. In default of the exercise of such power, the corpus was to pass
in equal one-third shares to the sons. In 1967, G released her power of appointment as to
one-quarter of the Marital Trust corpus, in partial consideration of the settlement of a
dispute with the sons concerning the termination distribution of a certain inter vivos trust.
[FN2] The one-quarter share of the Marital Trust vested in the sons in 1967 and each
son's one-third share of the vested one-quarter interest in the Marital Trust is referred to
as (that son's) "Vested Share." In 1990, one of the sons, X, assigned his Vested Share to
W, who in 1991 further assigned a portion of the Vested Share to the Federal Deposit
Insurance Corporation (FDIC). The remaining three-quarters of the Marital Trust (the
"Non-Vested Share") remained subject to G's general power of appointment.

A Corp is a holding company, created by M, which owns directly or indirectly full or


partial interests in real property. One-third of the stock of A Corp is owned by the Marital
Trust and the other two-thirds is owned by the Foundation. A Corp owns all of the stock
of B Corp which, in turn, owns certain real property assets. In addition, the Marital Trust,
the Foundation, the 1937 Trust, A Corp, B Corp and the sons own, as tenants-in-
common, several other properties in various combinations and proportions.

G died in 1988. By will, she gave the bulk of her estate and appointed the Non-Vested
Share of the Marital Trust to the Foundation.

In June 1989, X and Y initiated a will contest in probate court, alleging that G lacked
testamentary capacity and had been unduly influenced by the appointed personal
representatives of her estate. However, this action was stayed pending the outcome of a
second lawsuit filed by X and Y in probate court in August 1989. This second suit alleges
that, by appointing the Foundation, G had not validly exercised her power of appointment
over the Non- Vested Share. X and Y claimed that the power was not exercisable in favor
of a corporation, such as the Foundation. This latter contest is referred to as the
"construction proceeding." In April 1991, the probate court granted X's and Y's motion
for summary judgment, ordering immediate distribution of the Non-Vested Share of the
Marital Trust to the sons pursuant to the default provisions of the power of appointment.
The Foundation appealed this decision and enforcement of the order was stayed. In
December 1993, the parties to both civil suits entered a Settlement Agreement which, by
its terms, would terminate the litigation between them and substantially eliminate the
common ownership of properties by the parties. To achieve this result as to B Corp, the
following EXCHANGE is proposed:

In EXCHANGE for B Corp's transfer to the Marital Trust of c% of T-9 and d% of T-


10, the Marital Trust will transfer to B Corp:
Taxpayer makes the following additional representations regarding the general
qualifications of the described transactions for tax-free treatment under section 1031 of
the Code:

1. All relinquished properties are held by Taxpayer either for


investment or for productive use in a trade or business and all
replacement property will be held for one of the same purposes.
2. The fair market values of the properties subject to this ruling
were determined by independent appraisal to which all parties
agreed to be bound. The parties utilized such appraisals to
determine that the fair market values of the properties to be
EXCHANGED were approximately equal, taking into account
the amounts of any mortgages to which such properties are
subject.
3. All property to be EXCHANGED is real property. [FN3]

Section 1031(A)(1) of the Internal Revenue 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.

Section 1031(B) of the Code provides, in part, that if an EXCHANGE would be within
the provisions of subsection (a) if it were not for the fact that some property received in
the EXCHANGE consists not only of property permitted by such provisions to be
received without the recognition of gain, but also of other property or money, then the
gain, if any, to the recipient shall be recognized, but not in excess of the sum of such
money and the fair market value of such other property.

Section 1031(D) of the code provides, in part, that if property was acquired on an
EXCHANGE described in this section, then the basis shall be the same as that of the
property EXCHANGED, decreased in the amount of any money received by the taxpayer
and increased in the amount of gain or decreased in the amount of loss to the taxpayer
that was recognized on such EXCHANGE. It further provides that where as part of the
consideration to the taxpayer another party to the EXCHANGE assumed a liability of the
taxpayer or acquired from the taxpayer property subject to a liability, such assumption or
acquisition (in the amount of the liability) shall be considered as money received by the
Taxpayer on the EXCHANGE.

Section 1.1031(B)-1(C) of the Income Tax Regulations provides, in part, that


consideration received in the form of an assumption of liabilities (or a transfer subject to
a liability) is to be treated as "other property or money," for purposes of section 1031(B).
Where on an EXCHANGE described in section 1031(B), each party to the EXCHANGE
either assumes a liability of the other party or acquires property subject to a liability,
then, in determining the amount of "other property or money" for purposes of section
1031(B), consideration given in the form of an assumption of liabilities (or a receipt of
property subject to a liability) shall be offset against consideration received in the form of
an assumption of liabilities (or a transfer subject to a liability). See s 1.1031(D)-2,
example (2).

The simultaneous transfers of like-kind properties, of approximately equal value, is


treated as an EXCHANGE. In this case, Taxpayer is simultaneously EXCHANGING real
property held for investment solely for other real property to be held for investment. All
of the properties to be EXCHANGED in the proposed transactions are held by two or
more of the parties as tenants in common. The legislative history of section 1031(F) of
the Code suggests that a fractional interest in a fee, i.e., a tenancy in common, is of like
kind to a fee interest in real property. [FN4] Hence, this transaction involves like-kind
property within the meaning of section 1031(A) of the Code.

In the proposed EXCHANGE between the Marital Trust and B Corp the parties will be
transferring and receiving real property subject to shares of an existing mortgages. Under
section 1031(D) of the Code and the related regulations cited above, the relief of liability
on a mortgage, whether by its assumption by another party or by transfer of property
subject to a mortgage, equates to the receipt of cash or other property for which gain must
be recognized. Furthermore, the relief of liability as to the Marital Trust is offset by the
amount of any liability to which the property it receives is subject.

Therefore, the Taxpayer will recognize no gain or loss in its EXCHANGE with the
Marital Trust in connection with the Settlement Agreement except to the extent required
by application of section 1031(B) of the Code relating to the receipt of money or other
property, including relief from mortgage debt, in connection with the EXCHANGE. As
to the mortgage debt, no gain will be recognized with respect to such transfers except to
the extent of the excess, if any, of liabilities transferred over liabilities assumed by
Taxpayer. The scope of this ruling is limited to the land, buildings and fixtures
constituting real property under local law and has no application to the transfer of
tangible personal property, if any, located in or on the real properties to be transferred,
where such tangible personal property does not constitute a fixture under local law.

No opinion is expressed as to the tax treatment of this item(s) (or transaction(s)) under
the provisions of any other section of the Code or regulations which may be applicable
thereto, or the tax treatment of any conditions existing at the time of, or effects resulting
from, the item(s) (or transaction(s)) described which are not specifically covered in the
above ruling. Moreover, the amount of mortgage liability to which T-9 may be subject is
not clear as of the date of this letter. Therefore, we express no opinion as to what extent,
if any, Taxpayer may experience net gain as a result of its transfer and receipt of
mortgage encumbered property or of how Taxpayer's basis in its remaining property may
be affected by its transfer of c% of T-9 subject to the mortgage.

If it is later determined that the values of the properties EXCHANGED are not
approximately equal, there may be a basis for holding that part of the consideration for
the EXCHANGE was the receipt of non-like-kind property or may have involved an
EXCHANGE of a chose in action, a relinquishment of a chose in action or be taxable as
some other form of income. We express no opinion on the factual question of the relative
values of the EXCHANGE properties. In this connection, we note that section
1031(A)(2)(F) of the Code states that section 1031 shall not apply to any EXCHANGE of
a chose in action.

A copy of this letter should be attached to the federal tax return for the year in which
the item(s) (transaction(s)) in question occurs. This ruling is directed only to Taxpayer
who requested it. Section 6110(j)(3) of the Code provides that it may not be used as
precedent. Sincerely, Assistant Chief Counsel (Income Tax & Accounting) * * * *

FN1 The Foundation was organized as a not-for-profit corporation under the laws of
the District of Columbia. Under such laws, the Foundation is prohibited from issuing
stock (D.C.Code s 29-527). Accordingly, the Foundation has not issued stock.

FN2 The inter vivos trust was yet another trust set up by M in 1939 for the benefit of G
and the sons.

FN3 The only exception is the property designated as Tract 12, which consists of a
ground lease that has less than thirty years remaining in its term, and improvements.
However, Taxpayer represents that prior to closing on the transactions at issue, the
ground lease on Tract 12 will be extended so that its remaining term (as of the date of
closing) will exceed thirty years. Furthermore, the rights of the lessee under the lease will
be transferred along with the improvements thereon in the EXCHANGE. All other
transfers will involve fee simple interests in land, together with any and all buildings and
fixtures located thereon.

FN4 See S. Print No. 101-56, 101st Cong., 1st Sess. 152 (1989), which makes mention
with evident approval of "a transaction involving an EXCHANGE of undivided interests
in different properties that results in each taxpayer holding either the entire interest in a
single property or a larger undivided interest in any of such properties."

PRIVATE LETTER RULING 9535031

Section 1031 --
EXCHANGE of Property Held for Productive Use or Investment
June 1, 1995
Publication Date: September 1, 1995

Dear ____:
This responds to the letter dated January 24, 1995 requesting private letter rulings (and
earlier correspondence dated August 30, 1994, December 21, 1994, January 12, 1995 and
January 18, 1995) concerning the application of the like- kind EXCHANGE rules to the
transaction you propose. Taxpayer is Z. The following facts are represented:

M and G were married in 1929 and had three sons, X, Y and Z. M accumulated
substantial holdings in real estate. In 1937, M established a trust for the benefit of G for
life with the remainder to be distributed to the sons, per stirpes, 21 years after the death of
G. The 1937 Trust holds various interests in real property. In 1948, M established the
Foundation, an entity exempt from income tax under section 501(c)(3) of the Internal
Revenue Code and a private foundation within the meaning of section 509(a) of the
Code. [FN1] M died in 1964. M's will bequeathed one-half of his residuary estate to the
Foundation, one-quarter to the Marital Trust (established under the will of M) and the
balance to the sons in equal shares.

M's will also granted G a general power of appointment over the corpus of the Marital
Trust exercisable by will. In default of the exercise of such power, the corpus was to pass
in equal one-third shares to the sons. In 1967, G released her power of appointment as to
one-quarter of the Marital Trust corpus, in partial consideration of the settlement of a
dispute with the sons concerning the termination distribution of a certain inter vivos trust.
[FN2] The one-quarter share of the Marital Trust vested in the sons in 1967 and each
son's one-third share of the vested one-quarter interest in the Marital Trust is referred to
as (that son's) "Vested Share." In 1990, one of the sons, X, assigned his Vested Share to
W, who in 1991 further assigned a portion of the Vested Share to the Federal Deposit
Insurance Corporation (FDIC). The remaining three-quarters of the Marital Trust (the
"Non-Vested Share") remained subject to G's general power of appointment.

A Corp is a holding company, created by M, which owns directly or indirectly full or


partial interests in real property. One-third of the stock of A Corp is owned by the Marital
Trust and the other two-thirds is owned by the Foundation. A Corp owns all of the stock
of B Corp which, in turn, owns certain real property assets. In addition, the Marital Trust,
the Foundation, the 1937 Trust, A Corp, B Corp and the sons own, as tenants-in-
common, several other properties in various combinations and proportions.

G died in 1988. By will, she gave the bulk of her estate and appointed the Non-Vested
Share of the Marital Trust to the Foundation.

In June 1989, X and Y initiated a will contest in probate court, alleging that G lacked
testamentary capacity and had been unduly influenced by the appointed personal
representatives of her estate. However, this action was stayed pending the outcome of a
second lawsuit filed by X and Y in probate court in August 1989. This second suit alleges
that, by appointing the Foundation, G had not validly exercised her power of appointment
over the Non- Vested Share. X and Y claimed that the power was not exercisable in favor
of a corporation, such as the Foundation. This latter contest is referred to as the
"construction proceeding." In April 1991, the probate court granted X's and Y's motion
for summary judgment, ordering immediate distribution of the Non-Vested Share of the
Marital Trust to the sons pursuant to the default provisions of the power of appointment.
The Foundation appealed this decision and enforcement of the order was stayed. In
December 1993, the parties to both civil suits entered a Settlement Agreement which, by
its terms, would terminate the litigation between them and substantially eliminate the
common ownership of properties by the parties. To achieve this result as to Z, the
following EXCHANGE is proposed:
In EXCHANGE for Z's transfer to the Marital Trust of b% of T-2, the Marital Trust
will transfer to Z a% of T-1.

Regarding these like-kind EXCHANGES, section 23(a) of the Settlement Agreement


provides:

Each party receiving any of the real property interests transferred to him/her or it ... (a
"Receiving Party"), pursuant to any of the like-kind EXCHANGES described in [this
agreement] hereby agrees to retain title to each such EXCHANGED real property interest
acquired for a minimum of two (2) years after the Closing Date and further agrees that,
during such two (2) year minimum holding period, he/she or it will not directly or
indirectly, cause or permit there to be any sale, contract for sale, option for sale or any
other agreement or transaction which would cause a disposition of such EXCHANGED
real property interest for purposes of Section 1031(F) of the IRC or cause a suspension of
the running of the two (2)-year holding period under Section 1031(G) of the IRC;
provided, however, that a disposition described in Section 1031(F)(2)(A), (B) or (C) of
the IRC shall not be a violation of this section 23(a). If the Receiving Party pursuant to a
Like-Kind EXCHANGE seeks to qualify a disposition under Section 1031(F)(2)(C) of
the IRC, the Receiving Party and the party or parties transferring such property to the
Receiving Party pursuant to a Like-Kind EXCHANGE (the "Transferring Party") shall
cooperate in establishing to the satisfaction of the IRS (whether by ruling request or
otherwise) that the disposition qualifies under Section 1031(F)(2)(C) of the IRC;
provided, however, that the Receiving Party shall pay all reasonable out-of-pocket
expenses incurred by the transferring party, including reasonable attorneys fees, in
connection with the qualification of such disposition under Section 1031(F)(2)(C) of the
IRC. In the event of a breach of the provisions of this Section 23(a), the breaching party
shall be liable for the damages incurred as a result of such breach, including, but not
limited to, any income or capital gain taxes and any applicable interest thereon arising as
a result of such breach.

Taxpayer further discloses that most of the properties to be received by the Marital
Trust and the Estate in such EXCHANGES would be distributed by the Marital Trust and
Estate within a short period to the Foundation, to the sons, to W, and to the FDIC as
provided in the Settlement Agreement. Such transfers, coupled with the distribution of
the residue of the Estate and remainder of the Non-Vested Share of the Marital Trust to
the Foundation, would terminate the Marital Trust and the Estate for federal income tax
purposes.

Taxpayer makes the following additional representations regarding the general


qualifications of the described transactions for tax-free treatment under section 1031 of
the Code:

1. All relinquished properties are held by Taxpayer either for


investment or for productive use in a trade or business and all
replacement property will be held for one of the same purposes.
2. All property to be EXCHANGED is real property.
3. The fair market values of the properties subject to this ruling
were determined by independent appraisal to which all parties
agreed to be bound. The parties utilized such appraisals to
determine that the fair market values of the properties to be
EXCHANGED were approximately equal, taking into account
the amounts of any mortgages to which such properties are
subject.
4. None of the properties to the Settlement Agreement has the
present intention of seeking, by a ruling of the Service or
otherwise, to utilize the provisions of section 1031(F)(2)(C) of
the Code with respect to the real property interests transferred to
him/her or it, or to his/her or its immediate predecessor in title,
pursuant to any of the proposed like-kind EXCHANGES
described.

Section 1031(A)(1) of the Internal Revenue 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.

The simultaneous transfers of like-kind properties, of approximately equal value, is


treated as an EXCHANGE. In this case, Taxpayer is simultaneously EXCHANGING real
property held for investment solely for other real property to be held for investment.
Furthermore, all of the properties to be EXCHANGED in the proposed transactions are
held by two or more of the parties as tenants in common. The legislative history of
section 1031(F) of the Code suggests that a fractional interest in a fee, i.e., a tenancy in
common, is of like kind to a fee interest in real property. [FN3] Hence, this transaction
involves like-kind property and is an EXCHANGE within the meaning of section
1031(A) of the Code.

Section 1031(F)(1) of the Code provides, in part, that if--

(A) a taxpayer EXCHANGES property with a related person,


(B) there is nonrecognition of gain or loss to the taxpayer under
this section with respect to the EXCHANGE of such property
(determined without regard to this subsection), and
(C) before the date of two years after the date of the last transfer
which was part of such EXCHANGE--
(i) the related person disposes of the such property, or
(ii) the taxpayer disposes of the property received in the
EXCHANGE from the related person which was of like
kind to the property transferred by the taxpayer, there
shall be no nonrecognition of gain or loss under this
section to the taxpayer with respect to such EXCHANGE.
Section 1031(F)(2) of the Code provides that for purposes of paragraph (1)(C), there
shall not be taken into account any disposition--

(A) after the earlier of the death of the taxpayer or the death of the
related person,
(B) in a compulsory or involuntary conversion (within the
meaning of section 1033) if the EXCHANGE occurred before
the threat or imminence of such conversion, or
(C) with respect to which it is established to the satisfaction of the
Secretary that neither the EXCHANGE nor such disposition
had as one of its principal purposes the avoidance of Federal
income tax.

Under section 1031(F) of the Code, recognition of gain from the EXCHANGE of real
property between related parties is triggered (with some exceptions noted above) when
either of the parties within two years disposes of the interest acquired in the
EXCHANGE. The parties to the proposed EXCHANGE are related for purposes of
section 1031(F). However, section 23(a) of the Settlement Agreement gives substantial
assurances that neither party will make any subsequent disposition of the EXCHANGE
property which will trigger gain recognition under section 1031(F).

Therefore, Z will recognize no gain or loss in its EXCHANGE with the Marital Trust
under the Settlement Agreement. The scope of this ruling is limited to the land, buildings
and fixtures constituting real property under local law and has no application to the
transfer of tangible personal property, if any, located in or on the real properties to be
transferred, where such tangible personal property does not constitute a fixture under
local law.

No opinion is expressed as to the tax treatment of this item(s) (or transaction(s)) under
the provisions of any other section of the Code or regulations which may be applicable
thereto, or the tax treatment of any conditions existing at the time of, or effects resulting
from, the item(s) (or transaction(s)) described which are not specifically covered in the
above ruling.

If it is later determined that the values of the properties EXCHANGED are not
approximately equal, there may be a basis for holding that part of the consideration for
the EXCHANGE was the receipt of non-like-kind property or may have involved an
EXCHANGE of a chose in action, a relinquishment of a chose in action or be taxable as
some other form of income. We express no opinion on the factual question of the relative
values of the EXCHANGE properties. In this connection, we note that section
1031(A)(2)(F) of the Code states that section 1031 shall not apply to any EXCHANGE of
a chose in action.

We make no commitment to entertain ruling requests regarding the application of


section 1031(F)(2)(C) of the Code to any given case.
A copy of this letter should be attached to the federal tax return for the year in which
the item(s) (transaction(s)) in question occurs. This ruling is directed only to Taxpayer
who requested it. Section 6110(j)(3) of the Code provides that it may not be used as
precedent.

Sincerely,

Assistant Chief Counsel


(Income Tax & Accounting)

Taxpayer Information:

FN1 The Foundation was organized as a not-for-profit corporation under the laws of
the District of Columbia. Under such laws, the Foundation is prohibited from issuing
stock (D.C.Code s 29-527). Accordingly, the Foundation has not issued stock.

FN2 The inter vivos trust was yet another trust set up by M in 1939 for the benefit of G
and the sons.

FN3 See S. Print No. 101-56, 101st Cong., 1st Sess. 152 (1989), which makes mention
with evident approval of "a transaction involving an EXCHANGE of undivided interests
in different properties that results in each taxpayer holding either the entire interest in a
single property or a larger undivided interest in any of such properties."

PRIVATE LETTER RULING 9535032

Section 1031 --
EXCHANGE of Property Held for Productive Use or Investment
June 1, 1995
Publication Date: September 1, 1995

Dear ____:
This responds to the letter dated January 24, 1995 requesting private letter rulings (and
earlier correspondence dated August 30, 1994, December 21, 1994, January 12, 1995 and
January 18, 1995) concerning the application of the like- kind EXCHANGE rules to the
transaction you propose. Taxpayer is Y. The following facts are represented:

M and G were married in 1929 and had three sons, X, Y and Z. M accumulated
substantial holdings in real estate. In 1937, M established a trust (the 1937 Trust) for the
benefit of G for life with the remainder to be distributed to the sons, per stirpes, 21 years
after the death of G. The 1937 Trust holds various interests in real property. In 1948, M
established the Foundation, an entity exempt from income tax under section 501(c)(3) of
the Internal Revenue Code and a private foundation within the meaning of section 509(a)
of the Code. [FN1] M died in 1964. M's will bequeathed one-half of his residuary estate
to the Foundation, one-quarter to the Marital Trust (established under the will of M) and
the balance to the sons in equal shares.
M's will also granted G a general power of appointment over the corpus of the Marital
Trust exercisable by will. In default of the exercise of such power, the corpus was to pass
in equal one-third shares to the sons. In 1967, G released her power of appointment as to
one-quarter of the Marital Trust corpus, in partial consideration of the settlement of a
dispute with the sons concerning the termination distribution of a certain inter vivos trust.
[FN2]

The one-quarter share of the Marital Trust vested in the sons in 1967 and each son's
one-third share of the vested one-quarter interest in the Marital Trust is referred to as
(that son's) "Vested Share." In 1990, one of the sons, X, assigned his Vested Share to W,
who in 1991 further assigned a portion of the Vested Share to the Federal Deposit
Insurance Corporation (FDIC). The remaining three-quarters of the Marital Trust (the
"Non-Vested Share") remained subject to G's general power of appointment.

A Corp is a holding company, created by M, which owns directly or indirectly full or


partial interests in real property. One-third of the stock of A Corp is owned by the Marital
Trust and the other two-thirds is owned by the Foundation. A Corp owns all of the stock
of B Corp which, in turn, owns certain real property assets. In addition, the Marital Trust,
the Foundation, the 1937 Trust, A Corp, B Corp and the sons own, as tenants-in-
common, several other properties in various combinations and proportions.

G died in 1988. By will, she gave the bulk of her estate and appointed the Non-Vested
Share of the Marital Trust to the Foundation.

In June 1989, X and Y initiated a will contest in probate court, alleging that G lacked
testamentary capacity and had been unduly influenced by the appointed personal
representatives of her estate. However, this action was stayed pending the outcome of a
second lawsuit filed by X and Y in probate court in August 1989. This second suit alleges
that, by appointing the Foundation, G had not validly exercised her power of appointment
over the Non- Vested Share. X and Y claimed that the power was not exercisable in favor
of a corporation, such as the Foundation. This latter contest is referred to as the
"construction proceeding." In April 1991, the probate court granted X's and Y's motion
for summary judgment, ordering immediate distribution of the Non-Vested Share of the
Marital Trust to the sons pursuant to the default provisions of the power of appointment.
The Foundation appealed this decision and enforcement of the order was stayed.

In December 1993, the parties to both civil suits entered a Settlement Agreement
which, by its terms, would terminate the litigation between them and substantially
eliminate the common ownership of properties by the parties. To achieve this result as to
Y, the following EXCHANGES are proposed:

1. In EXCHANGE for Y's transfer to the Marital Trust of b% of


T-2, the Marital Trust will transfer to Y a% of T-1.
2. In EXCHANGE for Y's transfer to the Estate of d% of T-2, the
Estate will transfer to Y c% of T-1.
A copy of this letter should be attached to the federal tax return for the year in which the
item(s) (transaction(s)) in question occurs. This ruling is directed only to Taxpayer who
requested it. Section 6110(j)(3) of the Code provides that it may not be used as precedent.
Sincerely, Assistant Chief Counsel (Income Tax & Accounting) * * * *

FN1 The Foundation was organized as a not-for-profit corporation under the laws of
the District of Columbia. Under such laws, the Foundation is prohibited from issuing
stock (D.C.Code s 29-527). Accordingly, the Foundation has not issued stock.

FN2 The inter vivos trust was yet another trust set up by M in 1939 for the benefit of G
and the sons.

FN3 See S. Print No. 101-56, 101st Cong., 1st Sess. 152 (1989), which makes mention
with evident approval of "a transaction involving an EXCHANGE of undivided interests
in different properties that results in each taxpayer

PRIVATE LETTER RULING 9535033

Section 1031 --
EXCHANGE of Property Held for Productive Use or Investment
June 1, 1995
Publication Date: September 1, 1995

Dear ____:
This responds to the letter dated January 24, 1995 requesting private letter rulings (and
earlier correspondence dated August 30, 1994, December 21, 1994, January 12, 1995 and
January 18, 1995) concerning the application of the like- kind EXCHANGE rules to the
transaction you propose. Taxpayer is X. The following facts are represented:

M and G were married in 1929 and had three sons, X, Y and Z. M accumulated
substantial holdings in real estate. In 1937, M established a trust (the 1937 Trust) for the
benefit of G for life with the remainder to be distributed to the sons, per stirpes, 21 years
after the death of G. The 1937 Trust holds various interests in real property. In 1948, M
established the Foundation, an entity exempt from income tax under section 501(c)(3) of
the Internal Revenue Code and a private foundation within the meaning of section 509(a)
of the Code. [FN1] M died in 1964. M's will bequeathed one-half of his residuary estate
to the Foundation, one-quarter to the Marital Trust (established under the will of M) and
the balance to the sons in equal shares.

M's will also granted G a general power of appointment over the corpus of the Marital
Trust exercisable by will. In default of the exercise of such power, the corpus was to pass
in equal one-third shares to the sons. In 1967, G released her power of appointment as to
one-quarter of the Marital Trust corpus, in partial consideration of the settlement of a
dispute with the sons concerning the termination distribution of a certain inter vivos trust.
[FN2] The one-quarter share of the Marital Trust vested in the sons in 1967 and each
son's one-third share of the vested one-quarter interest in the Marital Trust is referred to
as (that son's) "Vested Share." In 1990, one of the sons, X, assigned his Vested Share to
W, who in 1991 further assigned a portion of the Vested Share to the Federal Deposit
Insurance Corporation (FDIC). The remaining three-quarters of the Marital Trust (the
"Non-Vested Share") remained subject to G's general power of appointment.

A Corp is a holding company, created by M, which owns directly or indirectly full or


partial interests in real property. One-third of the stock of A Corp is owned by the Marital
Trust and the other two-thirds is owned by the Foundation. A corp owns all of the stock
of B Corp which, in turn, owns certain real property assets. In addition, the Marital Trust,
the Foundation, the 1937 Trust, A Corp, B Corp and the sons own, as tenants-in-
common, several other properties in various combinations and proportions.

G died in 1988. By will, she gave the bulk of her estate and appointed the Non-Vested
Share of the Marital Trust to the Foundation.

In June 1989, X and Y initiated a will contest in probate court, alleging that G lacked
testamentary capacity and had been unduly influenced by the appointed personal
representatives of her estate. However, this action was stayed pending the outcome of a
second lawsuit filed by X and Y in probate court in August 1989. This second suit alleges
that, by appointing the Foundation, G had not validly exercised her power of appointment
over the Non- Vested Share. X and Y claimed that the power was not exercisable in favor
of a corporation, such as the Foundation. This latter contest is referred to as the
"construction proceeding." In April 1991, the probate court granted X's and Y's motion
for summary judgment, ordering immediate distribution of the Non-Vested Share of the
Marital Trust to the sons pursuant to the default provisions of the power of appointment.
The Foundation appealed this decision and enforcement of the order was stayed.

In December 1993, the parties to both civil suits entered a Settlement Agreement
which, by its terms, would terminate the litigation between them and substantially
eliminate the common ownership of properties by the parties. To achieve this result as to
the Marital Trust, the following five EXCHANGES are proposed:

In EXCHANGE for X's transfer to the Marital Trust of b% of


1.
T-2, the Marital Trust will transfer to X a% of T-1.
In EXCHANGE for X's transfer to the Estate of d% of T-2, the
2.
Estate will transfer to X c% of T-1.

Regarding these like-kind EXCHANGES, section 23(a) of the Settlement Agreement


provides:

Each party receiving any of the real property interests transferred to him/her or it ... (a
"Receiving Party"), pursuant to any of the like-kind EXCHANGES described in [this
agreement] hereby agrees to retain title to each such EXCHANGED real property interest
acquired for a minimum of two (2) years after the Closing Date and further agrees that,
during such two (2) year minimum holding period, he/she or it will not directly or
indirectly, cause or permit there to be any sale, contract for sale, option for sale or any
other agreement or transaction which would cause a disposition of such EXCHANGED
real property interest for purposes of Section 1031(F) of the IRC or cause a suspension of
the running of the two (2)-year holding period under Section 1031(G) of the IRC;
provided, however, that a disposition described in Section 1031(F)(2)(A), (B) or (C) of
the IRC shall not be a violation of this section 23(a). If the Receiving Party pursuant to a
Like-Kind EXCHANGE seeks to qualify a disposition under Section 1031(F)(2)(C) of
the IRC, the Receiving Party and the party or parties transferring such property to the
Receiving Party pursuant to a Like-Kind EXCHANGE (the "Transferring Party") shall
cooperate in establishing to the satisfaction of the IRS (whether by ruling request or
otherwise) that the disposition qualifies under Section 1031(F)(2)(C) of the IRC;
provided, however, that the Receiving Party shall pay all reasonable out-of-pocket
expenses incurred by the transferring party, including reasonable attorneys fees, in
connection with the qualification of such disposition under Section 1031(F)(2)(C) of the
IRC. In the event of a breach of the provisions of this Section 23(a), the breaching party
shall be liable for the damages incurred as a result of such breach, including, but not
limited to, any income or capital gain taxes and any applicable interest thereon arising as
a result of such breach.

Taxpayer further discloses that most of the properties to be received by the Marital
Trust and the Estate in such EXCHANGES would be distributed by the Marital Trust and
Estate within a short period to the Foundation, to the sons, to W, and to the FDIC as
provided in the Settlement Agreement. Such transfers, coupled with the distribution of
the residue of the Estate and remainder of the Non-Vested Share of the Marital Trust to
the Foundation, would terminate the Marital Trust and the Estate for federal income tax
purposes.

Taxpayer also makes the following general representations:

All relinquished properties are held by Taxpayer either for


1. investment or for productive use in a trade or business and all
replacement property will be held for one of the same purposes.
2. All property to be EXCHANGED is real property.
The fair market values of the properties subject to this ruling
were determined by independent appraisal to which all parties
agreed to be bound. The parties utilized such appraisals to
3. determine that the fair market values of the properties to be
EXCHANGED were approximately equal, taking into account
the amounts of any mortgages to which such properties are
subject.
None of the parties to the Settlement Agreement has the present
intention of seeking, by a ruling of the Service or otherwise, to
utilize the provisions of section 1031(F)(2)(C) of the Code with
4.
respect to the real property interests transferred to him/her or it,
or to his/her or its immediate predecessor in title, pursuant to
any of the proposed like-kind EXCHANGES described.
Section 1031(A)(1) of the Internal Revenue 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.

Section 1031(B) of the Code provides, in part, that if an EXCHANGE would be within
the provisions of subsection (a) if it were not for the fact that some property received in
the EXCHANGE consists not only of property permitted by such provisions to be
received without the recognition of gain, but also of other property or money, then the
gain, if any, to the recipient shall be recognized, but not in excess of the sum of such
money and the fair market value of such other property.

Section 1031(D) of the Code provides, in part, that if property was acquired on an
EXCHANGE described in this section, then the basis shall be the same as that of the
property EXCHANGED, decreased in the amount of any money received by the taxpayer
and increased in the amount of gain or decreased in the amount of loss to the taxpayer
that was recognized on such EXCHANGE. It further provides that where as part of the
consideration to the taxpayer another party to the EXCHANGE assumed a liability of the
taxpayer or acquired from the taxpayer property subject to a liability, such assumption or
acquisition (in the amount of the liability) shall be considered as money received by the
Taxpayer on the EXCHANGE.

Section 1031(F)(1) of the Code provides, in part, that if--(A) a taxpayer EXCHANGES
property with a related person, (B) there is nonrecognition of gain or loss to the taxpayer
under this section with respect to the EXCHANGE of such property (determined without
regard to this subsection), and (C) before the date of two years after the date of the last
transfer which was part of such EXCHANGE--

(i) the related person disposes of the such property, or (ii) the taxpayer disposes of the
property received in the EXCHANGE from the related person which was of like kind to
the property transferred by the taxpayer, there shall be no nonrecognition of gain or loss
under this section to the taxpayer with respect to such EXCHANGE.

Section 1031(F)(2) of the Code provides that for purposes of paragraph (1)(C), there
shall not be taken into account any disposition--(A) after the earlier of the death of the
taxpayer or the death of the related person, (B) in a compulsory or involuntary conversion
(within the meaning of section 1033) if the EXCHANGE occurred before the threat or
imminence of such conversion, or (C) with respect to which it is established to the
satisfaction of the Secretary that neither the EXCHANGE nor such disposition had as one
of its principal purposes the avoidance of Federal income tax.

In this case, Taxpayer is simultaneously EXCHANGING real property held for


investment solely for other real property to be held for investment. Hence, this
transaction involves like-kind property within the meaning of section 1031(A) of the
Code. Furthermore, the simultaneous transfers of like-kind properties, of approximately
equal value, is treated as an EXCHANGE.
In the proposed EXCHANGES between the Taxpayer and the Estate and between
Taxpayer and the Marital Trust, Taxpayer will receive c% and a% of T-1, which is
subject to an existing mortgage. This factor will have no effect on the tax treatment of the
Taxpayer in this EXCHANGE, except that his basis will take into account the amount of
liability on the said mortgage.

Under section 1031(F) of the Code, recognition of gain from the EXCHANGE of real
property between related parties is triggered (with some exceptions noted above) when
either of the parties within two years disposes of the interest acquired in the
EXCHANGE. Some of the parties to the proposed EXCHANGES (including Taxpayer
and the Marital Trust) are related for purposes of section 1031(F). However, section 23(a)
of the Settlement Agreement gives substantial assurances that none of the parties will
make any subsequent disposition of the EXCHANGE property which will trigger gain
recognition under section 1031(F).

All of the properties to be EXCHANGED in the proposed transactions are held by two
or more of the parties as tenants in common. The legislative history of section 1031(F) of
the Code suggests that a fractional interest in a fee, i.e., a tenancy in common, is of like
kind to a fee interest in real property. [FN3]

Therefore, X will recognize no gain or loss in his EXCHANGES with the Marital Trust
and the Estate under the Settlement Agreement. The scope of this ruling is limited to the
land, buildings and fixtures constituting real property under local law and has no
application to the transfer of tangible personal property, if any, located in or on the real
properties to be transferred, where such tangible personal property does not constitute a
fixture under local law.

No opinion is expressed as to the tax treatment of this item(s) (or transaction(s)) under
the provisions of any other section of the Code or regulations which may be applicable
thereto, or the tax treatment of any conditions existing at the time of, or effects resulting
from, the item(s) (or transaction(s)) described which are not specifically covered in the
above ruling. Moreover, the amount of mortgage liability to which T-1 may be subject is
not clear as of the date of this letter. Therefore, we express no opinion as to the amount
by which taxpayer's basis is increased by reason of acquiring T-1 subject to the mortgage.

If it is later determined that the values of the properties EXCHANGED are not
approximately equal, there may be a basis for holding that part of the consideration for
the EXCHANGE was the receipt of non-like-kind property or may have involved an
EXCHANGE of a chose in action, a relinquishment of a chose in action or be taxable as
some other form of income. We express no opinion on the factual question of the relative
values of the EXCHANGE properties. In this connection, we note that section
1031(A)(2)(F) of the Code states that section 1031 shall not apply to any EXCHANGE of
a chose in action.

We make no commitment to entertain ruling requests regarding the application of


section 1031(F)(2)(C) of the Code to any given case.
A copy of this letter should be attached to the federal tax return for the year in which
the item(s) (transaction(s)) in question occurs. This ruling is directed only to Taxpayer
who requested it. Section 6110(j)(3) of the Code provides that it may not be used as
precedent. Sincerely, Assistant Chief Counsel (Income Tax & Accounting) * * * *

FN1 The Foundation was organized as a not-for-profit corporation under the laws of
the District of Columbia. Under such laws, the Foundation is prohibited from issuing
stock (D.C.Code s 29-527). Accordingly, the Foundation has not issued stock.

FN2 The inter vivos trust was yet another trust set up by M in 1939 for the benefit of G
and the sons.

FN3 See S. Print No. 101-56, 101st Cong., 1st Sess. 152 (1989), which makes mention
with evident approval of "a transaction involving an EXCHANGE of undivided interests
in different properties that results in each taxpayer holding either the entire interest in a
single property or a larger undivided interest in any of such properties."

PRIVATE LETTER RULING 8035049

This Ruling holds that where a steel company agreed to transfer its plant and facilities
to a tool manufacturer, subject to the agreement that the manufacturer had to locate land
and plant facilities in another location, properly structured, this could qualify for the
exchange. The manufacturer purchased a tract of land and contracted for construction of
plant facilities on behalf of a future exchange with the steel company. After construction
was finished, the steel company and manufacturer undertook simultaneous transfers of
their interests. This qualified for the tax-deferred exchange.

PRIVATE LETTER RULING 8035049

Dear ____:
This is in reply to a letter dated November 19, 1979 and subsequent correspondence
dated April 7, 1980 submitted on behalf of X by its authorized representatives. Those
letters ask for rulings under sections 1031 and 1223 of the Internal Revenue Code of
1954 (the 'Code').

Pursuant to a telephone conversation on April 11, 1980 between one of your authorized
representatives and a member of this office we hereby acknowledge the withdrawal of
ruling request number two.

The facts and representations submitted with your request are substantially as follows.
X is a domestic corporation engaged in the business of processing steel products. Y is a
domestic corporation engaged in tool and dye manufacturing. Both X and Y are located
in J.

X wished to expand its facilities to land which is adjacent to land on which Y conducts
its business. Y, however, also needed more land on which to conduct its business and
consequently asked X to forego its plant expansion on the land adjacent to Y. Y proposed
that X sell its presently held property to Y and that X then relocate elsewhere in J. X
agreed to forego its plant expansion and to transfer its existing manufacturing facilities to
Y on the condition that Y locate suitable land and manufacturing facilities which would
be acquired by Y and transferred to X in a like kind exchange. During the period of
negotiations between X and Y, X found suitable replacement property located on *** in
J. That land was owned by the city and was being sold by the city to the highest bidder. X
submitted a bid of $10x and made a deposit of $1x with the city as required in the bidding
instructions. The bid was contingent upon the successful completion of negotiations
between X and Y. X has been verbally advised that its bid was the highest submitted and
will be accepted once its negotiations with Y are completed.

It is further represented that the bid option is not binding upon X in that X may
withdraw the bid and regain its deposit prior to the consummation of a sales contract
between Y and J.

Subsequent to the bid, X and Y agreed that Y would acquire the city owned land and
contract for the construction thereon of manufacturing facilities in accordance with plans
and specifications approved by X. Pursuant to this agreement X will assign the bid right
of the land held by the city to Y and upon assignment J will release X from any
obligation under the original contract under the bid. In exchange for receipt of the bid Y
will reimburse X for the bid deposit made by X. Y will then complete the purchase of the
property and pay the balance of the purchase price to the city. Y will then contract for the
construction of a manufacturing facility according to plans and specifications acceptable
to X. Any change, alteration, or modification of the plans and specifications will require
the approval of X.

It is also agreed that Y will pay the sum of $70x for the acquisition of the city owned
property and construction of improvements thereon. To the extent the cost of acquisition
and construction exceed $70x, X will loan excess funds or cause excess funds to be
loaned to Y on an 'interest free' basis. Such loans will be secured by a second mortgage
on the property to be executed and delivered to X on the date such funds are first
advanced.

Y will have control over the construction project prior to the exchange with X and will
bear the risk of loss during that time. If any disputes arise with contractors and as a result
X fails or refuses to approve payment of any portion of an invoice submitted by a
contractor, Y may, at its option, pay the disputed amount to an escrow account with a
bank in J. These funds will be disbursed upon instructions received by the escrow agent
from J that the problem has been resolved to the extent necessary to enable the city to
issue its completion certificate.

Upon completion of the construction Y will transfer the property and all improvements
thereon to X and assign to X all its rights and interest. In exchange for the transfer of title
and assignments by Y, X will contemporaneously transfer title to X's property and all
buildings and improvements thereon to Y. X will reimburse or arrange for the
reimbursements to Y for any excess funds advanced by Y over and above its cost of
construction. Neither transferred property will be transferred subject to a mortgage. X
will also transfer certain other property located near X's property to Y for $8x.

Section 1031(a) of the Code provides, in part, no gain or loss shall be recognized if
property held for productive use in trade or business or for investment is exchanged
solely for property of a like kind to be held either for productive use in trade or business
or for investment.

Section 1031(b) of the Code provides, in general and in part, if an exchange would be
within the provisions of subsection 1031(a), if it were not for the fact that the property
received in exchange consists not only of property permitted by such provisions to be
received without the recognition of gain, but also money, then the gain, if any, to the
recipient shall be recognized, but in an amount not in excess of the sum of such money.

Section 1031(d) of the Code provides, in part, if property was acquired in an exchange
described in section 1031 then the basis shall be the same as that of the property
exchanged, decreased in the amount of any money received by the taxpayer and increased
in the amount of gain the taxpayer recognized on such exchange.

Section 1223(1) of the Code provides, in part, that in determining the period for which
the taxpayer has held property received in an exchange, there shall be included the period
for which he held the property exchanged if, under this chapter, the property has, for the
purpose of determining gain or loss from a sale or exchange, the same basis in whole or
in part, in his hands as the property exchanged, and the property exchanged at the time of
such exchange was property described in section 1231 of the Code.

Section 1232(b) of the Code defines, with certain exceptions not herein relevant,
property used in the trade or business as property used in a trade or business, of a
character which is subject to the allowance for depreciation provided in section 167, held
for more than 1 year, and real property used in a trade or business.

Rev. Rul. 75--291, 1975--2 C.B. 332 involved a fact pattern similar to the one presented
above. That Rev. Rul. provided that the exchange of land and a factory used by a
manufacturing corporation for land acquired and a factory constructed solely for the
exchange by an unrelated corporation qualifies for non-recognition of gain or loss under
section 1031(a) of the Code by the corporation exchanging the existing property but not
the corporation exchanging the new property.

Accordingly, since X holds the property to be exchanged with Y for the purpose of
productive use in trade or business, and will hold the property received from Y for
productive use in trade or business the exchange, with respect to X, qualifies as a like
kind exchange within the meaning of section 1031 of the Code.

Also, in accordance with section 1031(d) of the Code the basis of the property received
by X will be the basis of the property exchanged, decreased by the amount of any money
received by X and increased in the amount of gain or decreased in the amount of loss to
the taxpayer which was received on the exchange.

Lastly, as the property to be exchanged by X is the type of property described in section


1231(b) of the Code the holding period of the property received by X in the exchange
shall, in accordance with section 1223(1) of the Code, include the period during which X
held the property, given up in the exchange.

This ruling is given upon the assumption that X will not lend any amounts to Y to
enable Y to complete construction of the above project. We express no opinion as to the
tax consequences under section 1031 of the Code or any other section of the Code should
such loan or loans be made.

PRIVATE LETTER RULING 8110028

Can a taxpayer use a Code §1031 exchange even when the other side is to build on the
property and the taxpayer is to receive it in a Code §1031 transaction, with taxpayer's
approval regarding the building work?

PRIVATE LETTER RULING 8110028

Dear ____:
This is in response to your ruling request dated November 12, 1979, concerning the
federal income tax consequences of an exchange of real estate between Corp. M and
Corp. N.

Corp. M was incorporated on October 12, 1973 under the general corporation laws of
the State of ***. Corp. M files its federal income tax returns with the Internal Revenue
Service in ***

In late 1973 and early 1974, Corp. M acquired from various owners approximately 46
acres of land. Corp. M then constructed numerous improvements on its 46 acre tract
including a pump factory building. These improvements were the first phase of a
contemplated factory complex to be used in connection with the manufacture and
distribution of pumps. The manufacture and distribution of pumps is Corp. M's principal
business activity. Since the completion of the first improvement on this land in 1977,
Corp. M has continuously used the improvements for the manufacture and distribution of
pumps.

Contiguous to Corp. M's 46 acres is a 70 acre lot. Corp. N and others propose to
construct a regional shopping center on the 70 acre lot.

When Corp. M originally acquired its 46 acres, its 46 acres and all the surrounding land
was zoned for manufacturing purposes only. This zoning status for the general area is
important to Corp. M because commercial use of the land is wholly incompatible with the
manufacturing uses of Corp. M.
After constructing its original pump manufacturing plant, Corp. M intended to construct
further manufacturing facilities on this site. However, after Corp. M prepared plans and
specifications for the construction of its additional facilities, it learned that the owners of
the adjacent 70 acres had undertaken proceedings to change the zoning of their 70 acres
from manufacturing to commercial.

Corp. M personally and through its attorney actively resisted this zoning change.
However, the owners of the adjacent 70 acres prevailed, and this property was rezoned
for commercial purposes. Due to this rezoning, Corp. M decided not to proceed with its
plans to construct additional manufacturing facilities. Following this rezoning, Corp. N
proposed to exchange a parcel of land selected by Corp. M for certain undeveloped
portions of Corp. M's industrial site. In addition, Corp. N proposed to have factory
buildings constructed on the land selected by Corp. M according to plans and
specifications approved by Corp. M, who would also approve the construction contractor.
The written agreement describing this exchange also provides that if the cost of the
exchange property plus the cost of the improvements to be completed thereon exceeds
***, Corp. M will pay any excess to Corp. N in cash. However, if the cost of the
exchange property plus the cost of the improvements is less than ***, any deficiency will
be paid by Corp. N to Corp. M.

Corp. M's entire property is presently subject to two encumbrances, one in favor of
Corp. O and the other in favor of A. The agreement between Corp. M and Corp. N
contemplates that Corp. M will use its best efforts to obtain reconveyances of these
encumbrances with respect to the portion of its property being transferred to Corp. N
('Undeveloped Land') thereby enabling Corp. M to convey real estate to Corp. N free and
clear of any encumbrances. Corp. M and Corp. N recognize, however, that this may not
be possible. Therefore, paragraph 2.2 of the agreement between Corp. M and Corp. N
regarding this exchange ('Agreement') contemplates that Corp. N will encumber the
property it will exchange if Corp. M is unable to obtain the reconveyances. Corp. M and
Corp. N contemplate that the amount of the encumbrance on Corp. N's exchange property
will be equal to the total amount of the encumbrance against Corp. M's Undeveloped
Land.

Section 1031(a) of the Internal Revenue Code ('Code') provides that no gain or loss
shall be recognized if property held for productive use in trade or business or for
investment (not including stock in trade or other property held primarily for sale, nor
stock, bonds, notes, choses in action, certificates of trust or beneficial interest, or other
securities or evidences of indebtedness or interest) is exchanged solely for property of a
like kind to be held either for productive use in trade or business or for investment.

Section 1031(b) of the Code provides that if an exchange would be within the
provisions of section 1031(a), if it was not for the fact that the property received in
exchange consists not only of property permitted by such provisions to be received
without the recognition of gain, but also of other property or money, then the gain, if any,
to the recipient shall be recognized, but in an amount not in excess of the sum of such
money and the fair market value of such other property.
Section 1031(d) of the Code provides that if property was acquired in an exchange
described in certain sections, including section 1031, then the basis shall be the same as
that of the property exchanged, decreased in the amount of any money received by the
taxpayer and increased in the amount of gain or decreased in the amount of loss to the
taxpayer that was recognized on such exchange. If the property so acquired consisted in
part of the type of property permitted by section 1031 to be received without the
recognition of gain or loss, and in part of other property, the basis provided in this
subsection shall be allocated between the properties (other than money) received, and for
the purpose of the allocation there shall be assigned to such other property an amount
equivalent to its fair market value at the date of the exchange. For purposes of section
1031, where as part of the consideration to the taxpayer another party to the exchange
assumed a liability of the taxpayer or acquired from the taxpayer property subject to a
liability, such assumption or acquisition (in the amount of the liability) shall be
considered as money received by the taxpayer on the exchange.

Section 1.1031(a)--1(b) of the Income Tax Regulations ('regulations') provides that as


used in section 1031(a), the words 'like kind' have reference to the nature or character of
the property and not to its grade or quality. One kind or class of property may not be
exchanged for property of a different kind or class. 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. Unproductive real estate held by one
other than a dealer for future use or future realization of the increment in value is held for
investment and not primarily for sale.

Section 1.1031(a)--1(c)(2) of the regulations provides, in part, that no gain or loss is


recognized if a taxpayer who is not a dealer in real estate exchanges improved real estate
for unimproved real estate.

Section 1.1031(a)--1(a) of the regulations also provides that a transfer is not within the
provisions of 1031(a) if as part of the consideration the other party to the exchange
assumes a liability of the taxpayer (or acquires property from the taxpayer that is subject
to a liability), but the transfer, if otherwise qualified, will be within the provisions of
section 1031(b).

Section 1.1031(d)--1(a) of the regulations provides that if, in an exchange of property


solely of the type described in certain code sections, including section 1031, no part of
the gain or loss was recognized under the law applicable to the year in which the
exchange was made, the basis of the property acquired is the same as the basis of the
property transferred by the taxpayer with proper adjustments to the date of exchange. If
additional consideration is given by the taxpayer in the exchange, the basis of the
property acquired shall be the same as the property transferred increased by the amount
of additional consideration given.

Section 1.1031(d)--1(b) of the regulations provides that if, in a section 1031 exchange,
gain to the taxpayer was recognized under the provisions of section 1031(b), on account
of the receipt of money in the transaction, the basis of the property acquired is the basis
of the property transferred (adjusted to the date of the exchange), decreased by the
amount of money received and increased by the amount of gain recognized on the
exchange.

Section 1.1031(d)--2 of the regulations provides that for the purposes of section
1031(d), the amount of any liabilities of the taxpayer assumed by the other party to the
exchange (or of any liabilities to which the property exchanged by the taxpayer is
subject) is to be treated as money received by the taxpayer upon the exchange, whether or
not the assumption resulted in a recognition of gain or loss to the taxpayer under the law
applicable to the year in which the exchange was made.

In example 2 of section 1.1031(d)--2 of the regulations, two taxpayers, D and E,


exchanged apartment buildings that were both subject to mortgages. D's apartment
building was subject to an $80,000 mortgage and E's apartment building was subject to a
$150,000 mortgage. In addition to his apartment house, E also gave D $40,000 cash. The
example explains that for purposes of section 1031(b) of the Code, the amount of 'other
property or money' received by D is $40,000. Consideration received by D in the form of
a transfer subject to a liability of $80,000 is offset by consideration given in the form of a
receipt of property subject to a $150,000 liability. Thus, only the consideration received
in the form of cash, $40,000 is treated as 'other property or money' for purposes of
section 1031(b).

In Rev. Rul. 75--291, 1975--2 C.B. 332, Y entered into a written agreement with X for
the acquisition of a tract of land and a factory owned by X. Pursuant to this agreement, Y
acquired another tract of land and constructed a factory thereon solely for the purpose of
exchanging the tract of land and new factory for X's land and existing factory. Under the
terms of the agreement, Y would terminate the agreement if the costs of purchasing the
land and building the factory exceeded a specified amount. Y purchased the land, built
the factory on its own behalf, and consummated the exchange. No personal property was
involved in the exchange.

Rev. Rul. 75--291 concludes that with respect to X, a taxable exchange is not deemed
to arise merely because Y acquired the property specifically to complete the exchange, if
the transaction otherwise qualifies for nonrecognition of gain under section 1031(a) of the
Code. However, this conclusion is qualified by a finding that the party, Y, acquiring the
property to be exchanged with the taxpayer, X, did so on his own behalf and not as an
agent of X. Furthermore, any depreciation recaptured as a result of the exchange of X's
property is subject to tax as ordinary income under the provisions of section 1250(d)(4).
Although this revenue ruling is factually distinguishable from the instant case in that
Corp. M is proposing to exchange unimproved real estate for improved real estate, the
revenue ruling does sanction one party (Y) to the exchange acquiring real estate and
improving it to meet the specifications of the other party (X) to the exchange provided
that Y is not acting as the agent of X. As explained in Rev. Rul. 75--291, Y would not be
able to claim the nonrecognition treatment of section 1031 of the Code. Corp. M's
position, however, is analogous to that of X's position in the instant case.
In a telephone conversation on June 25, 1980, we informed taxpayer's representative, B,
that we could issue a favorable ruling only if it specifically stated that the exchanges
would be simultaneous. B agreed to this caveat.

Accordingly, for federal income tax purposes:

1. Provided that the exchange of properties between Corp. M and


Corp. N is simultaneous, and that Corp. N is not acting as Corp.
M's agent, the conveyance by Corp. M of its Undeveloped Land
to Corp. N in exchange for a parcel of property selected by
Corp. M and upon which improvements have been constructed
by Corp. N according to Corp. M's specifications constitutes a
tax free exchange within the meaning of section 1031 of the
Code.
2. In the event that the property and improvements received by
Corp. M in exchange for its Undeveloped Land are acquired by
Corp. N at a total cost which is less than *** the receipt by
Corp. M of cash in an amount equal to the difference will be
treated as boot and will be included in Corp. M's gross income
but will not adversely affect the portion of the exchange that
constitutes a like kind exchange pursuant to section 1031 of the
Code.
3. If Corp. N is unsuccessful in obtaining a reconveyance of the
encumbrances against its Undeveloped Land, then Corp. N will
encumber the property it intends to exchange in the same
amount and as part of the transaction will assume the
indebtedness encumbering Corp. M's Undeveloped Land
intended for exchange. To the extent that the amount of the
encumbrances assumed by Corp. N and Corp. M are equal, the
assumption of the encumbrance by Corp. N on the Undeveloped
Land will not result in the receipt of taxable boot by Corp. M.
4. The property and improvements received by Corp. M in
exchange for its Undeveloped Land will have a basis in the
hands of Corp. M equal to Corp. M's basis in its Undeveloped
Land increased by the amount of gain recognized by Corp. M as
a result of receiving cash as described in ruling two and the
amount of any cash which Corp. M is required to pay Corp. N
pursuant to the Agreement.

For a general article involving exchanging multiple assets, and for the considerations in
such multi-asset exchange, see the article by Raitz, Ronald and Raitz, Bridgette,
"Maximizing Multi-Asset Exchanges," Commercial Investment Real Estate Journal 21
(January-February, 1999).

CHAPTER 12:
BASIS AND HOLDING PERIOD BASIS OVERVIEW
Code Section 1031(a) provides for the general nonrecognition rule as to gain or loss of
an exchange if other subsections do not otherwise disqualify the transaction.

If the transaction is qualified, the next question addresses the effect on basis of property
received by the taxpayer.

As an example, if A transfers his property in an exchange with B, with an adjusted


basis of $40,000, and a fair market value of $100,000, and assuming no debt on the
property, and other like-kind property received by A from B, what is A's basis?

If the transaction is simplified, as noted, where A is transferring his property to B, and


B is transferred by A to B or B to A, A must look to Section 1031(d) to determine his
basis.

This Section of the Code provides that if property was acquired in an exchange
described under Section 1031(a), the basis is the same as that of the property exchanged
by A. In this case, the basis to A, in his new property, B-1, would be $40,000.

Basis is decreased in the amount of any money received by the taxpayer. Thus, if A had
received $10,000 from B, A's basis would be $40,000, reduced by the $10,000 received.

The Section further states that basis is increased in the amount of gain or decreased in
the amount of loss to the taxpayer that was recognized on such exchange. It is obvious,
from the prior discussion, that should A receive $10,000 in cash from B, since this is non-
like-kind property, that A would have recognized $10,000 in gain. Thus, his basis would
be decreased by the amount received, namely $10,000. However, from the additional rule
noted, it would be increased in the amount of gain recognized. Since he would have
taxable income on the $10,000, his basis would have been $40,000, initially, reduced by
the $10,000 received, and increased by the $10,000 recognized. This result is correct,
since the taxpayer should retain his $40,000 basis. He reported the gain on the $10,000 at
the time of the exchange. Remember, Section 1031 is merely to defer or postpone the
recognition of gain or loss, where applicable; it is not to eliminate the same. This is why
Section 1031(d) requires the taxpayer to retain his basis. (If A had taken a basis of
$100,000 in the example and was not taxed, he would eliminate the gain, not merely
postpone it.)

Had there been loss recognized to A, he would have decreased his basis in the amount
of the loss that was recognized.

PARTIALLY QUALIFIED PROPERTY

Section 1031(d) provides that if property acquired in the exchange consists of the type
of property, in part, which is permitted by the Section and part of which is not, the basis
provided under Section 1031(d) is allocated among the properties -- excluding money --
which are received. It further provides that for the purpose of the allocation there is to be
assigned to such other property, that is, the non-like-kind property, an amount equivalent
to its fair market value at the date of the exchange.

The subsection states that where, as part of the consideration to the taxpayer, A in our
example, another party to the exchange, B in the example, assumes a liability of A, or
acquires from A the property in question "subject to a liability," that liability is
considered as money received by A on the exchange.

ALLOCATION OF BASIS AMONG PROPERTIES

To further interpret Section 1031(d), Treas. Regs. Section 1.1031(d)-1(c) provides that
if there is an exchange of like-kind properties the taxpayer receives other property, which
is not permitted to be received without recognition of gain, that is boot, and gain from the
transaction is recognized as provided under Section 1031(b), the basis, adjusted to the
date of the exchange, of the property transferred by the taxpayer, A, will be decreased by
the amount of any money received, and increased by the amount of gain recognized.

As stated above, the basis must be allocated to the properties, other than money,
received in the exchange. For the purpose of the allocation of the basis of the properties
received, the Regulations state that there must be assigned to such other property, that is,
the non-like-kind property, an amount equivalent to its fair market value at the time of the
exchange. The Regulations provide illustrations.

Section 1031(d) and Treas. Regs. Section 1.1031(d)-1(b) state that if a Section 1031
exchange of properties is made, and there is gain to the taxpayer which is recognized
under Section 1031(b), because the taxpayer received money in the transaction or other
non-like-kind property, the basis of the property acquired is the basis of the property
transferred, adjusted to the date of the exchange (e.g., depreciation), and decreased by the
amount of the money received and increased by the amount of gain recognized on the
exchange. The application of this rule is illustrated in the Regulations by an example
which involves a truck. However, I have changed the labels to real estate, since we are
dealing with realty; the concept is the same.

For example, A, an individual, in 1954 transferred one parcel of real estate (held for
investment), with an adjusted basis in his hands of $2,500, to B, in exchange for a piece
of real estate from B to be used in A's trade or business or for investment. The real estate
from B had a fair market value of $2,400 and B also paid A $200 in cash. A would
realize a gain of $100 upon the exchange, all of which would be recognized under
Section 1031(b), since the fair market value of A's land must in fact be $2,600, and he
has a basis of $2,500. Thus, we have a gain of $100. The basis of the real estate received
by A from B, which we will label B-1, is determined as follows:

Adjusted basis of A's land $2,500


Less: Amount of money received 200
The difference: $2,300
Plus: Amount of gain recognized 100
Basis of land required by A $2,400

The basis of land to A should be $2,400, since he must reduce his basis by $200
because this is the money received. The net reduced basis is $2,300, but it is increased by
the amount of gain recognized. Gain is recognized to the extent of $100 because this is
the lesser of the gain realized ($100), or the boot ($200).

If A sold the property (B-1) for $2,400, he would report no gain or loss. Since he had
$200 from before, $100 being taxed, he already received $100 toward his old basis on
property A of $2,500.

BASIS: ALLOCATION WITH MULTIPLE-USE PROPERTIES

It is also possible that a problem can arise in Section 1031 transaction when
determining basis where the taxpayer is occupying part of the property for personal use,
such as an apartment, and the other apartments in the apartment building are rented. If the
apartment building is exchanged in a Section 1031 transaction, the basis must be
allocated among the properties. In other words, where the asset is used for personal as
well as for business use, the transaction can qualify under Section 1031 as to the business
portion use of the property.

If a total ten-unit apartment building, the taxpayer occupied one apartment and the
other nine apartments were rented, assuming all of the apartment units to be equal in
value, then we would need to allocate the basis accordingly. If we assume that the ten-
unit apartment building was exchanged for a five-unit structure, all of it being used for
rental, then an allocation is necessary. If the value of the property received with regard to
the personal use property being transferred for it is equal, that is one-tenth of the property
being transferred by the taxpayer, then arguably one-tenth of the value of the new
building would be attributable to the personal use. On the other hand, the basis of the
personal portion being transferred would be one-tenth of the total basis of the property,
without being reduced for depreciation, since there has been no depreciation on the
personal portion, i.e., the unit occupied by the taxpayer.

This same concept applies where property was transferred by a taxpayer and that
property was used partially for business and partially for personal use. The best example
in this particular case, and most common to most taxpayers, is the use of an automobile
which is partially used for business and partially for pleasure. An allocation of the basis is
necessary to consider the portion of gain, if any.

BASIS: WHEN AN EXCHANGE ALSO INVOLVES BOOT

If the taxpayer recognizes gain on a transaction which also in part qualifies under
Section 1031, the recognized gain increases the basis of the new property.

For example, if the taxpayer has transferred the property in a Section 1031 transaction
with a basis of $20,000 and also paid boot of $20,000, his basis in the new property, thus
far, would be $40,000. If he also recognized gain with respect to the transaction involved,
that additional amount, such as $7,000 for an example, would raise the total basis in the
example given to $47,000.

If non-like-kind property is also involved in the exchange, the basis of the property
acquired by taxpayer, A, is the same as the property transferred, in the prior example
$40,000, but increased by the amount of additional consideration given by A.

If A transferred his property to B, and A's basis was $40,000, and A also transferred
property with an adjusted basis of $6,000, $6,000 in cash, A's basis for property B-1,
acquired from B, would be the $40,000, which was A's basis in the real estate he
transferred, and the additional $6,00 paid, or a total basis of $46,000. This is also
consistent with Section 1016, which is the section of Internal Revenue Code dealing with
adjustments to basis. See Treas. Regs. Section 1.1031(d)-1(a).

PRIVATE LETTER RULING 8515012

This Private Letter Ruling assumes a tax-deferred treatment on an exchange under


Code §1031. Therefore, with that assumption, it follows and addresses the issue as to
adjustments to basis when there is a §1031 treatment.

PRIVATE LETTER RULING 8515012

This is in reply to a letter of August 22, 1984 from your authorized representative,
requesting rulings under section 1031 of the Internal Revenue Code. In a letter dated
January 7, 1985 we ruled that the exchange of Property a for Property b qualifies as a like
kind exchange under section 1031(a)(1) of the Internal Revenue Code. It was understood
that we would address at a later time the bases of the properties held by the taxpayers
after the exchange.

The information submitted indicates that X owns Property a for the production of rental
income. A and B, noncorporate shareholders of X, jointly own and rent Property b to X
for use in the trade or business of X. Property a and Property b consists of unencumbered
real property. An independent appraiser hired by the taxpayers concluded that the fair
market value of Property a is $19x, while the fair market value of Property b is $18x.
$19x is a greater amount than $18x.

Section 1031(a)(1) 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.

Section 1031(d) of the Code provides, in part, that if property was acquired on an
exchange described in this section, then the basis shall be the same as that of the property
exchanged, decreased in the amount of any money received by the taxpayer and increased
in the amount of gain or decreased in the amount of loss to the taxpayer that was
recognized on such exchange.

Section 301(a) of the Code provides that, except as otherwise provided, a distribution of
property made by a corporation to a shareholder with respect to its stock shall be treated
in the manner provided in subsection (c). Section 301(b) provides that for noncorporate
distributees, the amount of any distribution shall be the amount of money received, plus
the fair market value of the other property received. Section 301(c) provides generally
that if there is a distribution to which subsection (a) applies, then the portion of the
distribution which is a dividend (as defined in section 316) shall be included in gross
income. Section 301(d) provides that for noncorporate distributees, the basis of property
received in a distribution to which subsection (a) applies shall be the fair market value of
such property.

Section 316(a) states that the term "dividend" generally means any distribution of
property made by a corporation to its shareholders out of the corporation's earnings and
profits.

Section 1.301-1(j) of the Income Tax Regulations provides, in part, that if property is
transferred by a corporation to a shareholder which is not a corporation for an amount
less than its fair market value in a sale or exchange, such shareholder shall be treated as
having received a distribution to which section 301 applies in an amount equal to the
difference between the amount paid for the property and its fair market value.

Provided that $19x and $18x reflect the fair market values of Property a and Property b,
it is held as follows:

(1) For purposes of the exchange subject to section 1031, the basis
of Property a after the exchange shall equal the basis of
Property b prior to the exchange and the basis of Property b
after the exchange shall equal the basis of Property a prior to
the exchange.
(2) A and B will be treated upon the exchange described above as
having received a distribution from X of property to which
section 301(a) of the Code applies. The distribution will
consist of the amount by which the fair market value of
Property a exceeds the fair market value of Property b (section
1.301- 1(j) of the regulations).
(3) The basis of the property received in the distribution will be
the fair market value of such property (section 301(d)).
BASIS: PRIVATE LETTER RULING 8540005

This Private Letter Ruling examines Code §1031(b) as to basis, among other Code
Sections that affect basis. After an exchange, obviously one of the calculations that is
necessary for the parties is to determine basis of the new property held. Certainly
appropriate bases adjustments must be made to reflect that Code §1031 involves a
postponement of gain, not an elimination of gain. This postponement of gain is reflected
by the basis adjustments, which takes into account the fact that the income has not been
recognized.

PRIVATE LETTER RULING 8540005

This is in reply to a letter of August 22, 1984 from your authorized representative,
requesting rulings under section 1031 of the Internal Revenue Code. In a letter dated
January 7, 1985 we ruled that the exchange of Property a for Property b qualifies as a like
kind exchange under section 1031(a)(1) of the Internal Revenue Code. It was understood
that we would address at a later time the bases of the properties held by the taxpayers
after the exchange.

The information submitted indicates that X owns Property a for the production of rental
income. A and B, noncorporate shareholders of X, jointly own and rent Property b to X
for use in the trade or business of X. Property a and Property b consists of unencumbered
real property. An independent appraiser hired by the taxpayers concluded that the fair
market value of Property a is $19x, while the fair market value of Property b is $18x.
$19x is a greater amount than $18x.

Section 1031(a)(1) 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.

Section 1031(d) of the Code provides, in part, that if property was acquired on an
exchange described in this section, then the basis shall be the same as that of the property
exchanged, decreased in the amount of any money received by the taxpayer and increased
in the amount of gain or decreased in the amount of loss to the taxpayer that was
recognized on such exchange.

Section 301(a) of the Code provides that, except as otherwise provided, a distribution of
property made by a corporation to a shareholder with respect to its stock shall be treated
in the manner provided in subsection (c). Section 301(b) provides that for noncorporate
distributees, the amount of any distribution shall be the amount of money received, plus
the fair market value of the other property received. Section 301(c) provides generally
that if there is a distribution to which subsection (a) applies, then the portion of the
distribution which is a dividend (as defined in section 316) shall be included in gross
income. Section 301(d) provides that for noncorporate distributees, the basis of property
received in a distribution to which subsection (a) applies shall be the fair market value of
such property.

Section 316(a) states that the term "dividend" generally means any distribution of
property made by a corporation to its shareholders out of the corporation's earnings and
profits.
Section 1.301-1(j) of the Income Tax Regulations provides, in part, that if property is
transferred by a corporation to a shareholder which is not a corporation for an amount
less than its fair market value in a sale or exchange, such shareholder shall be treated as
having received a distribution to which section 301 applies in an amount equal to the
difference between the amount paid for the property and its fair market value.

Provided that $19x and $18x reflect the fair market values of Property a and Property b,
it is held as follows:

(1) For purposes of the exchange subject to section 1031, the basis
of Property a after the exchange shall equal the basis of
Property b prior to the exchange and the basis of Property b
after the exchange shall equal the basis of Property a prior to
the exchange.
(2) A and B will be treated upon the exchange described above as
having received a distribution from X of property to which
section 301(a) of the Code applies. The distribution will
consist of the amount by which the fair market value of
Property a exceeds the fair market value of Property b (section
1.301-1(j) of the regulations).
(3) The basis of the property received in the distribution will be
the fair market value of such property (section 301(d)).

BASIS: LOSSES

Section 1031 provides that losses will not be recognized where there is an exchange of
properties under Section 1031(a), along with boot. See also Code Section 1031(c). How
does this rule affect basis?

The Regulations provide under Section 1.1031(d)-1(d) that the basis of the property or
properties, excluding money, that are received by the taxpayer is the basis, adjusted to the
date of the exchange, of the taxpayer in the property transferred by the taxpayer, reduced
by the amount of any money received. This basis is allocated to the properties received.
For this purpose, there must be allocated to such other property, that is the boot, an
amount of such basis equivalent to the fair market value at the date of the exchange.

The Regulations under Treas. Regs. Section 1.1031(d)-1(e) state that if, upon a Section
1031 exchange of property, the taxpayer also exchanged other property, which he could
not transfer without the recognition of gain or loss, and gain or loss from the transaction
is recognized under Section 1002 of the Code, the basis of the property acquired by the
taxpayer is the total basis of the properties transferred, adjusted to the date of the
exchange, increased by the amount of gain, and decreased by the amount of loss
recognized on other property.
For purposes of this rule, the Regulations state that the taxpayer is deemed to have
received in exchange for such other property an amount equal to its fair market value on
the date of the exchange. This point is illustrated by the Regulations.

For example, A exchanges real estate held for investment, plus stock, for real estate to
be held for investment. The real estate transferred by A has an adjusted basis of $10,000
and a fair market value of $12,000. The stock transferred has an adjusted basis of $4,000
and a fair market value of $13,000. A is deemed to have received a $2,000 portion of the
acquired real estate in exchange for the stock, since $2,000 is the fair market value of the
stock at the time of the exchange.

A's $2,000 loss is recognized under Section 1001 on the exchange of stock for real
estate. No gain or loss is recognized on the exchange of the real estate, since the property
received is like-kind property. The basis of the real estate acquired by A is determined as
follows:

Adjusted basis of real estate transferred $10,000


Adjusted basis of stock transferred 4,000
$14,000
Less the loss recognized on the transfer of the stock 2,000
Basis of the real estate acquired upon theexchange 12,000
$12,000

A is taking his basis in the real estate and the stock, namely $10,000 and $4,000,
respectively ($14,000 total), into the new property acquired. There is an adjustment,
reducing the basis from $14,000 to $12,000 because of the $2,000 loss which was
recognized by A and reported on his tax return relative to the transfer of the stock which
was sold at a loss.

This loss recognition is allowed because the stock is not like-kind property. Had the
property transferred been real estate of like-kind, the loss would not have been
recognized; therefore, there would not have been the reduction of basis for the loss
recognized.

BROKERAGE COMMISSIONS: REVENUE RULING 72-456

Under Rev. Rul. 72-456, the government rendered advice relative to the proper
treatment to be accorded brokerage commissions which are paid when a Section 1031
transaction is involved.

Because this Ruling gives a number of examples of circumstances where commissions


are paid and the tax treatment for them, this Ruling is reprinted almost in full.
In Situation 1 of the Ruling, the cash received was $10,000, but brokerage commissions
paid were $2,000, for a net cash received of $8,000. This was the amount of the
recognized gain in the example.

In Situation 2 of the Ruling, there was no realized gain, and, therefore, since recognized
gain is limited to the lesser of realized gain or boot received, there was no recognized
gain.

In the third example, there was no boot received, even though there was gain realized of
$8,000. Therefore, there was no recognized gain.

REVENUE RULING 72-456


1972-2 C.B. 468

Advice has been requested concerning the proper treatment to be accorded brokerage
commissions paid in connection with exchanges of properties that result in nontaxable or
partially nontaxable exchanges under section 1031 of the Internal Revenue Code of 1954
in the situations described below.

Situation A taxpayer exchanged his property, land held for


1. productive use in trade or business or for investment, with
an adjusted basis of $12,000, for property of a like kind, to
be held for productive use in trade or business or for
investment, with a fair market value of $20,000 and
$10,000 in cash. He paid a commission of $2,000 to a real
estate broker.
Situation A taxpayer exchanged his property, land held for
2. productive use in trade or business or for investment, with
an adjusted basis of $29,500, for property of a like kind, to
be held for productive use in trade or business or for
investment, with a fair market value of $20,000 and
$10,000 in cash. He paid a commission of $2,000 to a real
estate broker.
Situation A taxpayer exchanged his property, land held for
3. productive use in trade or business or for investment, with
an adjusted basis of $10,000, for property of a like kind, to
be held for productive use in trade or business or for
investment, with a fair market value of $20,000. He paid a
commission of $2,000 to a real estate broker.

Section 1.1031(d)--1(c) of the Income Tax Regulations provides, in part, that if, upon
an exchange of properties of the type described in section 1031 of the Code, the taxpayer
received other property (not permitted to be received without the recognition of gain) and
gain from the transaction was recognized as required under section 1031(b) of the Code,
the basis of the property transferred by the taxpayer, decreased by the amount of any
money received and increased by the amount of gain recognized, must be allocated to and
is the basis of the properties (other than money) received on the exchange.

Section 1.1031(d)--2 of the regulations, example (2), indicates that money paid out in
connection with an exchange under section 1031 of the Code is offset against money
received in computing gain realized and gain recognized and is also added in determining
the basis of the acquired property.

Accordingly, it is held that the three factual situations presented result in the following:

SITUATIONS
Received 1 2 3
----------- ----------- -----------
Land-F.M.V. $20,000.00 $20,000.00 $20,000.00
Cash 10,000.00 10,000.00 -0-
----------- ----------- -----------
Total $30,000.00 $30,000.00 $20,000.00
Less Brokerage
2,000.00 2,000.00 2,000.00
commision
----------- ----------- -----------
Amount realized $28,000.00 $28,000.00
Given up: Land-
12,000.00 29,500.00 10,000.00
basis
----------- ----------- -----------
Realized gain(loss) $16,000.00 $(1,500.00) $8,000.00
=========== =========== ===========
Recognized gain
(lesser of realized
gain or net cash
received) $8,000.00 $-0- $-0-
(Emphasis by
=========== =========== ===========
Author)
Basis
Land given up-basis $12,000.00 $29,000.00 $10,000.00
Less cash received (10,000.00) (10,000.00) -0-
Plus recognized
8,000.00 -0- -0-
gain
Plus brokerage
2,000.00 2,000.00 2,000.00
commission
----------- ----------- -----------
Basis of land
$12,000.00 $21,500.00 $12,000.00
received
=========== =========== ===========
ISSUES OF BOOT AND BASIS LIABILITIES AND DEBT:
BASIS AND BOOT GIVEN

Where the taxpayer transfers not only like-kind property, but also transfers boot to a
second party, the basis of the property acquired by our taxpayer would include the basis
of the property he transferred and also the boot that he also transferred (with other
adjustments as discussed herein).

Likewise, it is a form of giving boot when the taxpayer assumes or takes subject to a
debt on the property. Thus, if A transferred his building worth $100,000 with a basis of
$50,000 to B for his building worth $110,000, with a mortgage on it of $10,000, which A
is to assume, A would be giving boot in the sense of assuming the $10,000. This would
be part of A's basis, and thus A's basis, without any other adjustments, would be his basis
in the old building, namely $50,000 plus a $10,000 increase for the assumption of the
debt.

STOCK

Where boot other than money or indebtedness is received, the basis of the property is
increased by the amount of the gain recognized because of the boot. As an example,
where the taxpayer in question transfers a building worth $100,000, with the basis of
$20,000, in exchange for another building worth $90,000, and the taxpayer also receives
$10,000 in stock, the $10,000 is obviously boot. Since the boot will be taxed because it is
less than the actual gain, the basis of the property being carried over to the new property
must be allocated. A portion of that basis is first charged to the stock, that is the boot
property. It is allocated to the boot property up to the amount of the fair market value of
the boot. The balance, in our example $20,000 less $10,000 allocated to the stock, would
result in $10,000 of basis being allocated to the newly acquired building. (There is also a
$10,000 increase adjustment to basis as a result of recognizing gain on the boot, thus, the
net basis is $20,000.)

BOOT AND APPORTIONMENT OR DIVISION OF BOOT

The question arises as to how the boot is apportioned when there are multiple pieces of
property involved. It is a difficult position to determine the proper allocation of boot in a
given setting. Thus, a taxpayer may net boot, as discussed in this material. Once he has
determined that he has a given net amount of boot, such as debt relief, we must determine
not only the character of the gain on the property, but also the property to which the boot
relates if there are multiple pieces of property involved.

Assume a taxpayer transfers a piece of real estate with a value of $3,000, and an
adjusted basis of $2,000. This is a potential gain of $1,000.

Assume that the taxpayer in this transaction received other real estate of like-kind
nature and also received $500 in cash. The $500 is clearly boot; therefore, the $500,
being less than the $1,000 of realized gain, would be taxed.
ALLOCATION OF BASIS: REVENUE RULING 68-36

Where a taxpayer acquires a property in a tax-deferred exchange, he transfers or carries


his basis with him to the new property, adjusted as provided herein. However, a question
is raised as to what the taxpayer does when he acquires multiple properties. Thus, if X
transfers his building in exchange for two buildings from Y, what is the basis to X in his
new buildings? Generally speaking, we say that the basis of the property acquired would
be allocated between the two new properties based on the fair market value of those
properties in relation to each other. Thus, if a new building acquired by X had a fair
market value of $50,000, and the other building had a fair market value of $150,000, one-
quarter of the basis would go to the first building and three-quarters of the basis would go
to the second building.

In this Ruling, the advice that was requested deals with the proper method of allocating
the basis of a piece of income-producing real estate between two pieces of like-kind
property acquired in an exchange under Section 1031.

Under the Ruling, the basis to the taxpayer in the acquired properties is the same as the
basis in the exchange property, allocated between the two properties received, on the
basis of their respective fair market values on the date of the exchange.

To illustrate this principle, the Ruling notes that we could assume that a given piece of
realty, with a basis of $110,000, $100,000 of which is attributable to the land, and
$10,000 of which is attributable to a building, is exchanged for Lots 2 and 3, under the
provisions of Section 1031. Each of these lots has a building on it. The fair market value
of Lots 2 and 3 are then stated in the Ruling. An allocation is made based on the fair
market value.

REVENUE RULING 68-36


1968-1 C.B. 357

Advice has been requested as to the proper method of allocating the basis in a piece of
income-producing real property to two pieces of like property acquired in an exchange
which qualifies under section 1031(a) of the Internal Revenue Code of 1954.

M corporation owns improved lots 1, 2, and 3 and is in the business of owning and
leasing real property. O corporation owns improved lot 4 and is in the business of owning
and leasing real property. Lots 1 and 4 are contiguous and, although the buildings are
separate structures, certain facilities (the lobby, elevator, and boiler and tank in the
basement) are common facilities utilized by both buildings. It is proposed that M
corporation transfer lots 2 and 3 to O corporation in exchange for lot 4. The value of lots
2 and 3 is in the aggregate equal to the value of lot 4. Neither corporation will assume
any liabilities in connection with the exchange. The corporations have no present
intention to sell or otherwise dispose of these properties after the exchange and they will
hold them for the same purpose as they were held before the exchange, as rental
properties.
In E. C. Laster v. Commissioner, 43 B.T.A. 159 (1940), reversed and affirmed on other
issues, 128 F.2d 4 (1942), the taxpayer exchanged oil leases for oil leases, including the
well equipment on each. The court sustained the Commissioner's allocation of the basis
of the property exchanged to the property acquired according to the relative values of the
properties acquired at the date of the exchange.

Since the exchange of properties by M corporation and O corporation complies with


Section 1031(a) of the Code, there can be no recognition of gain or loss to either M or O
corporation.

Accordingly, the basis to O corporation in the two acquired properties shall be the same
as the basis in the exchanged property allocated between the two properties received on
the basis of their respective fair market values on the date of the exchange.

To illustrate this principle, assume that lot 4, with a basis of $110,000, $100,000 of
which is attributable to land and $10,000 of which is attributable to building, is
exchanged for lots 2 and 3 under the provisions of section 1031 of the Code. Each of
these lots has a building on it. The fair market values of lots 2 and 3 are:

lot 2 lot 3
land ........... $20,000 $30,000
building ....... 80,000 120,000
-------- --------
Total..... $100,000 $150,000
Computation of the basis of each lot to O corporation is as follows:
lot 2
$100,000 2 150,000 3
------------------------ = ------ ------------------------ = ------
250,00 5 250,000 5
(2/5)X$110,000= (Total (3/5)X $110,000= (Total
$44,000 basis) $66,000 basis)

Basis allocated to land and building:


lot 2 lot 3
land: $20,000 1 $30,000 1
------------------------ = ------ ------------------------ = ------
100,000 5 150,000 5
(1/5)X$44,000=$8,800 (1/5)X$66,000=$13,200

building: $80,000 4 120,000 4


------------------------------- = ------ ------------------------------ = ------
100,000 5 150,000 5
(4/5)X$44,000=$35,200 (4/5)X$66,000=$52,800
Therefore, the basis to O corporation in the two acquired properties will be $44,000 for
lot 2 ($8,800 allocated to the land and $35,200 to the building) and $66,000 for lot 3
($13,200 allocated to the land and $52,800 to the building).

CAVEAT: The following article was written in 1983. However, aside from the ACRS
rules (under the TRA of 1986), most of the exchange concepts herein continue to apply.

EXCHANGING: AN ILLUSTRATION OF THE TREATMENT


TO BASIS, ALLOCATIONS, DEPRECIATION and ACRS
by:Dr. Mark Lee Levine

I. INTRODUCTION:
A. PURPOSE:
The intent of this short note is to illustrate the implications of a tax-deferred exchange
involving multiple parties. The deferral part will be only on one side of this transaction.
This illustration also depicts loan relief and a number of other basic points in the
exchange area. However, the main thrust is to illustrate the division of a dollar amount
allocated to basis between land, buildings and personalty/fixtures, considering both pre-
ACRS and the application of ACRS rules.

B. FACTUAL SETTING - SUMMARY:


The illustration herein involves an actual transaction that took place in l983. The
transaction involved multiple considerations by various parties, including two (2)
partnerships and various individuals. Considerations included the typical positions of
relief from cash drains (alligators), a desire on the tax-deferred side to move into
depreciable property from unimproved property, other concerns with tax benefits, loan
relief issues, settlements to split interests of various parties, and numerous other practical
points that seem to come up on a day-by-day basis in the real estate world. However, it
also appeared that many of these items came together in this one case, with particular
emphasis on the tax issues in the exchange area. The intent of this note is to illustrate
those points.

II. TRANSACTION:
A. FACTUAL SETTING:
This transaction was negotiated over many months. One Group, known as Plaza, owned
a shopping center or shoppette. Their main concern was relief from a situation caused by
approximately a 75% vacancy factor. The cash drain, negative considerations for
improvements in the future, and internal considerations with the partners encouraged
those partners to look to some means out of the property in question.

The tax-deferred exchange side, which might be referred to as the Williams Fork/Pitler
side, was interested in moving from unimproved property that had been held for a
number of years into improved property which could lend depreciation and other benefits
to this Group.
Also included in the Pitler Group, in addition to Williams Fork Reservoir, Ltd., a
Limited Partnership, were individuals who were placing cash into the transaction.

The motives were set for the Pitler Group, which included Williams Fork and the
individual investors, to come together and own as tenants in common in a co-ownership
or joint venture arrangement. That is, the Williams Fork Group as a Partnership was to
undertake a transfer of their property for part interest in their shopping center. The Pitler
Group and others individuals would claim an interest as joint venturers or tenants in
common with the Williams Fork Group. This point is emphasized inasmuch as a new
Partnership was not formed, but rather a tenancy in common position was formed, with
the proper agreements to affect the rights and responsibilities of the parties in question.

The property owned by Williams Fork had appreciated in value, and the investors in
that Partnership did not desire to generate taxable gain. Further, they desired to obtain tax
benefits from the depreciation in the shopping center.

The Plaza Group knew that if it transferred its property, worth approximately
$l,400,000, with an $800,000 loan, it would have debt relief, inasmuch as it was
transferring its property in consideration of its receipt of:

1. The assumption of its loan on the Plaza property in the amount


of approximately $800,000;
2. A rental condominium unit; and
3. The acquisition of the Williams Fork acreage, which had a
small loan on the same.

Therefore, the tax-deferred position was the Williams Fork/Pitler side, and not on the
Plaza side.

Having this setting, additional facts that adjusted the positions of the parties seemed to
occur throughout the negotiations, as is commonly the case. For example, one interesting
twist on the transaction is an adjustment by the parties that makes the valuation somewhat
contingent. The parties agreed on the exchange, noted above, but with the qualification
that if lease-up occurs by the Williams Fork Group on the Plaza center that was acquired
before the Williams Fork Group expended the sum of $50,000 (specifically defined in the
Contract to include only certain items), then the Pitler Group, within a given period of
time, would transfer an additional condominium unit. On the other hand, if the Pitler
Group expended the sum of $50,000 prior to a given date, there would be no liability for
the additional unit.

The use of this contingency as to an additional transfer of property seemed to solve


some of the concerns of some of the parties with regard to the valuation issue.

B. ADDITIONAL PROBLEMS AND ISSUES:


As is true with any exchange, there were obviously other issues that needed to be
resolved. However, the focus in this note is on the tax issues, which are addressed in the
next Section of the paper. These emphasize the bases that were involved for the tax-
deferred exchange side, the Williams Fork side, and how those bases were allocated, and
the affect of such allocation as to depreciation and ACRS.

III. TAX IMPLICATIONS TO BASES, ALLOCATION, DEPRECIATION AND


ACRS:
A. TAX IMPLICATIONS IN GENERAL:
We are familiar with the general implications of a Code §l03l exchange if we deal in
any depth in the commercial field. However, the focus, as mentioned, is not to look at the
general qualifications of the transaction for §l03l, even though that is important, but
rather to focus on the issues as to applying the division of the various bases involved to
the properties that were acquired.

B. BASIS: The basis of the property for this joint venture of Williams Fork/Pitler
parties included the transfer of the basis of the Williams Fork property from the
Partnership along with the basis of property acquired by the transfer of the Logan
Condominium Unit #2-B. In addition, basis was added or increased by assumption of the
loan of $803,000, as indicated in the attached Exhibit (see Item C of the Exhibit).

Once the basis was determined, the basis must be allocated. That is, although the value
of the Center arguably may have been $l,400,000 (loan plus the properties), as illustrated
in the past Exhibit, Item A, there is no increase in basis in this setting for the Williams
Fork/Pitler Group since they had no recognition of income. (We are assuming like-kind
property, no debt relief and no boot.)

Per the Exhibit, the basis of $948,000 (rounded) must be allocated. Allocation of the
adjusted basis is based on fair market value of the properties received in relationship to
the total properties received.

C. ALLOCATION: As mentioned, allocation of the adjusted basis to the various


properties is determined by looking to the fair market value of each item that is acquired
in relationship to the total fair market value of all the property acquired. Although some
of the figures were rounded, they are illustrated in the allocation and the Exhibit attached.
See Item D.

You will note that the fair market value of the land was $l40,000, with a value of the
personalty/fixtures at $70,000, and the value of the building at $l,l90,000. This results in
a total valuation of $l,400,000, and it is this figure that becomes the denominator. As
illustrated in Item D of the Exhibit, the percentages allocated based on fair market value
are illustrated for each of the categories noted.

It is these percentages that are applied to determine the amount of the adjusted basis of
each item.

The allocation is illustrated in the Exhibit, Item E, wherein the percentages will be
applied to the adjusted basis of the properties as noted
.

D. DEPRECIATION AND ACRS:


The depreciation is determined by allocating the bases that were pre-l98l (that is prior
to the Economic Recovery Tax Act of l98l and the creation of ACRS).

Thus, as seen on the Exhibit, Item C, the pre-l98l items involved the Williams Fork
property and the Logan property. Those items, namely $ll3,205 for Williams Fork, and
$3l,472 for the Logan property, constitute the portion of the bases that will apply the pre-
ACRS rules. The division of the basis of the new property for these amounts as among
land, personalty and building are based on the allocations noted earlier. See Item D of the
Exhibit.

The adjusted bases that were new from the exchange, that is applying the ACRS rules,
consists of the cash placed in the venture along with the loan assumed of $803,265.

Thus, the allocation would be made based upon the percentages applied to both the pre-
and the ACRS-bases.

IV. CONCLUSION:

In summary, the complexities that seem to be involved in these types of transactions are
created because of many tax laws which not only require as to allocate a price between or
among properties that are acquired, but we also have undertaken the allocation based
upon the fair market value relationship of the properties in question when they are
acquired in the exchange. In addition, the rules require that we allocate a portion of the
basis to the pre-ACRS rules for property and apply the pre-ACRS depreciation rules. The
balance of the basis would be depreciated under the ACRS rules.

Again, these complexities are created as a result of changes in the tax law. When these
rules are coupled with some of the other requirements to undertake a tax-deferred
exchange, one can see that it does take a degree of planning for the tax issues in addition
to the non-tax points.

NUMEROUS ASSET EXCHANGE

Where a number of assets are exchanged, an allocation of basis must be made, as


indicated earlier. Thus, if the taxpayer, under Section 1031, exchanged unimproved real
estate for an office building, the basis of the land must be allocated among the properties
acquired with regard to the office building. The office building would include certain
unimproved ground, the building itself and items contained within the building. The basis
of the acquired properties must be adjusted or allocated to the new properties based on
the fair market value of the properties involved. Thus, if the land had a basis of $12,000,
but a fair market value of $40,000, and it was exchanged for the office building and land
on which the office building sits, together having a fair market value of $40,000, the
$12,000 would be allocated in proportion to the fair market value of the properties
acquired. If we assume the land which is the site of the office building has a fair market
value of $10,000 and the building has a fair market value of $30,000, the allocation of the
$12,000 would be one-fourth to the land and three-fourths to the office building.

Clearly, we now have depreciable property, where there was no depreciation on the
ground. That is one of the many reasons why an exchange might be advantageous.

This same concept of allocating basis to multiple assets also applies where businesses
or other activities are acquired. For more on this point, see Rev. Rul. 57-365 and Code
§1060.

SUMMARY OF ADJUSTMENTS: BASIS ON EXCHANGE

The basis for an exchange is determined by the following method, subject to special
adjustments that may arise in special circumstances.

Determine the adjusted basis of the Section 1031 property that


A.
is transferred.
Take the adjusted basis of boot property (other than money)
B.
that is transferred.
C. Take the total of A and B and add to that:
1. Other monies paid;
2. Debt which is on property that is being acquired;
3. Any gain recognized.
Total these items, and this is the total basis, reduced by the
D.
following:
1. Cash or other boot received;
2. Debt on the property that is transferred;
3. Any loss that is recognized.
E. The total of these items is the new basis. (See Appendix 2.)

BASIS CALCULATION

One illustration that may, in addition, help to prove basis or evidence the methodology
dictated by the Code to prove basis is indicated in "A" below.

It is also true that the REALTORS NATIONAL MARKETING INSTITUTE, through


the CCIM Program, has suggested a format which utilizes the premise of starting with
fair market value of the property acquired and making adjustments of the same. This is
evidenced in "B", below.

FORM TO PROVE BASIS


A. TECHNICALLY: CODE SECTION 1031 (assume the
following):
+ (Carryover) adjusted basis of old: + $125
+ Transfer costs = old -0-
+ To acquire/exchange = new + 35
- Loan on old = 175
+ Loan on new + 150
cash $10
- Boot note 15
Rec other -- TOTAL = - 25

+ Boot given + -0-


+ Gain recognized + 50
- Loss recognized - -0-
TOTAL: = $160
B. C.C.I.M. FORM:
F.M.V. of property acquired $200
1. Less: Gain not recognized -(55)
2. Plus: Costs in acquisition 15
3. Plus: Loss not recognized -0-
__________________________________________________
New adjusted basis $160

One may need to use "technical method" when splitting basis, due to Code Section 168
A.C.R.S. - Anti-churning and other applicable rules.

HOLDING PERIODS

Although we know that the basis generally is carried over by the taxpayer to the new
property that he acquires in a Section 1031 tax-deferred exchange, there is also the
question as to the holding period.

For example, if A engages in a Section 1031 transaction and transfers property that he
has held two years, and acquires a new asset, what is the holding period for A on the new
asset if four months later, without any preconceived intent to transfer, he makes a
subsequent sale of that asset for cash?

Is the holding period for A long-term because he previously held the A property for two
years and then held the B property for an additional four months? Or, is the holding
period merely four months?

The answer is that it is a long-term holding period, since the holding is in fact two years
and four months -- assuming a Section 1031 transaction on the exchange.
The general rule is that if the acquired property has the same basis in whole or in part as
that of the property surrendered, the holding period of the acquired property will include
the holding period of the property previously surrendered. See Code Section 1223(1).

Generally speaking, under Code Section 1223(1), the property must be §1221 property
(capital gain property) or §1231 property (property used in the trade or business). If it
does not fit this requirement, then generally there is no tacking or adding of the prior
holding period from the transferred property to the acquired property, unless some other
exception applies. A number of other exceptions with regard to determining holding
periods are discussed under Code Section 1223. See also Levine, West text, Section 574.

HOLDING PERIOD AND QUALIFYING AND NONQUALIFYING PROPERTY

As discussed, if a Code Section 1031 transaction applies, the holding period of the
acquired asset will include the holding period of the transferred asset. However, the
question arises as to what the holding period will be if boot is also received in addition to
qualifying property.

Since the aggregate basis of property surrendered is first allocated to the boot property,
excluding money or debt, to the extent of the fair market value of that property
(§1031(d)), we must also determine the holding period of that property. Generally
speaking, since it is boot property, there is no carryover of basis as to that property, and,
therefore, no tacking can take place. The argument on the other hand, is that part of the
basis of the transferred property is in fact allocated to the acquired property, even though
it is boot. Treas. Reg. Section 1221-1(a), which interprets Code Section 1231(1),
references various exchanges. Under Code Section 1223(2), the same general rule as
under Section 1223(1) applies, that is that the holding period carries over if the basis
carries over. However, the important point is that it mentions that the tacking or using of
the prior holding period, applies where the basis is the same in whole or in part. Thus,
this strengthens the argument that tacking should apply where there is partially like-kind
property and, therefore, a partial basis carryover. Arguably, it then fits within Section
1223(2) and, therefore, tacking should apply.

HOLDING PERIODS: MULTIPLE ASSETS TRANSFERRED

If multiple assets are transferred in the exchange, the holding periods on those assets
must be allocated to the acquired property to determine their various holding periods,
assuming the tacking of those holding periods which would apply in a normal Section
1031 transaction.

One could argue that the holding periods to be allocated to the acquired assets could be
in proportion to the value of the assets transferred. However, this is not that clear. A
transfers, for example, three assets: a car, a typewriter and a computer. Assume that these
assets were exchanged for other like-kind property. If we assume that the first two assets
transferred had short-term holding periods and the third a long-term, and the assets
acquired by the taxpayer were subsequently sold within a few months, would they
generate a long-term or short-term treatment, if, in fact, short-term would result on the
two assets if tacking did not take place? This issue is not readily settled and arises in very
few instances. See Treas. Regs. Section 1.1223-1(i) and §1.1012-1(c).

NEGATIVE BASIS: WILHELM

A taxpayer cannot have a negative basis! Even the Commissioner cannot successfully
assert a negative basis on exchange or otherwise.

MARY R. WILHELM, Petitioner


v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

T.C. Memo. 1983-274


MEMORANDUM FINDINGS OF FACT AND OPINION
DRENNEN, Judge:

OPINION OF THE SPECIAL TRIAL JUDGE

HALLETT, Special Trial Judge:


Respondent determined deficiencies in petitioner's 1977 and 1978 Federal income tax
in the respective amounts of $4,120.80 and $4,341.59, and imposed an addition to tax
pursuant to section 6653(a) for the 1978 taxable year in the amount of $217.08.

After concessions the issues remaining are as follows: * * * * (2) whether petitioner is
entitled to depreciation deductions with respect to her 1973 and 1977 automobiles for
1977 and 1978; (3) whether petitioner must recognize gain on the trade-in of her 1973
automobile; * * * *

GAIN ON TRADE-IN OF 1973 AUTOMOBILE


AND DEPRECIATION ON 1977 AUTOMOBILE

In October 1977, petitioner purchased a 1977 Cadillac for $10,797. Petitioner was
allowed a trade-in allowance of $1,500 for her 1973 Cadillac as part payment of the
purchase price, and the balance of the price ($9,297.16) was financed. After its
acquisition by petitioner and during the remainder of 1977, the 1977 automobile was used
12 percent of the time for business purposes. During 1978, the automobile was used by
petitioner for business purposes 29 percent of the time.

Petitioner reported no gain or loss on the disposition of her 1973 automobile on her
1977 return. She claimed depreciation with respect to the 1977 Cadillac of $720 for 1977
and $4,318 for 1978. In the notice of deficiency, respondent disallowed the 1977
depreciation and all of the deductions claimed on the 1978 return regarding the 1977
automobile, including depreciation. Respondent conceded at trial that petitioner is
entitled to the claimed "out of pocket" expenses for 1978 with regard to the automobile,
but contended petitioner is entitled to no depreciation for 1978.
In addition, respondent determined in the deficiency notice for 1977 that petitioner
must recognize gain on the trade-in of the 1973 automobile of $4,579. In the stipulation
of facts, respondent modified his position as to the amount of gain to be recognized in
connection with the trade-in of the 1973 automobile in 1977 (in paragraph 6, respondent
contends the gain should be $3,267.30; in paragraph 19, calculations are set forth
showing gain of $4,143). On brief, respondent contends that under section 1031,
petitioner need recognize no gain on the disposition of the 1973 automobile, but that
petitioner has a negative basis in the 1977 automobile, such that she is entitled to no
depreciation on it.

Central to respondent's original position (in the notice of deficiency) that petitioner had
recognized gain arising out of the 1977 trade-in of her 1973 automobile, as well as his
current position that petitioner has a negative basis in the 1977 automobile, is the issue as
to the consequences of petitioner's being allowed depreciation on the 1973 automobile for
years prior to 1977 in a total amount exceeding her "business basis" in the automobile. In
this regard, respondent took the position (up until filing his brief) that depreciation
petitioner claimed in prior years on the 1973 automobile created a negative basis to the
extent it exceeded the portion of the original cost (46 percent) allocable to business use,
and that this situation gave rise to recognized gain on the disposition of the automobile.
On brief, respondent conceded the gain recognition issue, based upon the notion that the
trade-in of the 1973 automobile in connection with the acquisition of the 1977
automobile qualified as a nontaxable exchange under section 1031. But respondent still
maintained that petitioner had a negative basis in the 1973 automobile (due to
depreciation being claimed in excess of the "business" portion of basis), and that the
negative basis carries over under section 1031, to the basis of the 1977 automobile.

Respondent has overlooked his own position that an asset cannot have a negative basis.
In this respect, in Hall v. Commissioner, 595 F.2d 1059 (5th Cir. 1979), the Court's
opinion states that the Government in that case conceded on appeal that petitioner had no
gain on the sale of an asset because depreciation claimed in years prior to the sale
exceeded the assets's basis, and it sets forth the following statement made by the
Government in its brief at p. 1060:

* * * Essentially, taxpayer was assigned a 'negative basis' contrary to the long-standing[


[FN4]] position of the Internal Revenue Service. * * *

Accordingly, we conclude that in determining petitioner's basis in the automobile


involved, respondent's long-standing position should be followed and basis should not be
reduced below zero. In reaching this conclusion, we have considered authorities which
raise some question as to whether the applicable Code sections preclude altogether the
concept of negative basis. See Easson v. Commissioner, 294 F.2d 653 (9th Cir. 1961),
revg. 33 T.C. 963 (1960); Comment, Negative Basis, 75 Harvard Law Review 1352
(1962). However, in view of the context in which the matter is presented here, we do not
consider it appropriate to resolve this complex issue on the merits in this case,
particularly in view of the very recent statement of the Supreme Court in Commissioner
v. Tufts, 461 U.S. ---- (May 2, 1983).
We agree with respondent that, because petitioner's 1977 automobile was acquired in a
transaction qualifying for nonrecognition treatment under section 1031, its basis must be
determined in accordance with section 1.1031(d)-1, Income Tax Regs. [FN5] That
section provides that the basis of the acquired property shall be the same as the basis of
the property traded in, plus any additional consideration given. In determining the
additional consideration paid for the 1977 automobile, respondent fails to recognize that
not only did petitioner pay $9,297, but she paid the trade-in value of the personal portion
of the 1973 automobile. That amounts to $810 ($1,500 x 54 percent). Therefore, the total
additional consideration paid for the 1977 automobile is $10,107.

FN4. Consistent with the position taken by the Government on appeal in Hall v.
Commissioner, 595 F.2d 1059 (5th Cir. 1979), respondent ruled in Rev. Rul. 75-451,
1975-2 C.B.330, that an asset's adjusted basis is not to be reduced below zero.

FN5. Section 1031 only applies, however, to that portion of the basis in the automobile
traded in and the automobile acquired that is attributable to business use. In essence, each
automobile must be viewed as two separate assets - the business and non-business
portions. Respondent has adopted this view in his Form 2106, Part V, which provides a
form for taxpayers to calculate basis where an automobile is used in part for business and
part for personal purposes, and is traded in for another automobile, likewise used.

CHAPTER 13:
OTHER TAX SECTIONS IN CONJUNCTION WITH EXCHANGING:
COMBINING INSTALLMENT SALES AND TAX-DEFERRED
EXCHANGES:
1965-1 C.B. 356

Advice has been requested whether payments to be received in installments from an


exchange of investment property for like property, cash and a note, in a transaction
meeting the requirements of section 1031(b) of the Internal Revenue Code of 1954, may
be reported on the installment method for Federal income tax purposes as provided in
section 453(b) of the Code.

The taxpayer entered into a contract to exchange real property which he held for
investment for other real property of a like kind, cash and a note. The cash together with
the value of the similar property received in the year of exchange did not exceed 30
percent of the entire amount to be received under the contract. The balance of the debt
represented by a five-percent interest- bearing note was to be received in annual
installments in the seven succeeding taxable years.

Under the provisions of section 453(b) of the Code, income from the sale or other
disposition of real property may be reported on the installment basis if, in the taxable year
of the sale or other disposition, there are no payments or the payments (exclusive of
evidences of indebtedness of the purchaser) do not exceed 30 percent of the selling price.
Section 453 of the Code requires that where the installment method of reporting income
is elected there shall be reported in each year as income that percentage of the payments
received in such year which the total profit realized or to be realized bears to the total
contract price.

The situation involved in the instant case is analogous to that involved in Revenue
Ruling 75, C.B. 1953--1, 83, which holds that the gain recognized on the sale of the
taxpayer's residence may be reported on the installment method where the purchase of a
new residence results in the partial nonrecognition of gain on the sale pursuant to section
1034 of the Code.

Accordingly, it is held that the taxpayer may elect to use the installment method of
reporting the cash payments provided the transaction otherwise qualifies as an installment
sale under section 453 of the Code.

If such an election is made, the taxpayer should include in his gross income that portion
of each payment received which the total gain to be recognized under section 1031(b) of
the Code bears to the total contract price. The value of the like kind property received on
the exchange must be treated as a part of the initial payment for the purpose of
determining whether payments in the year of the sale or other disposition exceed thirty
percent of the selling price. This may be illustrated by the following example:

Example.--X exchanged property with a basis of 10x dollars for like property worth
20x dollars, 10x dollars in cash and a five-percent interest-bearing note in the amount of
70x dollars. The note was to be paid in seven annual installments of 10x dollars. The
realized gain is 90x dollars. The gain recognized under section 1031 of the Code is 80x
dollars. The basis of the property received is 10x dollars. In the first year the like kind
property and 10x dollars in cash were received.

The amount subject to tax in the first year is computed as follows:

30x dollars (payment) X 80x dollars (total recognized gain) = 24x dollars
100x dollars (contract price)
Thus, 24x dollars will be subject to tax for the first year.

The amount subject to tax in each of the remaining seven years is computed as follows:

10x dollars (payment) X 80x dollars (total recognized gain)


100x dollars (contract price)= 8x dollars
Thus, 8x dollars of the gain will be subject to tax in each of the remaining seven years.

In applying section 1031(d) of the Code to determine the basis of the like property
received, the transaction must be treated as though the money and other property has
been received immediately. Thus, the terms 'any money received' and 'amount of gain * *
* that was recognized on such exchange,' as used in section 1031(d) of the Code, must be
read as including money to be received and gain to be recognized.
INSTALLMENT SALES AND TAX-DEFERRED TREATMENT

As mentioned, the Installment Sales Revision Act of 1980 has eased the use of
installment sales coupled with tax-deferred exchanges. Historically there had been a
problem with trying to utilize an installment sale where there was like-kind property,
since the like-kind property, although possibly nontaxable under Section 1031, was
considered as a payment in the year of sale, when dealing with installment sales.

To eliminate this problem, the Act provided, under Code Section 453(f)(6), where there
is an exchange described under Section 1031(b), that is, a tax-deferred exchange, the total
price under Section 453 is reduced to take into account the amount of any property
permitted to be received in such exchange without recognition of gain. Thus, the Code
provides that when the taxpayer determines the contract price, the taxpayer excludes the
amount of any property received that is like-kind property.

The term "payment" under Section 453 does not include any property permitted to be
received in an exchange without recognition of gain. These rules are provided under
Section 453(f)(6).

The Committee Reports for the Installment Sales Revision Act of 1980 illustrated this
rule:

. . . property permitted to be received without recognition of gain in an exchange


described in Code Section 1031(b) will not be treated as payment for purposes of
reporting income under the installment method.

Thus, in reporting the gain on the exchange under the installment method where an
installment obligation is received in addition to the like kind property, the gross profit
will be the amount of gain which will be recognized on the exchange if the installment
obligation were satisfied in full at its face amount. Also, the total contract price will not
include the value of the like kind properties but instead will consist solely of the sum of
the money and fair market value of other property received plus the face amount of the
installment obligation.

The basis of the like kind property received, (determined under Section 1031(d)) will
be determined as if the obligation, had been satisfied at its face amount. Thus, the
taxpayer's basis in the properties transferred will first be allocated to the like kind
property received (but not in excess of its fair market value) and any remaining basis will
be used to determine the gross profit ratio.

These provisions may be illustrated by the following example. Assume that the
taxpayer exchanges property with a basis of $400,000 for like kind property worth
$200,000, and an installment obligation for $800,000 with $100,000 payable in the
taxable year of the sale and the balance payable in the succeeding taxable year. The
example compares present law, which takes like kind property into account as payment,
with the bill which reverses this rule.
Contract price $1,000,000 $800,000
Gross profit 600,000 600,000
Gross profit ratio
(60) (75)
(percent)
Gain to be reported for:
1. Taxable year of sale:
(a) 60% of $300,000 (payments "received" of 180,000
$100,000 cash and $200,000 value of like
property)
(b) 75% of $100,000 (cash payments) 75,000
2. Succeeding taxable year:
(a) 60% of $700,000 (cash received) 420,000
(b) 75% of $700,000 (cash received) 525,000
Total gain recognized: 600,000
3. Basis of like kind property received 200,000

EXCHANGES AND INSTALLMENT SALE RULES: COMBINED:

Code §1031, under the Regulations, allows the coordination of an installment sale,
along with an exchange.

For an excellent discussion of this issue, see the article by Handler, Adam, "Proposed
Regs. Coordinate Deferred Exchange and Installment Sale Rules," 44 Journal of Taxation
(July, 1993). Although the Regulations have been finalized under Code §1031, the
concept mentioned in the Handler article of the installment sale used with an exchange is
certainly applicable.

Mr. Handler gave an easy example that illustrated the concept of these intertwined
rules.

In the example by Mr. Handler, Mr. A sold his unimproved property, having a basis of
$40,000, and a value of $100,000. This was sold for $80,000 in cash, and a note for
$20,000. The note was payable in one (1) year.

Under this scenario, A has gross profit of $60,000, i.e., $100,000 less the $40,000 basis.
Therefore, the gross profit ratio, the relationship of profit to the contract price, was 60%,
or $60,000 profit divided by the $100,000 contract price. Therefore, there would be a
recognition of gain in the year of sale of 60% of the payment of $80,000,or $48,000. The
other $12,000 was a return of the investment or basis.

Under Code §453(f)(6), the installment sale rule, the concept of the exchange with the
installment sale is covered.
Under these rules, Mr. Handler noted there are three (3) main considerations. (The
following assumes the same facts as above, but the $80,000 Note has changed to $80,000
Qualified Exchange Property.)

(1) The contract price of $100,000 in the example would be


reduced to allow for the fair market value of the property under
Code §1031 that can be received, tax deferred. Thus, the
$100,000 was reduced by $80,000, leaving a balance of
$20,000.
(2) The gross profit under the exchange, the $60,000 example, was
reduced for the gain not recognized. In this example, the gain
that would be deferred was the $40,000, thus resulting in a
$60,000 amount reduced by $40,000, or a net of $20,000. (This
is the $20,000 cash received, with a 100% profit ratio, i.e., sales
price of $100,000 - $80,000 = $20,000 contract price.)
(3) The property that can be received under Code §1031 is received
under the installment sale rule, Code §453, and is not treated as
a payment for purposes of the installment sale rule. Thus, the
payment in the year of sale would be only any actual payments
which were made, not the fair market value of the qualified real
estate ($80,000) that was received.

Under the Code §1031 Regulations, dealing with nonsimultaneous exchanges, there are
more examples on the use of exchanges with installment sales. See Treasury Reg.
§1.1031(k)-1.

CODE §1031 AND §453:PRIVATE LETTER RULING 9509021 AND


PRIVATE LETTER RULING 9509022

This Private Letter Rul. illustrates the circumstance where the taxpayer incorrectly
attempted to use an exchange as well as and installment sale. Although it was incorrectly
handled by the partnership, the installment sale method was allowed, even though there
was an "inadvertent" election against the use of the installment sale method.

The taxpayer was permitted to revoke the election of not using the installment sale
method.

The subsequent ruling was a parallel situation. See Private Letter Ruling 9509022.

PRIVATE LETTER RULING 9509021


November 30, 1994
Publication Date: March 3, 1995

Dear ____:
This is in reply to your letter of August 24, 1994, submitted on behalf of Partnership A,
requesting that Partnership A be allowed to revoke an unintended election out of the
installment method for reporting the gain from the sale of Property M.

Partnership A was organized as a general partnership on Date 1. The partners of


Partnership A consist of Corp X, which has a 90% interest and Individual A, who has a
10% interest. Partnership A was formed for the purpose of acquiring, owning and
operating Property M.

On or about January 5, 1993, Partnership A entered into a sales agreement with


Partnership B whereby Partnership A agreed to sell Property M to Partnership B and
Corp X agreed to sell certain of its property to Partnership B. Partnership B subsequently
transferred its rights and obligations to Partnership C.

Partnership A entered into the sales agreement with the intention of qualifying the
disposition of Property M for like kind EXCHANGE treatment under section 1031 of the
Code. To that extent the sales agreement obligated Partnership B to cooperate with
Partnership A in structuring a qualified like kind EXCHANGE. In addition Partnership A
entered into a separate EXCHANGE agreement with EXCHANGE Company which
agreed to facilitate a deferred like kind EXCHANGE in compliance with the regulations
under section 1031. Partnership A assigned its rights in and to the sales agreement to
EXCHANGE Company for purposes of facilitating the like kind EXCHANGE.

At the real estate closing Partnership A transferred Property M to the purchaser in


EXCHANGE for cash and a promissory note. Partnership A's represents that it intended
that the disposition of Property M be reported as a like kind EXCHANGE with gain
attributable to the promissory notes being reported when payments were received in
accordance with the installment method under section 453 of the Code.

An employee of Corp X prepared the Tax Return for Partnership A and erroneously
assumed that the proper method of reporting was for the Partnership A to report on Form
1065 the full amount of the gain realized from the disposition and for the partners to
reflect the deferral of gain recognition under section 1031 and section 453 on their
separate returns. Based on that assumption Corp X caused Partnership A to report the
entire gain realized form the disposition. Corp X did not consult with outside
professionals regarding its conclusions as to the proper method of reporting the
transactions, nor did it arrange for outside professionals to review the tax returns or any
Schedule K-1 prior to them being mailed on March 28, 1994.

Corp X did not discover the problem until May 15 1994, when it was contacted by
Individual A concerning the reporting of the gain. A representative of Corp X then met
with its law firm on May 31, 1994 and the law firm subsequently submitted this ruling
request.

Section 453(a) of the Internal Revenue Code provides that income from an installment
sale shall be taken into account for purposes of this title under the installment method.
Section 453(d)(1) of the Code provides, in general, that section 453(a) shall not apply
to any disposition if the taxpayer elects to have subsection (a) not apply to such
disposition. Paragraph (2) provides that, except as otherwise provided by regulations, an
election under paragraph (1) with respect to a disposition may be made only on or before
the due date prescribed by law (including extensions) for filing the taxpayer's return of
the tax imposed by this chapter for the taxable year in which the disposition occurs.
Paragraph (3) provides that an election under paragraph (1) with respect to any
disposition may be revoked only with the consent of the Secretary.

Section 453(d)(3) of the Code provides that an election under section 453(d)(1) with
respect to any sale may be revoked only with the consent of the Secretary of the
Treasury.

Section 15a.453-1(d)(4) of the Temporary Income Tax Regulations provides that


generally an election made under paragraph (d)(1) is irrevocable. An election may be
revoked only with the consent of the Internal Revenue Service. A revocation is
retroactive. A revocation will not be permitted when one of its purposes is the avoidance
of federal income taxes or when the taxable year in which any payment was received has
closed.

Partnership A has established through its factual representations that the election out of
the installment method was an inadvertent error. In addition, this request was filed
promptly after discovery of the error and prior to the Partners filing their individual
income tax return.

Accordingly, based on the facts presented and the representations made, we rule as
follows:

(1) The reporting of gain by Partnership A in respect of the


promissory note in connection with the sale of Property M
constituted an election to forego installment treatment under
temporary regulation 15a.453-1(d)(1).
(2) The election out of the installment method by Partnership was
inadvertent, and Partnership A is entitled to revoke said election
and use the installment method to report gain attributable to the
receipt of the promissory note.

No opinion is expressed as to the tax treatment of the transaction under the provisions
of any other sections of the Code or regulations which may be applicable thereto, or the
tax treatment of any condition existing at the time of, or effected resulting from, the
transaction which are not specifically covered by the above ruling.

PRIVATE LETTER RULING 9509022


November 30, 1994
Publication Date: March 3, 1995
Dear ____:
This is in reply to your letter of August 24, 1994, submitted on behalf of Partnership A,
requesting that Partnership A be allowed to revoke an unintended election out of the
installment method for reporting the gain from the sale of Property M.

Partnership A was organized as a general partnership on Date 1. The partners of


Partnership A consist of Corp X, which has a 90% interest and Individual A, who has a
10% interest. Partnership A was formed for the purpose of acquiring, owning and
operating Property M.

On or about January 5, 1993, Partnership A entered into a sales agreement with


Partnership B whereby Partnership A agreed to sell Property M to Partnership B and
Corp X agreed to sell certain of its property to Partnership B. Partnership B subsequently
transferred its rights and obligations to Partnership C.

Partnership A entered into the sales agreement with the intention of qualifying the
disposition of Property M for like kind EXCHANGE treatment under section 1031 of the
Code. To that extent the sales agreement obligated Partnership B to cooperate with
Partnership A in structuring a qualified like kind EXCHANGE. In addition Partnership A
entered into a separate EXCHANGE agreement with EXCHANGE Company which
agreed to facilitate a deferred like kind EXCHANGE in compliance with the regulations
under section 1031. Partnership A assigned its rights in and to the sales agreement to
EXCHANGE Company for purposes of facilitating the like kind EXCHANGE.

At the real estate closing Partnership A transferred Property M to the purchaser in


EXCHANGE for cash and a promissory note. Partnership A's represents that it intended
that the disposition of Property M be reported as a like kind EXCHANGE with gain
attributable to the promissory notes being reported when payments were received in
accordance with the installment method under section 453 of the Code.

An employee of Corp X prepared the Tax Return for Partnership A and erroneously
assumed that the proper method of reporting was for the Partnership A to report on Form
1065 the full amount of the gain realized from the disposition and for the partners to
reflect the deferral of gain recognition under section 1031 and section 453 on their
separate returns. Based on that assumption Corp X caused Partnership A to report the
entire gain realized form the disposition. Corp X did not consult with outside
professionals regarding its conclusions as to the proper method of reporting the
transactions, nor did it arrange for outside professionals to review the tax returns or any
Schedule K-1 prior to them being mailed on March 28, 1994.

Corp X did not discover the problem until May 15 1994, when it was contacted by
Individual A concerning the reporting of the gain. A representative of Corp X then met
with its law firm on May 31, 1994 and the law firm subsequently submitted this ruling
request.
Section 453(a) of the Internal Revenue Code provides that income from an installment
sale shall be taken into account for purposes of this title under the installment method.

Section 453(d)(1) of the Code provides, in general, that section 453(a) shall not apply
to any disposition if the taxpayer elects to have subsection (a) not apply to such
disposition. Paragraph (2) provides that, except as otherwise provided by regulations, an
election under paragraph (1) with respect to a disposition may be made only on or before
the due date prescribed by law (including extensions) for filing the taxpayer's return of
the tax imposed by this chapter for the taxable year in which the disposition occurs.
Paragraph (3) provides that an election under paragraph (1) with respect to any
disposition may be revoked only with the consent of the Secretary.

Section 453(d)(3) of the Code provides that an election under section 453(d)(1) with
respect to any sale may be revoked only with the consent of the Secretary of the
Treasury.

Section 15a.453-1(d)(4) of the Temporary Income Tax Regulations provides that


generally an election made under paragraph (d)(1) is irrevocable. An election may be
revoked only with the consent of the Internal Revenue Service. A revocation is
retroactive. A revocation will not be permitted when one of its purposes is the avoidance
of federal income taxes or when the taxable year in which any payment was received has
closed.

Partnership A has established through its factual representations that the election out of
the installment method was an inadvertent error. In addition, this request was filed
promptly after discovery of the error and prior to the Partners filing their individual
income tax return.

Accordingly, based on the facts presented and the representations made, we rule as
follows:

(1) The reporting of gain by Partnership A in respect of the


promissory note in connection with the sale of Property M
constituted an election to forego installment treatment under
temporary regulation 15a.453-1(d)(1).
(2) The election out of the installment method by Partnership was
inadvertent, and Partnership A is entitled to revoke said election
and use the installment method to report gain attributable to the
receipt of the promissory note.

No opinion is expressed as to the tax treatment of the transaction under the provisions
of any other sections of the Code or regulations which may be applicable thereto, or the
tax treatment of any condition existing at the time of, or effected resulting from, the
transaction which are not specifically covered by the above ruling.
EXCHANGES AND INSTALLMENT SALES: INTERNAL REVENUE
SERVICE PUB. 537

For an IRS overview of the combination of exchanges and installment sales, see I.R.S.
Publication 537.

In this Publication, the Service emphasized that if one attempts to undertake an


exchange and also receives an installment obligation as to the exchange, the three (3)
crucial rules are as follows:

1. Contract price does not include the fair market value of the like-
kind property, relative to the exchange;
2. Gross profit is reduced by the gain on the exchange that is
allowed to be postponed under Code §1031; and
3. Like-kind property received in the exchange is not a payment
on the installment obligation.

See the following summary for an examination and examples of this approach, using
installment sales and exchanges in one transaction.

IRS Pub. 5371994 WL 763755 (I.R.S.)


Internal Revenue Service (I.R.S.)
Taxpayer Information Publication
PUBLICATION 537: INSTALLMENT SALES

For use in preparing 1994 Returns


CONTENTS
INTRODUCTION
WHAT IS AN INSTALLMENT SALE?
GENERAL RULES

Figuring Installment Income

A transfer after the death of the person making the first disposition or the related
person's death, whichever is earlier, is not treated as a second disposition.

LIKE-KIND EXCHANGES

If you trade your business or investment property for other property of the same kind,
you can postpone reporting part of your gain. These trades are known as 'like-kind
EXCHANGES.' The property you receive in a like-kind EXCHANGE is treated as if it
were a continuation of the property you give up.

In a like-kind EXCHANGE, you do not have to report any part of your gain if you
receive only like-kind property. But if you also receive money or other property, you
must report your gain to the extent of the money and the fair market value of the other
property received.

INSTALLMENT PAYMENTS. If, in addition to like-kind property, you receive an


installment obligation in the EXCHANGE, the following rules apply:

(1) The contract price must not include the fair market value of the
like-kind property received in the trade.
(2) The gross profit is reduced by any gain on the trade that can be
postponed.
(3) Like-kind property received in the trade is not considered
payment on the installment obligation.

EXAMPLE. In 1994, George Brown trades personal property with an installment sale
basis of $400,000 for like-kind property having a fair market value of $200,000. He also
receives an installment note for $800,000 in the trade. Under the terms of the note, he is
to receive $100,000 (plus interest) in 1995 and the balance of $700,000 (plus interest) in
1996.

George's gross profit is $600,000 (selling price of $1,000,000 minus $400,000


installment sale basis). The contract price is $800,000 ($1,000,000 minus the fair market
value of the like-kind property received, $200,000). The gross profit percentage is 75%
($600,000 divided by $800,000). He reports no gain in 1994 because the like-kind
property he receives is not treated as payment for figuring gain. He reports $75,000 gain
for 1995 (75% of $100,000) and $525,000 gain for 1996 (75% of $700,000).

For more information on like-kind EXCHANGES, see Like-Kind EXCHANGES in


Publication 544.

DEFERRED EXCHANGES.
A deferred EXCHANGE is one in which you have transferred the property and are to
receive like-kind property at a later date. Under this type of EXCHANGE, the person
receiving your property may be required to place funds in an escrow account or trust. If
certain rules are met, these funds will not be considered a payment until you have the
right to receive the funds or, if earlier, the end of the EXCHANGE period. See section
1.1031(k)-1(j)(2) of the regulations for these rules.

CONTINGENT SALES

For installment sales, a contingent sale is one whose total selling price cannot be
determined by the end of the tax year in which the sale takes place.

If the selling price cannot be determined by the end of the tax year, neither can the
contract price and the gross profit percentage be determined (using the same rules that
apply to an installment sale with a fixed selling price). This happens, for example, if you
sell your business and the selling price includes a percentage of its profits in future years.
For rules permitting use of the installment method to report a contingent sale and for
contingent sales with unstated interest, see section 15A.453-1(c) of the regulations.

PARENT: SUBSIDIARY EXCHANGES:


REVENUE RULING 57-365

Under Rev. Rul. 57-365, exchanges are covered with regard to exchanges between
related parties in the form of a parent and a subsidiary corporation. (However, see the
Code for changes as to related parties, per the 1989 legislative changes.)

In this Ruling, the parent corporation of a telephone system had caused one of its
operating subsidiaries to exchange all of its assets for other assets of another operating
telephone company. The Ruling held that the transaction would be considered an
exchange of property within the meaning of Section 1031, assuming the other general
conditions for an exchange were met.

REVENUE RULING 57-365


1957-2 C.B. 521

Where the parent corporation of a telephone system causes one of its operating
subsidiary companies to exchange all of its assets, including both real estate and personal
property (but not including items of inventory and securities), for all of the similar assets
of another operating telephone company and cash to equalize the value of the assets
exchanged, an exchange of the assets of one such business for identical assets of another
such business will be considered an exchange of 'property of like kind' within the
meaning of section 1031 of the Code, on which, pursuant to the provisions of section
1031(b), gain, if any, will be recognized only to the extent of the cash received. Cf.
Aaron F. Williams v. McGowan, 152 Fed.(2d) 570; also Rev. Rul. 55--79, C.B. 1955--1,
370.

PRIVATE LETTER RULING 9252001

This Private Letter Ruling addressed the question as to whether the nonsimultaneous
exchange requirements were met, involving corporations that were utilizing the exchange
process and a trust position to hold monies on a nonsimultaneous exchange.

The Ruling held that such exchange qualified under Code §1031 and the fact that there
were intervening mergers or spin-offs did not prevent the tax-deferred treatment.

The Ruling stated: "These concerns (with exchanges) are equally applicable when the
surviving corporation following a merger receives like-kind property in exchange for
property transferred by a predecessor corporation prior to the merger."

** (NOTE: Double check Private Letter Ruling 9252001 -- !!) ** (Chapter 10, 11, 12??)

SECTION 1034 COMPARED TO SECTION 1031


Section 1031 requires an exchange, not a sale with a taking of the proceeds and a
reinvestment. The concept of taking proceeds and reinvesting those proceeds, thereby
postponing any gain, exists in some other Code Sections. For example, Section 1034,
dealing with the sale of a principal residence and reinvesting those proceeds within the
time period allowed, generally 24 months, is different than Section 1031. Under Section
1031, the taxpayer cannot, as stated, sell the property and reinvest within a given period
of time.

EXCHANGES AND RELATED PARTIES: REVENUE RULING 72-151

Rev. Rul. 72-151 deals with the question of related parties and the use of Section 1031.

The taxpayer under the Ruling is the sole stockholder of a corporation. In 1958 the
taxpayer purchased real estate consisting of land and a house. In 1970 the taxpayer
exchanged his rental property for farm property that included real property and personal
property owned by the corporation. The taxpayer would not be living on the farm, but
intended to use the farm to raise cattle for profit, and the corporation intended to hold the
house and lot as rental property.

The Ruling states that where an exchange under Section 1031 involves multiple assets,
the fact that the assets in the aggregate comprise a business or an integrated economic
investment does not result in treating the exchange as a disposition of a single piece of
property. Rather, an analysis is required of the underling property involved in the
exchange. (This issue is also reviewed in the text with regard to multiples pieces of
property.)

The Ruling cites rules in the Internal Revenue Code, Section 267, which disallows
losses between certain related parties, and the Ruling looks to other related party points.
However, the general proposition seems to be that merely because the parties are related
will not create, per se, a problem with Code Section 1031. However, where gain is
recognized under Section 1031, other sections which might be applicable to related
parties can come into play. If there was an exchange which resulted in a loss, and one did
not fit within the requirements of Code Section 1031, Section 267 could come into play
and deny the loss if it is between certain related parties. See Levine, West text. See also
Code Section 453(g) and §1239(b).

CAVEAT: Part of the position of this Ruling is changed with respect to Installment
Sales, due to the Installment Sales Revision Act of 1980, referred to in this text. See also
the 1989 legislation by Congress as to Code Section 1031.

REVENUE RULING 72-151


1972-1 C.B. 225

Advice has been requested as to the application of the nonrecognition of gain or loss
provisions of section 1031 of the Internal Revenue Code of 1954 under the circumstances
described below.
The taxpayer is the sole stockholder of a corporation. In 1958, the taxpayer purchased
real property consisting of land and a house, which has been used since that time as rental
income producing property. In 1970, the taxpayer exchanged his rental property for farm
properties that included real property (farm land and improvements) and personal
property (farm machinery) owned by the corporation. The taxpayer will not live on the
farm but intends to use the farm property to raise cattle for profit, and the corporation
intends to hold the house and lot as rental income producing property. The fair market
value of the rental property equalled the fair market value of the farm property at the time
of the exchange.

Section 1.1031(a)--1(b) of the Income Tax Regulations provides, in part, that the words
'like kind' have reference to the nature or character of the property and not to its grade or
quality. One kind or class of property may not, under section 1031(a) of the Code, be
exchanged for property of a different kind or class. 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. Unproductive real estate held by one
other than a dealer for future use or future realization of the increment in value is held for
investment and not primarily for sale .

Section 1.1031(a)--1(c) of the regulations provides, in part, that no gain or loss is


recognized if a taxpayer who is not a dealer in real estate exchanges city real estate for a
ranch or farm or exchanges improved real estate for unimproved real estate.

Section 267 of the Code provides, in pertinent part, that no deduction shall be allowed
in respect of losses from sales or exchanges of property (other than losses in cases of
distributions in corporate liquidations), directly or indirectly, between persons specified
within any one of the paragraphs of section 267(b) of the Code.

Section 267(b) of the Code provides at paragraph (2) that an individual and a
corporation more than 50 percent in value of the outstanding stock of which is owned,
directly or indirectly, by or for such individual represents a relationship referred to in
section 267(a) of the Code.

Where, as in the instant case, an exchange under section 1031 of the Code involves
multiple assets, the fact that the assets in the aggregate comprise a business or an
integrated economic investment does not result in treating the exchange as a disposition
of a single piece of property. Rather, an analysis is required of the underlying property
involved in the exchange. See Rev. Rul. 55--79, C .B. 1955--1, 370.

Upon analysis of the property involved in the instant case, it is concluded that the rental
real property (land and improvements) and the farm real property (land and
improvements) are property of like kind for purposes of section 1031 of the Code.
However, due to the inclusion of the farm machinery, the exchange does not solely
involve property of 'like kind' and thus does not come within the provisions of section
1031(a) of the Code.
If the taxpayer realized a gain on the exchange, such gain should be recognized under
section 1031(b) of the Code in an amount not in excess of the fair market value of the
farm machinery. The total basis of the farm land, improvements, and machinery received
by the taxpayer is the adjusted basis of the land and house transferred increased by the
amount of any gain recognized, such basis being allocated to the properties. For purposes
of allocating such basis to the properties received, an amount equivalent to the fair
market value of the farm machinery on the date of the exchange should be assigned as its
basis.

If the exchange had resulted in a loss being realized by the taxpayer, sections 1031(c)
and 267 of the Code each provide that such loss should not be recognized. In that event,
the total basis of the farm land, improvements, and farm machinery received is the
adjusted basis of the land and house transferred. This basis should be allocated to the
properties received, and for this purpose, there must be allocated to the farm machinery
an amount equivalent to its fair market value on the date of the exchange.

Accordingly, in the instant case, since the exchange includes property not of like kind
(the farm machinery), the nonrecognition of gain or loss provisions of section 1031(a) of
the Code are inapplicable. However, if the taxpayer realizes a gain from the exchange,
such gain shall be recognized in accordance with section 1031(b) of the Code but only to
the extent of the fair market value of the farm machinery. If the taxpayer realizes a loss
from the exchange, such loss shall not be recognized in accordance with sections 1031(c)
and 267 of the Code. The basis of the property received by the taxpayer in the exchange
is governed by section 1031(d) of the Code.

PRIVATE LETTER RULING 9116009

Under Private Letter Rul. 9116009, the Service ruled that undertaking the tax-deferred
exchange between related parties relative to property held in the estate of the parent of
the children involved would not cause an acceleration of tax that is deferred under Code
§6166. This Section allows the deferral of the estate tax if certain requirements are met
and certain portions of the estate continue to be held. Since it was a tax-deferred
exchange between related parties, beneficiaries of the estate, it was still deemed that the
interests were held, and, therefore, the estate tax was not accelerated.

Thus, this shows the relationship and interplay of Code §6166 as a deferral of tax and
tax-deferred exchanges relative to Code §1031, and specifically Code §1031(f), related
parties.

EXCHANGES INVOLVING FARMS, CROPS, ETC.: REV. RUL. 59-229

The taxpayers in Rev. Rul. 59-229 entered in a transaction in which they mutually
exchanged their respective farm properties consisting of farm lands, farm buildings,
residences and unharvested crops.
After reviewing the application of Section 1031, the Ruling makes it clear that there are
really three questions:

1. What is the treatment of an exchange of the farm with an


unharvested crop thereon for similar property? The answer was
that an unharvested crop that is to be exchanged with the land is
considered property used in the trade or business. Thus, the
parenthetical exclusion under §1031 of "stock in trade or other
property held primarily for sale" does not apply.
2. The second question was how to treat the reciprocal assumption
of mortgages on the properties. The Ruling holds that should the
mortgages reciprocally assumed not cancel each other, any gain
resulting from such assumption is treated as gain on the sale or
exchange of a capital asset under §1031 and taxed accordingly. If
there is a loss on the transaction, it would not be recognized as a
result of Section 1031(c).
3. The third and final question of the Ruling dealt with the
treatment to be accorded the exchange of residences with the
assumption of mortgages thereon. Section 1031 is not applicable
to this portion of the exchange. However, all is not lost: Where
the dwellings are used as personal residences by the taxpayers
who are parties to the exchange, an exchange thereof is treated as
a separate transaction. Any resulting gain is subject to Section
1034, pertaining to the sale or exchange of a principal residence,
assuming the parties can meet those requirements. If there was a
loss on the residence, it would not be deductible as a result of
Code §262, which denies deductions for personal items. (See
also Code §165, which was not mentioned by the Ruling, but is
certainly applicable to limit losses by individuals on their
personal residences.)

In summary, the transaction on the crops could qualify, the transaction on the
mortgages may or may not be totally reciprocal in nature to net to zero, and the
residences would not be within §1031.

REVENUE RULING 59-229


1959-2 C.B. 180

Advice has been requested as to the treatment, for Federal income tax purposes, of an
exchange of farm properties under the circumstances described below.

The taxpayers, during the taxable year, entered into a transaction in which they
mutually exchanged their respective farm properties consisting of farm lands, farm
buildings, residences, all held for more than six months, and unharvested crops. The
lands, buildings, and residences on both properties involved were burdened with
substantial mortgages which were reciprocally assumed by the parties to the exchange.
For Federal income tax purposes, such an exchange raises three distinct problems:

(1) the treatment of the exchange of the farm with an unharvested


crop thereon for similar property;
(2) the treatment of the exchange with respect to the reciprocal
assumption of mortgages on the respective properties; and
(3) the treatment to be accorded the exchange of the residences with
the assumption of mortgages thereon.

Section 1231(b) of the Code, which provides the special rules for determination of
capital gains and losses from the sale or exchange of property used in a trade or business,
provides, in part, as follows:

(4) UNHARVESTED CROP.--


In the case of an unharvested crop on land used in the trade or business and held for
more than 6 months, if the crop and the land are sold or exchanged (or compulsorily or
involuntarily converted) at the same time and to the same person, the crop shall be
considered as 'property used in the trade or business'.

Inasmuch as section 1231(b)(4) of the Code provides that unharvested crops sold or
exchanged with land are considered property used in trade or business, the parenthetical
exclusion of section 1031(a) of the Code (stock in trade or other property held primarily
for sale) does not apply. The basis of the unharvested crops, in the hands of the vendor or
transferor, is adjusted according to section 1016(a)(11) of the Code for production
expenses disallowed as a deduction under section 268 of the Code. Thus, where
unencumbered farm lands, farm buildings, and unharvested crops are exchanged for 'like
property,' no gain or loss is recognized from the transaction. The bases of the properties
acquired in the hands of each transferee are the same as the bases to them of the
properties which each transferred, as provided in section 1031(d) of the Code.

The second problem, in an exchange of the type under consideration, is the effect of the
reciprocal assumption of mortgages.

In Walter F. Haass et al. v. Commissioner, 37 B.T.A. 948, the United States Board of
Tax Appeals held that where a taxpayer exchanges mortgaged real estate for other real
estate, in an otherwise tax-free 'like kind' exchange, the amount of the mortgage of which
he is relieved is treated as the equivalent of 'other property or money.' See also Brons
Hotel Inc. v. Commissioner, 34 B.T.A. 376. This holding is incorporated in section
1031(d) of the Code which provides in part, that where, as part of the consideration to the
taxpayer, the other party to the exchange assumes a liability of the taxpayer, such
assumption (in the amount of the liability) shall be considered as money received by the
taxpayer on the exchange. However, it is a long established rule that the Internal Revenue
Service will permit a balancing of liabilities when mortgaged property is exchanged for
mortgaged property and each party to the exchange assumes the mortgage of the other
party. See G.C.M. 2641, C.B. VI--2, 16 (1927). Therefore, in the instant case, should the
mortgages reciprocally assumed not cancel each other, any gain resulting from such
assumption is treated as a gain on the sale or exchange of a capital asset under section
1231 and taxed accordingly. However, a loss resulting from such a transaction is not
recognized under section 1031(c) of the Code. The bases of the respective properties
exchanged are determined according to the rules provided in section 1.1031(d)--2 of the
Income Tax Regulations, example (2).

The final consideration, in an exchange of the instant type, is the tax treatment of
residences (with mortgages thereon) which are exchanged with the farm properties. If
these residences were occupied by tenants acting, for example, in the capacity of
caretakers or farm workers for the taxpayers, such exchange would be treated under
section 1031(a) of the Code as 'property used in trade or business' in the same manner as
the exchange of the farm lands and buildings. However, where the dwellings are used as
personal residences by the taxpayers who are parties to the exchange, an exchange
thereof is treated as a separate transaction. Any resulting gain is subject to the provisions
of section 1034, pertaining to the sale or exchange of a residence. Any loss on the
exchange of a personal residence is recognized under section 1002 of the Code, but is not
deductible in computing net income, as provided in section 262 of the Code. In such case,
the basis of the residence received upon the exchange is its fair market value on the date
of the exchange.

Accordingly, it is held that an exchange of unencumbered farm lands, farm buildings


and unharvested crops for 'like property' constitutes a nontaxable exchange within the
meaning of section 1031(a) of the Code.

Where an exchange of farm properties involves a reciprocal assumption of mortgages,


any gain resulting from the exchange of mortgages is subject to the tax treatment under
the provisions of section 1231 of the Code. Any loss in such an exchange is not
recognized under section 1031(c) of the Code.

An exchange of personal residences along with farm lands, buildings, and crops is
treated as a separate exchange governed by the applicable provisions of section 1034 of
the Code for gain, and by section 262 of the Code for loss.

REINVESTMENT OF PROCEEDS FROM INVOLUNTARY


CONVERSION:
LIKE-KIND: REVENUE RULING 67-255

The question in this Revenue Ruling covered the issue of an involuntary conversion
under Code Section 1033. The purpose in reviewing it in this setting is to examine the
concept of like-kind that is used under Code Section 1033(g), when there is a
condemnation.

The issue in the case was whether the reinvestment of condemnation proceeds, where
the investment involved making improvements on real property already owned by the
taxpayer, could come within Code Section 1033, as a like-kind investment, as a result of
the condemnation.
The like-kind test is very broad, although the issue in the Ruling was whether it was
broad enough to cover a situation where a building, water system, storm drains and roads,
were constructed on land that was already owned by the taxpayer. This Ruling holds that
they do not qualify within Code Section 1033(g).

REVENUE RULING 67-255


1967-2 C.B. 270

Advice has been requested whether the investment of condemnation proceeds, under
the circumstances set forth below, will qualify as 'like kind' replacement of involuntarily
converted property for purposes of section 1033(g) of the Internal Revenue Code of 1954.

After 1957 land which the taxpayer held for investment was condemned. In the same
year, the taxpayer expended the proceeds of the condemnation in the construction of an
office building to be held for investment purposes on another site which he already
owned.

The taxpayer also owned two separate tracts of unimproved rural land, one of which
was condemned in a year after 1957. Immediately thereafter, the taxpayer invested the
proceeds of the condemnation in the installation of storm drains, water systems, and
roads on the remaining tract of rural land.

Section 1033(a)(3)(A) of the Code provides, in effect, that if property is compulsorily


or involuntarily converted into money and the taxpayer, during the period specified,
purchases other property similar or related in service or use to the property so converted,
at the election of the taxpayer the gain shall be recognized only to the extent that the
amount realized upon such conversion exceeds the cost of such other property.

Section 1033(g) of the Code provides, in part, that if real property (not including stock
in trade or other property held primarily for sale) held for productive use in trade or
business or for investment is (as the result of its seizure, requisition, or condemnation, or
threat or imminence thereof) compulsorily or involuntarily converted after December 31,
1957, property of a like kind to be held either for productive use in trade or business or
for investment shall be treated as property similar or related in service or use to the
property so converted.

Section 1.1033(g)--1 of the Income Tax Regulations provides, in part, that, for purposes
of applying section 1033 of the Code to the disposition of real property held for
productive use in trade or business or for investment, the principles of section 1.1031(a)--
1 of the regulations are to be considered in determining whether the replacement property
is of a like kind.

Section 1.1031(a)--1 of the regulations provides, in part, that the words 'like kind' have
reference to the nature or character of the property and not to its grade or quality. The
section further states:
(b) * * * One kind or class of property may not, * * * be
exchanged for property of a different kind or class. 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. * * *
(c) No gain or loss is recognized if * * * (2) a taxpayer who is not
a dealer in real estate exchanges city real estate for a ranch or
farm, or exchanges a leasehold of a fee with 30 years or more
to run for real estate, or exchanges improved real estate for
unimproved real estate * * *.

The effect of section 1033(g) of the Code is to extend the nonrecognition-of- gains
benefits of section 1033(a) of the Code to a taxpayer who acquires property of a like kind
to real property converted, but not necessarily similar or related in service or use to it.

In considering the 'like kind' test, although the term 'real estate' is often used to embrace
land and improvements thereon, land and improvements are by nature not alike merely
because one term is used to describe both. Land is not of the same nature or character as a
building, or a storm drain, or a water system, or a road.

Applying the foregoing to the facts in the instant case, the building constructed on land
already owned does not qualify as replacement property under section 1033(g) of the
Code as being of a like kind to the land involuntarily converted. Nor do the storm drains,
water systems and roads constructed on land already owned qualify as replacement
property under section 1033(g) as being of a like kind to the land involuntarily converted.
However, see Revenue Ruling 67--254, page 269, this Bulletin, for a situation where
improvements constructed on land already owned qualify as replacement property under
section 1033(a)(3)(A) of the Code.

Accordingly, the investment of the proceeds from an involuntary conversion of land


held for investment purposes, in the construction of an office building to be held for
investment purposes upon land already owned by the taxpayer, does not qualify as a 'like
kind' replacement of the converted property within the meaning of section 1033(g) of the
Code.

Also, the investment of the proceeds from an involuntary conversion of unimproved


rural land in the installation of storm drains, water systems and roads on other
unimproved rural land already owned by the taxpayer, does not qualify as a 'like kind'
replacement of the converted property within the meaning of section 1033(g) of the Code.

Revenue Ruling 55--749, C.B. 1955--2, 295; I.T. 4093, C.B. 1952--2, 130; and
Commissioner v. Kate J. Crichton, 122 F.2d 181 (1941), affirming 42 B.T.A. 490 (1940),
acquiescence, C.B. 1952--1, 2, are distinguishable because they do not involve land
improvements . These rulings and the case hold that mineral interests and water rights are
interests in real property and as such are of the same nature or character as fee interests in
land.
PRIVATE LETTER RULING 8128010

The question in this Ruling was whether a transaction, following an involuntary


conversion of the property, with the taxpayer purchasing other replacement property,
would or would not fall within Code §1033.

The Ruling held that if the taxpayer purchased qualified property within the meaning of
Code §1033(a)(2), on a timely basis, nonrecognition would be allowed. However, the
Ruling held that there was a question as to whether it was "purchased" and whether it was
undertaken in an arms'-length transaction. This was a factual issue that must be
determined in the field by an actual examination of the facts.

INVOLUNTARY CONVERSION AND LIKE-KIND ISSUES:DAVIS

The Court in the Davis case was faced with an involuntary conversion in which
proceeds were received as a result of condemnation. The question was whether the
proceeds were properly reinvested in a fashion to come within Code Section 1031,
interpreting the like-kind requirement under that Section. The taxpayers were successful.

Alan S. DAVIS et al., Plaintiffs,


v.
UNITED STATES of America, Defendant.

76-1 USTC Para. 9418


411 F.Supp. 964 (1976)

Action was brought to recover additional federal income taxes assessed on gain realized
from involuntary condemnation of agricultural property. The District Court, Wong, J.,
held that taxpayers' expenditure of condemnation award to permanently improve their
industrial park satisfied the 'purchase' requirement for nonrecognition of gain on an
involuntary conversion, that although improvements were not of the 'same general class'
as the condemned property and, thus, did not qualify for nonrecognition as property
similar or related in use or service to that converted, the improvements qualified for
nonrecognition of gain as real property of 'like kind' to the property condemned since the
improvements represent a substantial continuation of a prior commitment of capital.

WONG, District Judge.


Plaintiffs, as trustees of the estate of James Campbell, owned and leased real property
at various locations in the State of Hawaii. The real property consisted of lands zoned,
leased and used for agricultural purposes in the western part of Oahu. Portions of these
leased lands were condemned by the State of Hawaii for the construction of highways.
Plaintiffs realized a net amount of more than $260,000 during the years 1966, 1968 and
1971 as a result of the condemnations.

In 1970, plaintiffs further realized a net amount of approximately $2,700 from the
condemnation of some 1.3 acres of unleased and unimproved land also zoned for
agricultural use and received $5,000 from the condemnation of a fishing area. An
additional $25,000 was received by them in 1971 as proceeds from condemnation of the
fishery.

The plaintiffs' leased lands condemned for highway purposes had been utilized mostly
for sugar cane cultivation and livestock grazing. The proceeds from the condemnation of
the lands and fishery area were used by them in the regular course of the Campbell
Estate's business operations.

In 1972, however, plaintiffs expended approximately $335,800 in permanent


improvements to other property which they owned, located at the Campbell Industrial
Park. These improvements included the addition of a storm drainage and water system,
the grading of the land and the excavation of a roadway. The lots at Campbell Industrial
Park were not designed to be leased for agricultural purposes but rather to be leased to
large-scale manufacturers, raw material fabricators, heavy equipment dealers, and bulk
warehousing operators.

Plaintiffs in November 1972 formally notified the Internal Revenue Service that the
condemnation proceeds had been reinvested in the Campbell Industrial Park. The Service
informed plaintiffs that the investment in improvements on land already owned by
plaintiffs did not qualify as replacement property under Section 1033 of the Internal
Revenue Code (IRC). Plaintiffs thereupon paid the additional income taxes, plus interest
due, in the amount of $106,050.24 for the years 1966, 1968, 1970 and 1971. Plaintiffs
filed timely claims for refunds and subsequently instituted this suit following the
administrative denial of the refund claims.

Section 1033 of the Internal Revenue Code and its predecessor sections under prior
revenue laws were enacted to grant a taxpayer relief from taxation when, within a
specified period or within any period agreed to by the Internal Revenue Service, he
purchases real property of like kind or property similar in service or use to the
condemned real property. More specifically, §1033(a)(3) (A) relates to the qualification
for non-recognition by replacement of 'property similar or related in service or use' if the
taxpayer 'purchases' such property. Section 1033(g) contains a special rule broadening the
scope of the qualification so that 'like kind' property 'to be held either for productive use
in trade or business or for investment shall be treated as property similar or related in
service or use to the property so converted.'

Whether a replacement qualifies for non-recognition either under §1033(a)(3) (A) or


under §1033(g), it must first meet the requirement of having been acquired by a
'purchase.' Here the taxpayers conceded they did not 'purchase' another piece of land in
replacement of the lands condemned, as is the usual case of a replacement. Rather, they
'expended' moneys for improvements on other lands owned by them. In Dettmers v.
Commissioner, 430 F.2d 1019 (6th Cir. 1970), the court traced the legislative history of
IRC §1033(a)(3). The court indicated that when the requirement that proceeds from the
involuntary conversion be 'expended' was replaced by the requirement of timely
'purchase,' no substantive change in the nature of the relief afforded under the statute was
intended. The court also expressed the belief the reason the language was changed from
'acquisition' to 'purchases' was that 'Congress wanted to specify that the acquisition be by
purchase rather than, for example, by gift or devise.' Id. at 1022. Following this
reasoning, I am satisfied that the expenditures made by the taxpayers met the 'purchase'
requirement.

I turn next to the issue of whether taxpayers may 'purchase' improvements made on
land already owned by them to qualify under either §1033(a)(3) or §1033(g). Under the
latter, the property acquired must be of a like kind. For a definition of 'like kind,' Reg.
§1.1033(g)--1(a) refers to Reg. §1.1031(a)-- 1(b), which provides in pertinent part:

As used in §1031(a), the words, 'like kind' have reference to the nature or character of
the property and not to its grade or quality. One kind or class of property may not, under
that section, be exchanged for property of a different kind or class. 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.

In making a determination as to whether a replacement of 'like kind' property has been


made with the condemnation proceeds, one approach may be definitional; that is, whether
improvements of the type 'purchased' by the taxpayers constitute 'real property.' If so,
perhaps I need look no further, since exchange of real property for real property would be
a 'like kind' replacement. As the court stated in Commissioner v. Crichton, 122 F.2d 181,
182 (2d Cir. 1941), '(T)he distinction intended and made by the statute is the broad one
between classes and characters of properties, for instance, between real and personal
property.' See Fleming v. Campbell, 205 F.2d 549 (5th Cir. 1953).

Defendant relies principally on Rev.Rul. 67--255, 1967--2, Cum.Bull. 271. In that case,
the Service ruled that the building, storm drains, water systems and roads constructed on
land already owned by the taxpayer did not qualify as replacement property under s
1033(g) as being of a like kind to the land involuntarily converted. The expressed
rationale was that:

In considering the 'like kind' test, although the term 'real estate' is often used to embrace
land and improvements thereon, land and improvements are by nature not alike merely
because one term is used to describe both. Land is not of the same nature or character as a
building, or a storm drain, or a water system, or a road.

In Rev.Rul. 73--120, 1973--1, Cum.Bull. 369, the Service held that replacement of the
fee simple interest in a utility company's water plant, together with appurtenant pipelines,
mains, manholes, and accessory installations with a fee simple interest in an apartment
complex, qualified as like-kind replacement. The ruling does not indicate whether or not
the fee simple interest in the apartment complex included the land, which I surmise was
probably the case, unless the apartment complex was a condominium constructed on
leasehold property. In any event, the Service has either approved an 'improvements for
improvements' replacement or 'land and improvements for improvements' replacement. If
the former, then it is plain that it is consistent in holding that improvements cannot be
equated to land as 'real property'. If the latter, which appears more likely, then it has taken
an inconsistent position.

I need not decide this case on the basis of whether or not the label 'real property'
attaches to the improvements made by the taxpayers, or whether such improvements are
equivalent to land once the label attaches. Instead, I look to the purpose of the statute and
whether or not the improvements made by taxpayers 're-establishes (their) prior
commitment of capital.' Filippini v. U.S., 318 F.2d 841, 844 (9th Cir. 1963). In affirming
the decision of the lower court, the Ninth Circuit declared:

The statute is to be liberally construed to accomplish this purpose. On the other hand, it
was not intended to confer a gratuitous benefit upon the taxpayer by permitting him to
utilize the involuntary interruption in the continuity of his investment to alter the nature
of that investment tax free.

The lower court, Filippini v. U.S., 200 F.Supp. 286 (N.D.Cal.1961), after considering
various factors found that the replacement property, which consisted of a single
commercial office building erected upon six city lots, was not of the 'same general class'
as the property condemned. The condemned property consisted of a single parcel of rural
property. The major portion of the parcel was farm land devoted to an agricultural use
and the remaining portion was used by a tenant for the commercial purpose of operating a
drive-in theater. The court therefore held that the replacement property was not property
'similar or related in service or use' to the original property within the meaning of 1939
IRC s 112(f)(3)(A), the predecessor section to IRC §1033(a)(3)(A). It observed, however,
that the intent of Congress was 'to provide a rule broad enough to encompass the type of
replacement involved in this case . . ..' 200 F.Supp. at 294. It pointed out that under the
'like kind' test, 'it appears that the replacement of one investment property for another
investment property, without regard to any dissimilarity of characteristics or uses, would
be allowable.' Id. However, because the amended §1033(g) was made expressly
applicable only to the involuntary conversions of real estate occurring after the date of
taxpayer's conversion, the taxpayer could not benefit from the new amendment.

I find that the improvements made by the taxpayers in this case in connection with the
leasing of the Campbell Industrial lots were not of the 'same general class' as the land and
improvements used for agricultural purposes. Thus, it does not qualify under
§1033(a)(3)(A) as property similar or related in service or use to the property converted.

I do find, however, that the improvements made by the taxpayers represent a substantial
continuation of their prior commitment of capital and that these improvements qualify for
non-recognition of gain as real property of 'like kind' to the property condemned as
required by §1033(g).

Plaintiffs, as prevailing party herein, will prepare findings of fact and conclusions of
law in conformity with this Decision, and pursuant to the Rules of this Court, and
Fed.R.Civ.P. 52.
CODE §1033:
"SIMILAR" OR "RELATED IN USE" PROPERTY:
PRIVATE LETTER RULING 9620010

This Ruling addresses the utilization of Code §1033(g), the condemnation of real
property.

The Ruling follows through the fact situation in which the taxpayer utilized the
replacement real estate, including newly-completed improvements. The Ruling concluded
that it was property that was similar or related in service or use, and, therefore, qualified,
at least for this part, under Code §1033.

Internal Revenue Service (I.R.S.)


PRIVATE LETTER RULING 9620010
1996 WL 261512 (I.R.S.)
Issue: May 17, 1996
February 13, 1996

Dear ____:
This responds to your letter dated November 14, 1995, requesting a private letter ruling
regarding a proposed replacement of condemned property under section 1033 of the
Internal Revenue Code. The following facts are represented:

Taxpayer owns and manages **** in State X. One such t was Greenacre, which was
condemned by local government authority. On Date v, Taxpayer received $6x for
Greenacre. Taxpayer is currently seeking to timely replace Greenacre pursuant to section
1033(g) of the Code.

Taxpayer also owns and manages a shopping center which is partially situated on
Blackacre. Taxpayer holds Blackacre under a lease. The lease was entered into before the
condemnation and has a remaining term of y years.

Taxpayer proposes to replace Greenacre with (1) about $5x of improvements to that
part of the shopping center situated on Blackacre and (2) acquisition of fee title to
Blackacre for $1x. Taxpayer agreed in principal to purchase Blackacre before
construction of the improvements began. However, this transaction was not concluded
until now because of seller's estate planning concerns. Taxpayer represents that it intends
to acquire Blackacre in fee simple prior to end of its duly extended replacement period.
All costs for the improvements were incurred after condemnation and the improvements
were completed prior to Date z.

Taxpayer requests the following rulings:

1. The purchase by Taxpayer of the fee interest in Blackacre will


be treated, under the provisions of section 1033(g) of the Code,
as the purchase of "property similar or related in service or use"
to the condemned property.
2. The cost of the improvements to Blackacre will be treated as
replacement property.

Section 1033(a)(2)(A) of the Code provides, in part, that if property (as a result of its
destruction in whole or in part, theft, seizure, or requisition, or condemnation or threat or
imminence thereof) is compulsorily or involuntarily converted into money and if the
taxpayer (during the period specified elsewhere in the statute), for the purpose of
replacing the property so converted, purchases property similar or related in service or
use to the property so converted, at the election of the taxpayer, the gain shall be
recognized only to the extent the amount realized on such conversion exceeds the cost of
such other property.

Section 1033(g)(1) of the Code provides, in part, that for purposes of subsection (a), if
real property (not including stock in trade or other property held primarily for sale) held
for productive use in trade or business or for investment is (as the result of its seizure,
requisition, or condemnation, or threat or imminence thereof) compulsorily or
involuntarily converted, property of a like kind to be held either for productive use in
trade or business or for investment shall be treated as property similar or related in use to
the property so converted.

Section 1.1031(a)-1(b) of the Income Tax Regulations explains that as used in section
1031(a) of the Code, the words "like-kind" have reference to the nature and character of
the property and not to its grade or quality. One kind or class of property may not, under
that section, be exchange for property of a different kind or class. 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.

As examples of exchanges of property of a "like kind" for which no gain or loss is


recognized, section 1.1031(a)-1(c)(2) of the regulations lists a taxpayer, not a dealer in
real estate, who exchanges city real estate for a ranch or farm, or exchanges a leasehold
of a fee with 30 years or more to run for real estate, or exchanges improved real estate for
unimproved real estate.

Taxpayer concedes that Blackacre, which is used as a shopping center, is not, in the
literal sense, similar in service or use to Greenacre, a t. However, both Greenacre and the
underlying fee interest in Blackacre are real property.

Taxpayer is concerned that the application of section 1033(g) to this case may be
unclear due to the circumstance of Taxpayer's prior leasehold interest in the proposed
replacement property. In effect, by acquiring the underlying fee, Taxpayer is acquiring its
lessor's interest in Blackacre. Taxpayer represents that under the law of State X, a lessor's
interest in leased real estate is also a real property interest.

Even so, within the broad category of real property, not all types of real estate are of
like kind or class to each other. For example, we held in Rev. Rul. 72-601, 1972-2 C.B.
487 that a carve-out and transfer of a life estate in real property owned in fee simple by a
son, based on his 70-year-old father's life expectancy of less that thirty years, for a
remainder interest in other property owned by the father is not an exchange of "like kind"
property. As to the son, the transaction was treated as a transfer of a leasehold (the life
estate) and the receipt by the son of "rent" in the form of the remainder interest in his
father's property. As to the father, the life estate having a deemed duration of less than 30
years was equated to a lease which is not of like-kind to the transferred remainder interest
in fee simple.

In Fleming v. Commissioner, 24 T.C. 818 (1955), rev'd 241 F.2d 78 (5th Cir.1957), in
turn rev'd sub nom. Commissioner v. P.G. Lake, Inc., 356 U.S. 260 (1958), 1958-1 C.B.
516, the Tax Court held that where a taxpayer assigned carved-out oil payments in return
for a fee interest in real estate, the properties were not of like-kind. In its affirming
opinion, the Supreme Court pointed out that although the oil payments were considered
an interest in real property under applicable state law, the transaction was outside the
scope of (the predecessor of) section 1031(a) of the Code because it was, in effect,
merely a transfer of a future income stream from oil leases for real estate.

The facts of the present case are easily distinguished from those in either Rev. Rul. 72-
601 or the Fleming case. In this case Taxpayer is acquiring the underlying fee and is
thereby extinguishing his status as a lessee and becoming the outright owner of the
property. Taxpayer's fee interest in Greenacre was involuntarily converted. Taxpayer is
replacing Greenacre with a fee interest in Blackacre. Taxpayer in not entering into a
disguised rental arrangement as in the revenue ruling cited above and is not giving up or
receiving less than a fee interest in real estate.

On the other hand, in Rev. Rul. 68-394, 1968-2 C.B. 338, a taxpayer replaced his
condemned land by acquiring the 45-year lease on property he still owned but had
previously rented to a third party for use as a mobile home park. The ruling holds that the
purchase of a leasehold with 30 or more years to run on property already owned by
taxpayer qualifies as replacement property of like- kind for purposes of section 1033(g).
The ruling further states that it is not material that the taxpayer acquired the leasehold on
property already owned by him so long as he acquired it in an arms length transaction.

The facts of Rev. Rul. 68-394, while obviously different in some respects from those of
the present case, share the common element of the taxpayer acquiring an additional
interest in property in which it already had an interest. In both cases the end result is a
complete, possessory fee interest in the replacement property, eclipsing the prior interest
held by the taxpayer. Fundamentally, the underlying fee interest in the leased property,
Blackacre, partakes of the same nature and character as Greenacre, the property what was
taken.

Even more striking for similarity to the present case is Koch v. Commissioner, 71 T.C.
54 (1978), acq., 1979-1 C.B. 1. In Koch, the taxpayers traded their unencumbered
country club property (consisting of a clubhouse and golf course) for the fee interest in 17
parcels of real estate, each subject to 99-year condominium leases. The court held for the
taxpayers that the properties traded were of like kind. Part of the rationale supporting this
result was that the right to receive rents is an incident of fee simple ownership. Therefore,
the existence of leases on the replacement property should not disqualify the exchange.
Id., at 65, 68. The court further stated that the standard for comparison is that the property
be of "a like--not identical--kind." Id., at 65. This corresponds with the standard
articulated in the regulation that the words "like-kind" have reference to the nature and
character of the property and not to its grade or quality.

In the present case, Taxpayer's position is stronger than the one described in Koch
because of Taxpayer's prior status as lessee of the same property it proposes to acquire.
While it is true that the lessor's interest in Blackacre is not identical to unincumbered title
to Greenacre and may be an interest of an inferior grade or quality, the interests in both
properties are, nevertheless, of like kind for purposes of section 1031 and 1033(g) of the
Code. Once Taxpayer acquires the underlying fee in Blackacre, Taxpayer will be the only
party owning an interest in that property.

The improvements constructed on Blackacre, without more, are not of like kind to
Greenacre. Rev. Rul. 67-255, 1967-2 C.B. 270, Rev. Rul. 76-390, 1976-2 C.B. 242 and
Rev. Rul. 76-391, 1976-2 C.B. 243, all hold that improvements constructed on land
already owned by the taxpayer is not of like kind to land involuntarily converted from the
taxpayer. Land is not of like kind to motels or other commercial buildings, or to roads,
storm drains or other mere improvements to land.

In the present case, however, the facts are distinguishable from those of the three
revenue rulings cited. In the rulings, only improvements, without the land, are acquired.
Here, Taxpayer is acquiring land and improvements to the land, all during the
replacement period.

Moreover, Greenacre was a t owned and managed by Taxpayer and Blackacre is a


shopping center owned and managed by Taxpayer. Under section 1033(g) of the Code,
like-kind property acquired to replace condemned real property is treated as property
similar or related in service and use to the condemned property for purposes of section
1033(a) of the Code.

Therefore, the fee simple estate of Blackacre, including its newly completed
improvements, will be treated as "property similar or related in service or use" to
Greenacre.

No opinion is expressed as to the tax treatment of this item(s) (or transaction(s)) under
the provisions of any other section of the Code or regulations which may be applicable
thereto, or the tax treatment of any conditions existing at the time of, or effects resulting
from, the item(s) (or transaction(s)) described which are not specifically covered in the
above ruling.

A copy of this letter should be attached to the federal tax return for the year in which
the item(s) (transaction(s)) in question occurs. This ruling is directed only to Taxpayer
who requested it. Section 6110(j)(3) of the Code provides that it may not be used as
precedent.

Sincerely,

Assistant Chief Counsel


(Income Tax & Accounting)

This document may not be used or cited as precedent. Section 6110(j)(3) of the Internal
Revenue Code.

CODE §1033: THREAT OR IMMINENCE?


PRIVATE LETTER RULING 9706004

The taxpayer, a school, received condemnation proceeds and desired to undertake a


replacement of the condemned property, to come within Code §1033. The Ruling
addressed what constitutes a threat or imminence of condemnation. The Ruling
concluded that the timely replacement of property within Code §1033 allowed the
deferral of the gain. This was true even though the property that was lost was a leasehold
interest. The taxpayer lost a leasehold interest and acquired a fee interest. This was held
to be within Code §1033.

Internal Revenue Service (I.R.S.)


PRIVATE LETTER RULING 9706004
1997 WL 48394 (I.R.S.)
Issue: February 7, 1997
November 7, 1996

Dear ____:
This letter responds to your request for a private letter ruling, dated July 17, 1996,
submitted on behalf of the School. Specifically, you requested two rulings with respect to
the School's receipt of proceeds on the cancellation of its leases and its subsequent
purchase of similar property:

(1) The School's receipt of condemnation proceeds as


compensation for the School's property interest in the
unexpired term of its leasehold qualifies as an involuntary
conversion resulting from threat or imminence of
condemnation under section 1033 of the Internal Revenue
Code; and
(2) The School's investment of the condemnation proceeds in a fee
simple property interest qualifies as replacement property
similar or related in service or use to the leasehold interest
involuntarily converted.

FACTS:
The School is a licensed private school that offers vocational education and training in
various occupational fields. In November 1993, the School agreed to lease space in two
buildings in downtown City, located in State A. The School's lease was for 10 years,
ending January 31, 2004. The School made substantial improvements to the leased space
to ensure that the space suited the School's requirements. The lease contemplated that the
lease term could be terminated only in limited circumstances by the lessor or if the
property was condemned or taken under the power of eminent domain.

In September 1995, the lessor sold both buildings in which the School had leased space
to the City Economic and Industrial Development Corporation (the "CEIDC"), an
organization exempt from federal income tax under section 501(c)(3) of the Code that has
been designated as the lead economic development and investment agency for City. The
CEIDC is very closely linked to the City and the Urban Redevelopment Authority of City
(the "URA"). [FN1] The URA and the City have the power to take property through
eminent domain. In organizing the CEIDC, the City and the URA contemplated that the
URA would acquire properties by condemnation and turn them over to the CEIDC for
development. The CEIDC bought the buildings, intending to demolish them to proceed
with a planned redevelopment project.

In October 1995, the School received a letter from the Mayor of City. This letter stated,
in substance, that the CEIDC would be acquiring all leasehold interests in the buildings it
had acquired, and that all properties would have to be vacated before summer 1996. The
letter also stated, in substance, that a local real estate firm had been engaged to work with
the School to help it find a suitable new location and that individual X would be the real
estate firm's representative handling this project.

Negotiations between the School and the CEIDC began in October 1995. In objecting
to a proposal presented by the School's counsel, X stated that, if the School did not accept
CEIDC's offer, the School's building would be condemned and the School would be
forced to accept a lower amount for the leaseholds. X stated that the buildings in question
would be designated as a "blighted area" and would be condemned.

The City had taken preliminary steps required for the URA to condemn the buildings.
In June 1995, the City Planning Commission adopted a resolution that declared the "***
to be a "blighted area" under the State Redevelopment Law. The *** included the
buildings leased by the school.

While the School was negotiating with the CEIDC, the CEIDC caused the windows of
the buildings to be boarded up and removed the School's sign identifying its premises in
the buildings.

After considering the legal threat of X and the opinion of its legal counsel regarding the
CEIDC's ability to take the property through the URA's power of eminent domain, the
School and the CEIDC agreed in January 1996 that the School would vacate the leased
premises and terminate its lease. The School received $1.4 million under this settlement
agreement.
Later in January 1996, the School purchased a building for approximately $1 million
with the funds it had received under the settlement agreement. The School has exhausted
the remainder of the $1.4 million received under the settlement agreement on
improvements made to the purchased building to construct suitable facilities.

On May 26, 1996, the School vacated its leased premises and relocated its downtown
City operations to the new building.

LAW AND ANALYSIS:

Issue One:
Section 1033(a)(2) of the Code provides, in part, that, if property, as a result of its
condemnation or threat or imminence thereof, is compulsorily or involuntarily converted
into money, the taxpayer must recognize any realized gain except to the extent otherwise
provided in section 1033. Under section 1033(a)(2)(A), if the taxpayer during the
replacement period purchases other property similar or related in service or use to the
property so converted for the purpose of replacing the property so converted, then the
taxpayer may elect to recognize gain only to the extent that the amount realized on such
conversion (regardless of whether such amount is received in one or more taxable years)
exceeds the cost of such other property.

Section 1033(a)(2)(B) of the Code provides, in part, that the period within which
property must be replaced begins with the earlier of the date of disposition or the earliest
date of threat or imminence of condemnation and ends two years after the close of the
first taxable year in which any part of the gain on conversion is realized.

Rev. Rul. 63-221, 1963-2 C.B. 332, states the general rule regarding threat or
imminence of condemnation. For purposes of section 1033 of the Code, property is under
threat or imminence of condemnation when the owner of the property is informed, either
orally or in writing, by a representative of a governmental body or public official
authorized to acquire property for public use, that such body or official has decided to
acquire the property and the property owner has reasonable grounds to believe, from the
information conveyed to him by such representative, that the necessary steps to condemn
the property will be instituted if a voluntary sale is not arranged.

In Rev. Rul. 71-567, 1971-2 C.B. 309, the Service held that the enactment of a public
law authorizing acquisition of a property was a sufficient threat or imminence of
condemnation to qualify for treatment under section 1033 of the Code, notwithstanding
the absence of an actual appropriate of funds necessary to acquire the property.

Likewise, Rev. Rul. 69-303, 1969-1 C.B. 201, provides that the sale by a taxpayer to a
nonprofit organization, acting in cooperation with a governmental entity proposing to
acquire or condemn the property constitutes an involuntary conversion of such property
as a result of threat or imminence of condemnation within the meaning of section 1033 of
the Code. In Rev. Rul. 69-303, a representative of the Fish and Wildlife Service advised
the taxpayer that it had reached an understanding with a private nonprofit membership
organization that the organization would attempt to purchase the taxpayer's property and
hold it until the Fish and Wildlife Service obtained the funds to purchase it. The nonprofit
organization purchased the taxpayer's property pursuant to a resolution to resell the
property to the Fish and Wildlife Service when it obtained the funds needed to purchase
the property. The Service ruled in Rev. Rul. 69-303 that a threat or imminence of
condemnation existed pursuant to the principles set forth in Rev.Rul. 63-221. According
to the Service, while the property was not sold to the governmental body having the
authority to condemn it, it was sold under circumstances evidencing that the purchaser
was acting in cooperation with such governmental body for the purpose of acquiring the
property for public use.

In Rev. Rul. 81-180, 1981-1 C.B. 161, the Service ruled that a voluntary sale of
property to a third party qualified as an involuntary conversion under section 1033 of the
Code. The taxpayer in the ruling had reasonable grounds to believe that the necessary
steps to condemn the property would be instituted by the condemning authority if the
taxpayer did not arrange for a sale. The ruling indicates that the threat or imminence of
condemnation was established through a newspaper report, followed by a written
confirmation by an authorized official as to the correctness of the newspaper report.
Rather than wait for the city to exercise its power, the taxpayer sold the property to an
unrelated third party. The Service held that this sale occurred under a "threat of
condemnation" pursuant to section 1033.

The sale of the property to the CEIDC by the School will constitute a compulsory or
involuntary conversion of property by reason of the threat or imminence of condemnation
within the meaning of section 1033 of the Code. The School had reasonable grounds to
believe that, if it did not negotiate a cancellation of its lease with the CEIDC, the property
and/or the leasehold would be condemned. Therefore, the property will be considered
"compulsorily or involuntarily converted" as a result of the "threat or imminence" of
condemnation within the meaning of section 1033(a).

Issue Two:
In Davis Regulator Co. v. Commissioner, the Board of Tax Appeals held that the timely
acquisition of a fee simple interest in real estate qualified as replacement property
"similar or related in service or use" to the taxpayers who involuntarily converted a 20-
year leasehold. See Davis Regulator Co. v. Commissioner, 36 B.T.A. 437 (1937), acq.,
1937-2 C.B. 7. The Board reasoned that the property was similar or related in service or
use because it would be used by the taxpayer in the same business and for identical
purposes as the converted leasehold. According to the Board:

If the statute required that money derived from the sale or conversion be invested in
"similar" property and stopped there, there would be more substance to the respondent's
argument; but it goes further, and, as pointed out by this Board ... the word "similar" is
"followed immediately by the phrase 'or related', which ... considerably broadens the
scope of the statute and gives the taxpayer more latitude in making an investment ..." As
we view the facts before us, the petitioner has an interest in real estate, capable of being
used by it in connection with its business. This interest was sold and the money received
and was invested by it in another interest in real estate "similar or related in service or use
to the property so converted." That, we believe, is all that is required to entitle the
petitioner to the benefit of the section under consideration....

Id. at 443 (quoting Paul Haberland, 25 B.T.A. 1370 (1932)). Accordingly, the Board
held that the taxpayer was entitled to defer the gain to the extent that the buyout proceeds
were used for purchasing and constructing the replacement property. See also Rev. Rul.
83-70, 1983-1 C.B. 189 (following the holding in Davis Regulator).

Within the replacement period specified in section 1033 of the Code, the School used
its lease cancellation proceeds to purchase a building and make improvements to the
building to make it suitable for the School's use. Accordingly, the building purchased and
the improvements made qualify as property "similar or related in service or use" to the
property previously leased by the School. Thus, the building purchased by the School and
the improvements thereto are qualifying replacement property under section 1033.

CONCLUSION:

The School's receipt of condemnation proceeds as compensation for the School's


property interest in the unexpired term of its leasehold qualifies as an involuntary
conversion resulting from threat or imminence of condemnation under section 1033 of
the Internal Revenue Code. Moreover, the School's investment of the condemnation
proceeds in a fee simple property interest to be used for identical purposes as the
converted leasehold qualifies as replacement property similar or related in service or use
to the leasehold interest involuntarily converted.

Except as specifically ruled above, no opinion is expressed as to the federal tax


treatment of the above transactions under other provisions of the Code and regulations
that may be applicable. No opinion is expressed as to the tax treatment of any conditions
existing at the time of or effects resulting from the transaction that are not specifically
covered by the above ruling. A copy of this letter ruling should be attached to the
appropriate federal income tax returns for the taxable years in which the transactions
described herein are consummated.

This letter ruling is directed only to the taxpayer who requested it. Section 6110(j)(3) of
the Code provides that it may not be used or cited as precedent.
Assistant Chief Counsel
(Income Tax & Accounting)

By * * * *

FN1 The CEIDC's incorporators were the Deputy Mayor of City and the Executive
Director of the URA. Moreover, these two individuals and the City's Director of
Economic Development served as the CEIDC's initial board of directors and serve as the
CEIDC's officers. The CEIDC and the URA share the same address. The CEIDC depends
in part on the URA for its funding. There are also other ties between the CEIDC and the
URA as evidenced in the CEIDC's corporate documents.

This document may not be used or cited as precedent. Section 6110(j)(3) of the Internal
Revenue Code.

ELEMENTS OF CODE §1033 CONDEMNATION:


JOHNSON V. COMMISSIONER,
T. C. Memo 1998-448

This case focused on whether the taxpayers met the requirements for a qualified Code
§1033 involuntary conversion. The Court traced all of the requirements for a valid
condemnation within Code §1033, such as use of eminent domain, a threat of
condemnation, reasonable belief of the threat, and that it could take place as to
condemnation. The Court finally concluded that the condemnation fit within Code §1033
for postponing gain.

Michael H. JOHNSON and Patricia E. Johnson, Petitioners,


v.
COMMISSIONER OF INTERNAL REVENUE, Respondent.

United States Tax Court.


T.C. Memo. 1998-448
Dec. 23, 1998.

MEMORANDUM FINDINGS OF FACT AND OPINION

VASQUEZ, Judge:
Respondent determined a deficiency of $918,931, an addition to tax pursuant to section
6651(a)(1) of $181,033, and a penalty pursuant to section 6663(a) of $689,198 with
respect to petitioners' 1992 Federal income tax. [FN1]

The issues for decision are: (1) Whether petitioners are entitled to defer recognition of
gain on the disposition of property located at 45640 North 23d Street West in Lancaster,
California (the 23d Street property), pursuant to section 1033; (2) whether petitioners are
liable for the fraud penalty pursuant to section 6663(a), or, in the alternative, whether
petitioners are liable for the accuracy-related penalty pursuant to section 6662(a) for
1992; and (3) whether petitioners are liable for the addition to tax for failure to timely file
their return for 1992.

FINDINGS OF FACT

The 23d Street Property


In 1982, the Lancaster Redevelopment Agency (the LRA) prepared a Redevelopment
Plan for the Lancaster Fox Field Redevelopment Project pursuant to California
Community Redevelopment Law, California Health and Safety Code sections 33000-
33855 (West 1973 & Supp.1998). On November 1, 1982, the LRA passed, approved, and
adopted Resolution No. 12-82 transmitting its report and Redevelopment Plan to the City
of Lancaster, California (Lancaster). On December 20, 1982, at a meeting of the City
Council of Lancaster (the LCC), the LCC, by Ordinance No. 289, approved and adopted
the Redevelopment Plan for the Fox Field Redevelopment Project.

The rules and regulations of the Fox Field Redevelopment Project provided as follows:

The Project Area is large and contains many parcels of real property. As a result there is
a need to simplify the availability of participation opportunities. Therefore, as an
alternative to requiring a participation agreement for each property not to be purchased or
subject to Agency [the LRA] acquisition by eminent domain, the Agency is authorized to
make determinations of those properties which conform to the Redevelopment Plan. If
such a determination is made by the Agency then the property will not be subject to
eminent domain by the Agency as long as the property continues to conform to the
Redevelopment Plan. The Agency shall in good faith review the property contained in the
Project Area and issue Certificates of Conformance to qualifying properties as soon as
possible consistent with the restoration and redevelopment permitted by the Plan and
specific designs for development adopted by the Agency pursuant to the Plan.

The 23d Street property is located in the Fox Field Redevelopment Project. In February
1983, the LRA approved an agreement between the LRA and petitioner Michael H.
Johnson (Mr. Johnson) to assist in the development of a Ford motor vehicle dealership in
the Fox Field Redevelopment Project at the 23d Street property. Petitioners were then the
owners of the 23d Street property.

The Car Dealerships and City Tax Revenue


During the relevant time period, Mr. Johnson operated Ford and Lincoln-Mercury motor
vehicle dealerships on the 23d Street property.

Cities in California receive 1 percent of the gross sales tax from auto sales in that city.

The LCC, the LRA, and the Attorneys Involved

The LCC had five members. The LCC comprised the five voting members (directors)
of the LRA.

During the relevant time period, George Root (Mr. Root), Arnie Rodio (Mr. Rodio),
Henry Hearns, William Pursley (Mayor Pursley), and george Theophanis (Mr.
Theophanis) [FN2] were members of the LCC and directors of the LRA.

Steven Dukett (Mr. Dukett) was the Redevelopment Director of the LRA, and Mark
Asturias (Mr. Asturias) was the Senior Development Projects Coordinator of the LRA.
David McEwen (Mr. McEwen) was the city attorney of Lancaster and counsel for the
LRA. In April 1990, Mr. Johnson retained David Wright (Mr. Wright) in connection with
the Palmdale Auto Mall transaction.

The Palmdale Auto Mall v. the Lancaster Auto Mall


Lancaster and the City of Palmdale, California (Palmdale) are located in the Antelope
Valley of California, which is 75 miles north of Los Angeles. The cities are only 5 miles
apart.

During the period in question, Lancaster was engaged in an auto mall development
competition with Palmdale. Prior to October 1990, Lancaster had invested approximately
$10 million into the development of an auto mall. Previously, Lancaster lost a
competition for a regional shopping center to Palmdale.

Lancaster felt that it needed a domestic auto dealer as an anchor in its auto mall, and it
wanted Mr. Johnson's motor vehicle dealerships to relocate to the Lancaster Auto Mall.

On February 14, 1989, Mr. Johnson signed a Disposition and Development Agreement
(DDA) concerning a planned relocation to the Palmdale Auto Mall located in Palmdale.
[FN3]

On July 19, 1989, the LRA made a proposal to Mr. Johnson concerning relocating his
motor vehicle dealerships to the Lancaster Auto Mall. In a letter dated July 26, 1989, Mr.
Johnson declined this offer and indicated he was going to move his motor vehicle
dealerships to the Palmdale Auto Mall.

On August 18, 1989, Palmdale signed the DDA regarding Mr. Johnson's move to the
Palmdale Auto Mall.

After learning of Mr. Johnson's agreement with Palmdale but before Mr. Johnson
terminated his agreement with Palmdale, Mr. McEwen advised the LCC and the LRA
staff to refrain from any negotiations with Mr. Johnson concerning the 23d Street
property while Mr. Johnson was under agreement with Palmdale.

While under contract with Palmdale, Mr. Johnson tried to negotiate with Lancaster to
move his motor vehicle dealerships to the Lancaster Auto Mall. Between April 1990 and
September 1990, he sent several letters to Lancaster city officials in an effort to
communicate the terms of his offers. The LCC, however, was unwilling to negotiate with
Mr. Johnson during this time. A letter dated June 22, 1990, specifically mentioned
Lancaster's unwillingness to negotiate with Mr. Johnson. During this period, Lancaster
rejected Mr. Johnson's proposals.

In early 1990, Mr. Johnson's negotiations concerning relocating his motor vehicle
dealerships to the Palmdale Auto Mall began to deteriorate. This was due in part to the
fact that William Royster (Mr. Royster), the developer of the Palmdale Auto Mall who
was negotiating with Mr. Johnson on behalf of Palmdale, made representations that were
not the position of Palmdale and to which Palmdale was unwilling to commit.

By letter dated October 15, 1990, Mr. Johnson informed Mr. Royster that he (i.e., Mr.
Johnson) was withdrawing from the agreement to relocate his motor vehicle business to
the Palmdale Auto Mall. This letter was hand delivered to Mr. Royster.

After terminating discussions with Palmdale in mid-October 1990, Mr. Johnson


intended to remain at the 23d Street property or to sell the motor vehicle dealerships to a
third party.

In October 1990, shortly after Mr. Johnson terminated discussions with Palmdale,
Lancaster city officials learned that Mr. Johnson had withdrawn from his agreement with
Palmdale and that the withdrawal upset Palmdale city officials.

After learning that Mr. Johnson's negotiations with Palmdale had terminated, Mr.
McEwen advised the LCC and the LRA that they possessed the power and the authority
to condemn, and to threaten condemnation of, the 23d Street property.

The LCC and the LRA approved the use of threats of condemnation against petitioners.
The LRA directed its staff to notify Mr. Johnson that the LRA would condemn the 23d
Street property.

Lancaster Officials Tell Mr. Johnson That Lancaster Is Going To Condemn the 23d
Street Property
On or about October 16, 1990, while visiting Mr. Johnson at the 23d Street property,
Mr. Theophanis told Mr. Johnson that Lancaster would condemn the 23d Street property
unless petitioners agreed to sell the property to Lancaster and relocate the motor vehicle
dealerships to the Lancaster Auto Mall.

On October 29, 1990, in a meeting in Mayor Pursley's office at Lancaster City Hall,
Mr. Theophanis again advised Mr. Johnson that Lancaster would condemn the 23d Street
property. Mayor Pursley witnessed Mr. Theophanis' tell Mr. Johnson that Lancaster
would condemn the 23d Street property, and Mayor Pursley also informed Mr. Johnson
that Lancaster would condemn the 23d Street property.

At the October 29, 1990, meeting, Lancaster wanted to make it crystal clear to Mr.
Johnson that the LCC and the LRA were going to do everything in their power to put Mr.
Johnson in the Lancaster Auto Mall. In particular, Mr. Theophanis made it very clear to
Mr. Johnson that one way or the other, Mr. Johnson's motor vehicle dealerships were
going to end up in the Lancaster Auto Mall. If condemnation was required, that is what
Lancaster would do.

Mr. Dukett told Mr. Johnson that Lancaster would condemn the 23d Street property.
Mr. Dukett advised Mr. Johnson that the LCC supported telling Mr. Johnson that
Lancaster would condemn the 23d Street property and would proceed with condemnation
if Mr. Johnson refused to negotiate. Mr. Asturias witnessed Mr. Dukett advise Mr.
Johnson that Lancaster would condemn the 23d Street property. Mr. Asturias also
frequently informed Mr. Johnson that Lancaster would condemn the 23d Street property.

A letter to Mr. Johnson regarding condemnation of the 23d Street property was drafted,
and Mr. McEwen approved it as to form and content (with one change). This letter was
edited, dated August 4, 1991, and signed by Mr. Dukett. The letter stated the following:

This letter is to confirm conversations which you are having with the staff of the
Lancaster Redevelopment Agency concerning the acquisition of your property. The
property, located at 45640 North 23d Street West, commonly known as the Johnson
Ford/Lincoln Mercury Dealership location, is currently proposed to be acquired by the
Agency through negotiations. As you are aware, the Agency is authorized to acquire
property by the use of eminent domain. If these negotiations are unsuccessful, staff will
recommend to the Agency Board that they proceed with proceedings for the acquisition
of your property through the exercise of the power of eminent domain.

On or about August 4, 1991, Mr. Dukett delivered this letter to Mr. Johnson.

Mr. Johnson Seeks Advice After Being Told That Lancaster Would Condemn the
23d Street Property
In October 1990, after Mr. Theophanis informed Mr. Johnson that Lancaster would
condemn the 23d Street property, Mr. Johnson sought advice from Mr. Wright regarding
Lancaster's threats. Mr. Johnson specifically asked Mr. Wright, "Can they do that?" Mr.
Wright advised Mr. Johnson that (1) Lancaster had the authority to condemn the 23d
Street property, (2) whether or not Lancaster and the LRA had the ability to condemn was
not an issue, and (3) the only issue would be the fair market value of the property. Mr.
Wright made it clear to Mr. Johnson that he would not be able to win a condemnation
fight.

The Negotiations That Followed Mr. Johnson Being Told That Lancaster Would
Condemn the 23d Street Property
The negotiations between Lancaster and Mr. Johnson while the LRA and the LCC were
informing Mr. Johnson that Lancaster would condemn the 23d Street property were
hostile, strained, tense, and difficult with Lancaster repeatedly telling Mr. Johnson that
Lancaster would condemn the 23d Street property.

On September 16, 1991, Mr. Johnson entered into a DDA with the LRA. The DDA
expressly states that the LRA desired to acquire the 23d Street property "for purposes of
redevelopment by an action in eminent domain or by deed in lieu thereof," and the
purpose of the DDA was to effectuate the Redevelopment Plan by providing for the
LRA's acquisition of the 23d Street property "for redevelopment by agreement in lieu of
an action in eminent domain for such purposes."

Escrow documents executed in connection with the DDA expressly state that the
transaction was "in lieu of an action in eminent domain".
The New Property
In 1992, Mr. Johnson acquired property in the Lancaster Auto Mall that was "property
similar or related in service or use to" the 23d Street property. Mr. Johnson relocated to
the Lancaster Auto Mall immediately upon vacating the 23d Street property.

Petitioners' 1992 Tax Returns


Petitioners filed a Form 4868, 1992 Application for Automatic Extension of Time to
File U.S. Individual Income Tax Return. On April 15, 1993, respondent received the
Form 4868. On August 13, 1993, petitioners filed their 1992 tax return.

OPINION

I. Section 1033
As a general rule, gain realized from the sale or other disposition of property must be
recognized. Sec. 1001(c). Section 1033 provides an exception to this rule. If property, as
a result of condemnation or threat or imminence thereof, is compulsorily or involuntarily
converted into money, no gain shall be recognized if (1) the taxpayer elects
nonrecognition treatment, (2) the taxpayer purchases property similar or related in service
or use to the property converted within the statutory time limit, and (3) the cost of the
replacement property equals or exceeds the amount realized on the conversion. Sec.
1033(a).

Section 1033 is a relief provision enacted to allow a taxpayer to replace property


involuntarily converted without recognizing any gain resulting from that conversion.
John Richard Corp. v. Commissioner, 46 T.C. 41, 44 (1966). As a relief provision, this
section is construed liberally to achieve its purpose. Filippini v. United States, 318 F.2d
841, 844 (9th Cir.1963); John Richard Corp. v. Commissioner, supra at 44.

Respondent concedes that (1) petitioners have made the election, (2) petitioners
purchased property similar or related in service or use to the property converted within
the statutory time limit, and (3) the cost of the replacement property equaled or exceeded
the amount realized on the conversion. The only issue is whether Lancaster made a
"threat of condemnation" regarding the 23d Street property.

A "threat of condemnation" exists if (1) the body threatening condemnation possesses


the power of eminent domain, (2) the property owner is told by an official of the
threatening body that condemnation will be sought unless the owner negotiates a sale or
exchange of the property, and (3) the information conveyed to the owner gives the owner
reasonable grounds to believe that the threat was authorized and likely to be carried out
unless a sale or exchange is arranged. Tecumseh Corrugated Box Co. v. Commissioner,
94 T.C. 360, 376- 377 (1990), affd. 932 F.2d 526 (6th Cir.1991); Maixner v.
Commissioner, 33 T.C. 191, 195 (1959); Dominguez Estate Co. v. Commissioner, T.C.
Memo.1963-112; Carson Estate Co. v. Commissioner, T.C. Memo.1963-90.

The existence of a threat of condemnation is judged from the seller's perspective taking
into account all facts known at the time of sale. Tecumseh Corrugated Box Co. v.
Commissioner, supra at 377. Generally, we are willing to find that a threat of
condemnation has taken place if the taxpayer might reasonably believe from
representations of Government agents and from surrounding circumstances that
condemnation was likely to take place if the taxpayer did not sell the property. Id. at 376.
We have been unwilling to find a threat, however, where it should have appeared to the
taxpayer that the chance of condemnation was remote. Rainier Cos. v. Commissioner, 61
T.C. 68, 76 (1973), revd. and remanded in part on another issue without unpublished
order 538 F.2d 338 (9th Cir.1975); Warner v. Commissioner, 56 T.C. 1126, 1137 (1971),
affd. without published opinion 478 F.2d 1406 (7th Cir.1973). Whether property is
converted under a threat of condemnation is a question of fact, and petitioners bear the
burden of proof. Rule 142(a).

1. Eminent Domain
The body threatening condemnation must possess the power of eminent domain. Under
section 1033, as long as an agency could readily obtain authority to condemn in the event
that the taxpayer refused to cooperate, actual authority to condemn is not required at the
time the threat was made. See Balistrieri v. Commissioner, T.C. Memo.1979-115.

Petitioners argue that both Lancaster and the LRA had the power to condemn, via
eminent domain, the 23d Street property. Respondent concedes that Lancaster has
eminent domain authority pursuant to California Government Code section 37350.5 but
argues that the LRA could not condemn the 23d Street property using the power of
eminent domain.

We are unpersuaded by respondent's argument. As respondent concedes, California law


provides Lancaster with the power of eminent domain. Therefore, we need not consider
whether the LRA possessed this power. [FN4] We conclude that the body threatening
condemnation possessed the power of eminent domain.

2. The Threats
The taxpayer must have received a threat to acquire property through condemnation.
The taxpayer may receive threats orally or in writing.

Respondent points out that the gravamen of the case at bar is whether Lancaster
threatened Mr. Johnson with condemnation of the 23d Street property. Respondent argues
that the testimony of the multitude of witnesses who stated that numerous Lancaster city
officials threatened Mr. Johnson with condemnation of the 23d Street property is not
believable.

After considering the record as a whole, and determining the weight to be accorded to
the testimony of the various witnesses, we conclude, as we have found as facts, that
several Lancaster city officials made very clear threats of condemnation to Mr. Johnson.
Mayor Pursley, Mr. Rodio, Mr. Root, Mr. McEwen, Mr. Dukett, and Mr. Asturias all
credibly testified that, after Mr. Johnson terminated his agreement with Palmdale, the
LCC and the LRA repeatedly threatened Mr. Johnson with condemnation of the 23d
Street property. Mr. Asturias testified that threats of condemnation were used "practically
every time we talked to him." Several witnesses who were members of the LRA and the
LCC during the period in question also credibly testified that the threats were authorized
and that there was considerable animosity between (1) the LRA and Mr. Johnson and (2)
the LCC and Mr. Johnson.

The facts are that representatives of the LRA and members of the LCC threatened Mr.
Johnson with condemnation of the 23d Street property, and they meant it. We conclude
that members of the LCC and the LRA genuinely threatened Mr. Johnson with
condemnation of the 23d Street property.

3. Reasonable Belief of the Threat


The taxpayer must believe that the threat is likely to be carried out if a voluntary sale is
not arranged.

We conclude that petitioners had reasonable grounds to believe, and did believe, that
Lancaster authorized the threats of condemnation and was likely to carry them out unless
a sale or exchange was arranged.

4. Conclusion
The witnesses consistently and credibly testified that Lancaster city officials threatened
Mr. Johnson with condemnation of the 23d Street property and that Mr. Johnson
believed, and had reason to believe, these threats.

Based on the record, we conclude that a "threat of condemnation" existed, and


petitioners sold the 23d Street property because of repeated threats of condemnation from
a number of Lancaster city officials.

II. Fraud/Negligence

Section 6663(a) imposes a penalty equal to 75 percent of the portion of the


underpayment attributable to fraud. Section 6662(a) imposes a accuracy-related penalty
equal to 20 percent of the portion of the underpayment attributable to negligence or a
substantial understatement. See sec. 6662(b)(1) and (2).

For purposes of the fraud and accuracy-related penalties, an "underpayment" is the


amount by which any tax imposed by the Code exceeds the excess of the sum of the
amount shown as the tax by the taxpayer on his return plus amounts not so shown
previously assessed (or collected without assessment) over the amount of rebates made.
Sec. 6664(a). In this case, the adjustments respondent made in the statutory notice of
deficiency stem from the determination that petitioners are not entitled to defer
recognition of gain on their disposition of the 23d Street property pursuant to section
1033. We have found that petitioners are entitled to section 1033 deferral of gain;
therefore, there is no "underpayment", and petitioners are not liable for penalties pursuant
to section 6663(a) or section 6662(a).
In reaching all of our holdings herein, we have considered all arguments made by the
parties, and to the extent not mentioned above, we find them to be irrelevant or without
merit.

To reflect the foregoing,


Decision will be entered for petitioners.

MHS COMPANY, INC.,

When a taxpayer receives proceeds on condemnation of real property, the reinvestment


must be in real property, not personalty. This point was well emphasized for the taxpayer
in the following case, wherein the taxpayer could not come within the postponement
section.

This case examined the distinction between tenants in common and a joint
venture/partnership concept. Ownership in a partnership is personalty for the partner;
ownership as a tenant in common can be realty if the underlying property is real estate.

M. H. S. COMPANY, INC., Petitioner-Appellant,


v.
COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

78-1 USTC P 9442 (6th Cir. 1978)


575 F.2d 1177 (1978)

Appeal was taken from a decision of the United States Tax Court, Irene F. Scott, J.,
involving federal income tax deficiencies. The Court of Appeals held that evidence
supported Tax Court's finding that corporate taxpayer invested proceeds realized from
eminent domain taking of its real property in joint venture and partnership and resultant
conclusion that interest purchased by taxpayer was personal rather than real property so
that taxpayer had not acquired "like kind" property and was not entitled to nonrecognition
of capital gain.

Affirmed.

Before PHILLIPS, Chief Judge, and


CELEBREZZE and KEITH, Circuit Judges.

PER CURIAM.
This is an appeal from the decision of the United States Tax Court involving federal
income tax deficiencies for the years ending September 30, 1966, 1967, 1969 and 1970 in
the amounts of $19,444.52, $62.13, $996.50 and $977.16, respectively. Reference is
made to the comprehensive findings of fact and opinion of Judge Irene F. Scott, reported
at 35 T.C.M. 733 (1976), for a recitation of pertinent facts.
The taxpayer, a Tennessee corporation, was formed for the purpose of acquiring and
leasing real estate. Certain of its real estate was acquired by the State of Tennessee by
eminent domain, resulting in a capital gain to the taxpayer.

The issue is whether the proceeds of the capital gain were invested in real estate as a
tenant in common with a co-owner, as the taxpayer contends, or whether the proceeds
were invested in a joint venture as asserted by the Commissioner. The Tax Court found
that the taxpayer invested in a joint venture and a partnership under both Tennessee and
federal law. The Tax Court concluded that because the interest purchased by the taxpayer
was a partnership interest, it was personal rather than real property; and that,
consequently, the taxpayer, having not acquired "like kind" property, was not entitled to
nonrecognition of the gain realized under s 1033 of the Internal Revenue Code.

Upon consideration of the briefs and oral arguments, and the entire record, we conclude
that the findings of fact of the Tax Court are not clearly erroneous, Commissioner v.
Duberstein, 363 U.S. 278, 290-91, 80 S.Ct. 1190, 4 L.Ed.2d 1218 (1960), and that its
conclusions of law are correct for the reasons stated in the Tax Court's opinion.

Accordingly, the decision of the Tax Court is affirmed. No costs are taxed. Each party
will bear its own costs on this appeal.

PRIVATE LETTER RULING 8540005

This Ruling examines the basic elements of a tax-deferred exchange under not only
Code §1031, but also other overlapping Sections of the Code that may apply in a given
setting. In addition, questions as to basis, distribution of property from a corporation and
related issues, were also covered.

PRIVATE LETTER RULING 8540005

This is in reply to a letter of August 22, 1984 from your authorized representative,
requesting rulings under section 1031 of the Internal Revenue Code. In a letter dated
January 7, 1985 we ruled that the exchange of Property a for Property b qualifies as a like
kind exchange under section 1031(a)(1) of the Internal Revenue Code. It was understood
that we would address at a later time the bases of the properties held by the taxpayers
after the exchange.

The information submitted indicates that X owns Property a for the production of rental
income. A and B, noncorporate shareholders of X, jointly own and rent Property b to X
for use in the trade or business of X. Property a and Property b consists of unencumbered
real property. An independent appraiser hired by the taxpayers concluded that the fair
market value of Property a is $19x, while the fair market value of Property b is $18x.
$19x is a greater amount than $18x.

Section 1031(a)(1) 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.

Section 1031(d) of the Code provides, in part, that if property was acquired on an
exchange described in this section, then the basis shall be the same as that of the property
exchanged, decreased in the amount of any money received by the taxpayer and increased
in the amount of gain or decreased in the amount of loss to the taxpayer that was
recognized on such exchange.

Section 301(a) of the Code provides that, except as otherwise provided, a distribution of
property made by a corporation to a shareholder with respect to its stock shall be treated
in the manner provided in subsection (c). Section 301(b) provides that for noncorporate
distributees, the amount of any distribution shall be the amount of money received, plus
the fair market value of the other property received. Section 301(c) provides generally
that if there is a distribution to which subsection (a) applies, then the portion of the
distribution which is a dividend (as defined in section 316) shall be included in gross
income. Section 301(d) provides that for noncorporate distributees, the basis of property
received in a distribution to which subsection (a) applies shall be the fair market value of
such property.

Section 316(a) states that the term "dividend" generally means any distribution of
property made by a corporation to its shareholders out of the corporation's earnings and
profits.

Section 1.301-1(j) of the Income Tax Regulations provides, in part, that if property is
transferred by a corporation to a shareholder which is not a corporation for an amount
less than its fair market value in a sale or exchange, such shareholder shall be treated as
having received a distribution to which section 301 applies in an amount equal to the
difference between the amount paid for the property and its fair market value.

Provided that $19x and $18x reflect the fair market values of Property a and Property b, it
is held as follows:

(1) For purposes of the exchange subject to section 1031, the basis
of Property a after the exchange shall equal the basis of
Property b prior to the exchange and the basis of Property b
after the exchange shall equal the basis of Property a prior to
the exchange.
(2) A and B will be treated upon the exchange described above as
having received a distribution from X of property to which
section 301(a) of the Code applies. The distribution will
consist of the amount by which the fair market value of
Property a exceeds the fair market value of Property b (section
1.301-1(j) of the regulations).
(3) The basis of the property received in the distribution will be
the fair market value of such property (section 301(d)).
TAXATION OF CITIZENS RENOUNCING CITIZENSHIP

Under Code Section 877(b), if there is a United States citizen who renounces his
citizenship, having it as a principal purpose to avoid tax from the United States, the U.S.
tax position can continue for ten (10) years, to thus tax the "citizen" as a U.S. citizen on
U.S. source income.

Code Section 887(c) provides for the special source rule to determine U.S. income.
This would include sale or exchange of property located in the United States, certain debt
obligations issued by U.S. persons, stock of U.S. corporations, and so forth.

Gain on a sale or exchange of the property, where the basis is determined in whole or in
part by reference to a basis of U.S. property, is treated as gain from the sale of U.S.
property. This means that tax-deferred exchanges can possibly be subject to tax where
there is an exchange and a subsequent disposition of that property. It could be construed
to be a disposition of United States property, as property located within the United States
and taxable under this rule. This change occurred relative to exchanges made after
September 25, 1985. (See also in this Chapter, infra, as to Rev. Rul. 68-363.)

Legislation in 1989, as to Code §1031, also eliminated treatment of property as like-


kind if it is U.S. realty for foreign realty.

EXCHANGE OF FOREIGN CURRENCY:


REVENUE RULING 74-7

Under Rev. Rul. 74-7, the conversion of a foreign country's currency into U.S. dollars,
after a visit to that country by a U.S. citizen, where one is not a dealer in foreign currency
or engaged in the trade or business in the country, is not a Section 1031 like-kind
exchange. The foreign currency is considered a capital asset, and any gain or loss which
is realized in the conversion is a capital gain or loss.

This Ruling updates a prior position relative to foreign currency and the question of
whether the currency would be "property used in the trade or business" or otherwise
qualify for an exchange.

REVENUE RULING 74-7


1974-1 C.B. 198

The purpose of this Revenue Ruling is to update and restate, under the current statute
and regulations, the position set forth in I.T. 3810, 1946--2 C.B. 55.

The question presented is whether, after the conversion of United States dollars into
foreign currency by a United States citizen traveling in the foreign country, the
reconversion of the foreign currency into dollars may be treated as an exchange of
property held for productive use in trade or business or for investment for property of a
like kind to be held for productive use in trade or business or for investment, under
section 1031 of the Internal Revenue Code of 1954. If not, the further question presented
is whether the gain or loss realized on such a transaction by a taxpayer, who is not a
dealer in foreign currency, constitutes capital gain or loss under section 1221 of the Code.

The taxpayer, a United States citizen, while traveling in a foreign country deposited
United States dollars in a bank in that country. At his request, the bank converted these
dollars to that country's currency for the taxpayer's personal use. The taxpayer was not a
dealer in foreign currency and was not engaged in trade or business in the foreign
country. During his travels there were no transactions in the foreign bank account. At the
conclusion of his stay, the taxpayer requested the bank to reconvert the foreign currency
to dollars and close his account. The value of the foreign currency, measured in terms of
dollars, differed at the time the account was closed from the value when the account was
opened.

In the instant case, the foreign currency does not constitute property held for productive
use in trade or business or for investment, and therefore the reconversion is not a like
kind exchange under section 1031(a) of the Code.

Section 1221 of the Code provides, in part, that the term 'capital asset' means property
held by the taxpayer, but does not include certain specified property. Section 1.1221--1(a)
of the Income Tax Regulations provides, in part, that the term 'capital assets' includes all
classes of property not specifically excluded by section 1221.

In the instant case, the foreign currency is not excluded from the definition of capital
assets contained in section 1221 of the Code.

Accordingly, the foreign currency is a capital asset and any gain or loss realized on the
reconversion by the taxpayer is a capital gain or capital loss.

I.T. 3810 is hereby superseded

CODE §1031 AND FIRPTA:

Under the Foreign Investors Real Property Tax Act (FIRPTA), the Regulations under
Treasury Reg. §1.1445-2(d)(2) provide for a requirement of notice that the FIRPTA
provisions for withholding do not apply. However, the time frame of 20 days may be
difficult to meet under FIRPTA, if it is a nonsimultaneous exchange, using a greater
period of time. For this issue, see the discussion of the same by Levine, Howard, in his
Section of the Georgetown University Law Center Colloquium on "Section 1031
Exchanges", in May, 1994, (Washington, D.C., 1994).

FOREIGN PROPERTY: REVENUE RULING 68-363

For an exchange outside of the United States, the Service has issued Rev. Rul. 68-363.
The taxpayer in the Ruling was a citizen in the United States. He exchanged a ranch in
the United States for a ranch in a foreign country and also received $250,000 in cash.
Both ranches were held by the taxpayer for productive use in trade or business.

The amount of gain realized by the taxpayer was $300,000. The received boot of
$250,000 and a realized gain of $300,000.

The Ruling makes it very clear that Section 1031 does not impose any qualification as
to the place where either the property transferred or the property received is located. No
such qualification can be inferred. As such, the transaction would qualify under Section
1031, subject to recognizing the lesser of the boot, $250,000, or the gain realized,
$300,000.

It is interesting that this Ruling refers to Rev. Rul. 54-611, which holds that the sale of
an old residence in the United States and the purchase of a new residence in a foreign
country by a citizen of the United States comes within the postponement of gain rules
under Code Section 1034, or its predecessor. (However, see this Chapter, supra, as to
Code Section 877(b).

CAVEAT: Under the 1989 legislation, such exchange would no longer qualify under
Code §1031.

REVENUE RULING 68-363


1968-2 C.B. 336

Advice has been requested whether a taxpayer may, under the circumstances described
below, avail himself of the nonrecognition of gain provisions of section 1031 of the
Internal Revenue Code of 1954.

The taxpayer, a citizen of the United States, exchanged a ranch in the United States for
a ranch in a foreign country and $250,000 in cash. Both ranches were held by the
taxpayer for productive use in his trade or business. He realized a gain of $300,000 on the
exchange.

Accordingly, the exchange of the ranches in this case comes within the purview of
section 1031(a) of the Code. However, under section 1031(b) of the Code, the gain
realized on the exchange is recognized to the extent of $250,000, the amount of the cash
received.

See Revenue Ruling 54--611, C.B. 1954--2, 159, which similarly holds that the sale of
an old residence in the United States and the purchase of a new residence in a foreign
country by a citizen of the United States comes within the purview of section 112(n) of
the Internal Revenue Code of 1939 (now section 1034 of the 1954 Code), relating to the
nonrecognition of gain from the sale or exchange of a residence.

CAVEAT: As a result of changes in 1989 to Code §1031, this property would not
qualify under Code §1031.
NON-LIKE KIND PROPERTY - FOREIGN REAL ESTATE

As a result of OBRA of 1989, under Code §1031 (a), real property located in the United
States and real property located outside of the United States are not considered like-kind
property under this rule. (This rule generally applied for transfers after July 10, 1989, for
some transitional rules with binding contracts.)

SALE QUALIFIES AS AN EXCHANGE FOR AN INCOMPETENT:


REVENUE RULING 57-469

Under Rev. Rul. 57-469, farm land belonging to an incompetent person was disposed of
for other farm land acquired by the means of a sale and purchase agreement, since the
state law did not permit an exchange by a guardian for the disabled or incompetent
person (the ward). The transaction, under the Ruling, constituted a nontaxable exchange
under Section 1031, assuming the other requirements of that section were met, even
structured as a sale! It was the unique position of state law which prevented this
transaction from being structured as an exchange.

REVENUE RULING 57-469


1957-2 C.B. 521

Advice has been requested whether a transfer of an incompetent's farm for another farm
under a sale and purchase agreement, in the circumstances described below, will
constitute an exchange for property of a like kind for the purposes of section 1031 of the
Internal Revenue Code of 1954.

In the instant case, a person, who has been adjudged incompetent by a probate court,
was the owner of a small tract of land which had been cultivated and held as an
investment by the guardianship estate . When the tract became valuable for residential
development, the guardian decided its continued use as farm land was not practical. Not
desiring to involve the estate in a speculative real estate development project, the
guardian entered into an agreement with B, the owner of another tract of farm land, for
the exchange of his ward's property for that owned by B.

The State law does not permit the guardian of an incompetent person to exchange his
ward's property for like property. It does, however, permit the sale of such property for
cash. Thus, in order to provide assurance that there would be no title objections, the
transaction was treated as a technical sale. Upon approval by the court of the guardian's
petition for authority to sell his ward's land, B gave the guardian a check in the amount of
the value of the land as appraised, and took title to the land involved. The entire proceeds
of the check were used to acquire the new tract of land from B. The entire transaction and
exchange took place in one day.

The courts have repeatedly held that where a sale is part of a transaction the purpose of
which is to effectuate an exchange, and whereby an exchange has resulted, the
transaction is an exchange for tax purposes and the sale is to be disregarded. In Century
Electric Company v. Commissioner, 192 Fed.(2d) 155, certiorari denied 342 U.S. 954,
there was an exchange where the taxpayer conveyed a foundry building and the land on
which it was situated to a college for a cash sum, and he received a lease on the building
and land from the college. In Louis W. Gunby, Inc. v. Helvering, 122 Fed.(2d) 203, an
exchange resulted where the taxpayer delivered securities to a corporation, gave it his
check in payment of preferred stock, and received from the corporation its check in
payment for his securities, and the checks which were simultaneously deposited cancelled
each other almost entirely. In Sylvester W. & E. H. Labrot v. David Burnet, 57 Fed.(2d)
413, Ct. D. 543, C.B. XI--2, 182 (1932), a similar result was reached where a farm owned
by partners was sold at a loss to a corporation organized and controlled by the partners. In
Allegheny County Auto Mart, Inc. v. Commissioner, 208 Fed.(2d) 693, where a cash sale
and cash purchase transaction was made with the same person, the reciprocal sales were
regarded as an exchange.

A fundamental principal (sic.) of taxation is that substance and not form governs in tax
matters. In Harry H. Weiss v. Louis Stearn, et al., 262 U.S. 242, T.D. 3609, C.B. III--2,
51, at 53 (1924), the court stated:

* * * Questions of taxation must be determined by viewing what was actually done,


rather than the declared purpose of the participants; and when applying the provisions of
the sixteenth amendment and income laws enacted thereunder we must regard matters of
substance and not mere form. * * *

In determining the substance of a transaction, the situation as it existed in the beginning


and at the end of a series of steps and the object sought to be accomplished should be
considered. In the instant case, since the sale was only a necessary step in reaching the
ultimate desired exchange, the transaction was an exchange within the provisions of
section 1031 of the Code. The other requirement of section 1031(a) of the Code, that
property held for productive use in trade or business or for investment be exchanged for
like property to be used in a trade or business or for investment purposes, has also been
fulfilled.

Although most of the focus of real estate people relative to Code §1031, the tax-
deferred exchange area, is on real estate, personalty is also a consideration.

Technically, the personalty may fall within Code §1031 and also be subject to tax-
deferred treatment, assuming the requirements of that Section are met. (For example, this
assumes like-kind property is exchanged for other like-kind property, held in a trade or
business or for investment. It also assumes no boot, etc.)

However, Regulations addressed this area. These Regulations are important for
numerous reasons, especially for those dealing with exchanging of personalty. In
particular, the Regulations focus on exchanging multiple pieces or assets, exchanging
where intangibles are involved and exchanges relative to debt that is incurred in
conjunction with the exchange.
For more in this area, see Chapter 9 for a detailed article and Chapter 5 and Appendix 1
herein for the full Regulations.

EXCHANGE OF PERSONALTY:

As for the exchange of personalty, there is nothing that prohibits the exchange of like-
kind personalty for other personalty that is qualified.

As to the question of an exchange of intangible personalty, there is an additional issue.


Technically such property can qualify under Code §1031. However, it must not be
specifically eliminated, such as intangible property that might fall in a separate listed
category that is excluded, e.g., choses in action.

For a discussion of this area as to intangible property that can qualify, along with
property that is excluded and does not qualify, see Treasury Reg. § §1.1031(a)-2(c). See
also GCM 39606.

For an examination of the issues on like-kind exchanges as well as intermingling of


estate planning issues, see the article by Kait, Richard, "Like-Kind Exchanges: Their Use
As An Estate Planning Technique," 8 Tax Mgmt. Real Est. J. 171 (September 2, 1992).
See also the Appendix herein

Where there is an exchange of personalty, and this is qualified tangible personalty used
in a trade or business, it may qualify for the Code §1031 treatment as like kind or like
class type property. See this discussion in Revenue Proc. 87-56, 1987-2 C.B. 674 and
Levine, H., 61-5th TM. See also Private Letter Ruling 8453034 and the discussion of the
same by Levine, Howard in his Tax Management Portfolio 567, "Tax Free Exchanges
Under Section 1031", published by BNA.

For a discussion of exchanging personal property as well as multiple properties, see the
unpublished paper by Handler, Adam, "Exchanges of Personal Property and Exchanges
of Multiple Properties," unpublished paper (Los Angeles, 1993). Mr. Handler is an
attorney with the firm of Sidley and Austin in California.

PRIVATE LETTER RULING 9127017

This Private Letter Ruling addressed issues as to exchanges involving vehicles under
master lease arrangements. Notwithstanding circumstances that might be simply
structured as a sale and purchase, the Ruling concluded that for Federal tax purposes it
would be treated as valid leases, and no gain would be recognized under Code §1031 as a
result of the exchanges of the personalty.

PRIVATE LETTER RULING 9127017


Publication Date: July 5, 1991
Dear Sirs:
This is in response to a request for rulings dated * * * and submitted on behalf of the
Owner Participant, the Lessee, and the Sublessee by your authorized representatives.
Your representatives have also submitted a supplemental letter dated * * * which
includes a report of the Independent Appraiser dated * * *. Your representatives have
requested that the Service issue the following two rulings: (1) that the lease transaction
described below will constitute a "true lease" for Federal income tax purposes, pursuant
to which the Owner Participant will be considered the owner and the lessor of the
Vehicles (as defined below) that are subject from time to time to the Master Lease
Agreement and the Lessee will be considered to be the lessee of the Vehicles; and (2) that
any exchange of Vehicles made pursuant to * * * the Master Lease Agreement will be
treated as an exchange of property under section 1031(a)(1) of the Internal Revenue Code
of 1986 (Code), with the result that the Owner Participant will not recognize gain or loss
on the exchanges.

The represented facts as pertinent to these rulings are set forth below. This ruling is
based on the facts as represented by the taxpayers and their authorized representatives.
Nothing in this letter should be read as an endorsement of the truthfulness of the
represented facts.

The Owner Participant, * * * is an accrual method taxpayer and is a member of an


affiliated group of corporations that files Federal income tax returns * * *. The
consolidated tax returns of the affiliated group are under the audit jurisdiction of the
District Director for District A.

The Lessee is an accrual method taxpayer and is the common parent of an affiliated
group of corporations that files Federal income tax returns on the basis of a * * *. The tax
returns of the Lessee are under the audit jurisdiction of the District Director for District
B.

The Sublessee, a wholly-owned subsidiary of the Lessee, is an accrual method taxpayer


and is a member of the affiliated group of corporations of which the Lessee is the
common parent. The tax returns of the Sublessee are also under the audit jurisdiction of
the District Director for District B.

SUMMARY OF TRANSACTION

This transaction can be summarized as follows. The subject property consists of * * *


("Vehicles") * * *. Under the terms of the below agreements, the Owner Trustee will,
concurrent with the purchase of the vehicles from the Sublessee, lease the vehicles to the
Lessee, which will immediately sublease the vehicles back to the Sublessee. The
Sublessee will distribute the vehicles to its network of dealers for rental to the public.

Under * * * of the Lease, * * * become subject to the Lease upon receipt by the * * *
from the Lessee (or from the Sublessee on behalf of the Lessee) of a document.
DETAILED DESCRIPTION OF THE TRANSACTION AND
REPRESENTATIONS

Pursuant to the terms of the Owner Trust Agreement, entered into between the Owner
Trustee and the Owner Participant, the Owner Trustee holds all the Vehicles, the Master
Lease Agreement (Lease), and other properties that constitute the trust estate for the use
and benefit of the Owner Participant. Because the Owner Participant holds the beneficial
interest in the Owner Trust, the Owner Trustee will make payments of profit to the
Owner Participant. The ability of the Owner Participant to transfer its interest in or under
any of the transaction documents or in the trust is subject to certain restrictions under * *
* the Participation Agreement. Under * * * this Agreement, the Owner Participant agrees
not to terminate or to revoke the Owner Trust Agreement.

Pursuant to a Participation Agreement dated * * * the Owner Participant, the Owner


Trustee, the Lessee, and the Sublessee, agreed that the Owner Participant would make
available to the Owner Trustee, in the amounts and on the funding dates summarized
below, capital contributions equal to * * * the Vehicles. Under * * * of the Participation
Agreement, the Owner Trustee will purchase the subject Vehicles from the Sublessee.
That section provides that on each Funding Date the Owner Trustee will purchase, accept
ownership of, and delivery of, the Vehicles and * * * from the Sublessee, as specified in
Bills of Sale delivered to the Owner Trustee and as set forth in a Funding Date Lease
Supplement. On each Funding Date the purchase of Vehicles will be effected by the
Owner Trustee's payment to the Sublessee, out of funds made available to the Owner
Trustee by the Owner Participant, of an amount equal to * * * as defined in * * * to the
Participation Agreement, of the Vehicles then being purchased.

Under * * * the Participation Agreement, the Owner Participant made available to the
Owner Trustee the proceeds of an equity investment in the Owner Trust equal to * * * of
the Vehicles specified in the Funding Date Lease Supplement. Under * * * the Owner
Participant also invested in the Owner Trust an amount equal to * * *. Your supplemental
letter of * * *, represents the total acquisition cost (within the meaning of section 1012 of
the Code) of all Vehicles acquired on the Funding Dates, and thereupon subjected to the
Lease, to be * * * exclusive of capitalizable transaction costs). This letter further
represents the Owner Participant's aggregate capital contribution * * * to the Owner
Trust, to be an equity investment equal to * * * of the aggregate * * * purchase price * *
* of the Vehicles. The below chart summarizes the Equity Fundings and transaction costs
on the Funding Dates:

Concurrent with the purchase by the Owner Trustee of the Vehicles, the Owner Trustee,
as lessor, leased the Vehicles to the Lessee under the Master Lease Agreement (Lease)
dated * * *. Concurrent with the Lease, the Lessee, as sublessor, subleased the Vehicles
subject to the Lease to the Sublessee pursuant to a Master Sublease Agreement
(Sublease) dated * * *.

Under the terms of dated and entered into between and the Owner Trust.
Under the terms of dated and entered into among the Lessee and the Sublessee.

Pursuant to * * * the Participation Agreement, * * * the Lease, and the Funding Date
Lease Supplement executed between the Owner Trustee and the Lessee, on each Funding
Date the Owner Trustee leased to the Lessee * * * the Vehicles which were acquired on
such Funding Date and specified in the Funding Lease Supplement. The Lease Term of
the Lease commences on the initial Funding Date, which the supplemental letter
represents to be * * * and ends on * * * which is defined in the Participation Agreement
as the earliest of the day after the * * * or one of several other dates specified therein.
Your authorized representatives represent that there is no provision for a renewal of the
Lease or an extension of the Lease Term except if the Lessee, under certain
circumstances, fails to surrender any Vehicle upon the expiration of the Lease Term.

Pursuant to * * * the Participation Agreement, * * * the Lease and * * * the Sublease,


the Lessee subleased to the Sublessee the Vehicles which became subject to the Lease on
any Funding Date for a term that corresponds to the Lease Term of the Lease. * * *
Under * * * the Sublease, the Sublessee is obligated to pay to the Lessee rent and other
charges in the same manner and in the same amounts as the Lessee is obligated to pay to
the Owner Trustee under the Lease. * * *

Under * * * the Lease, the Lessee is required to make "Basic Rent" payments to the
Owner Trustee for the Lease Term. * * * requires the Lessee to remit to the Owner
Trustee all payments of Basic Rent and Termination Value payable by the Lessee under
certain conditions upon the early termination of this transaction (see * * * the Lease). * *
* provides that the Lease is a "net" Lease and that Lessee's obligation to pay rent is
absolute. Under * * * the Lease, Basic Rent is payable * * * on each "Rent Payment
Date," which is generally the date that corresponds with the * * *, * * * anniversary date
of the Basic Term Commencement Date in each * * * occurring after the Basic Term
Commencement Date and during (and including the last day of) the Lease Term.
Moreover, under * * * the Lease, Basic Rent will be adjusted for Vehicles removed from
the Lease pursuant to provisions for the partial or complete termination of the Lease.
Adjustments to Basic Rent will be made so as to maintain the Owner Participant's * * * to
the Participation Agreement, * * *.

* * * the Lease requires that the Lessee pay from time to time to the Owner Trustee
amounts designated in * * * the Participation Agreement as * * *.

* * * the Lease requires the Lessee to obtain and maintain at its own expense insurance
for all Vehicles * * * reed [sic].

Each insurance policy must specify the Owner Trustee and the Owner Participant as
additional insureds.

* * * the Lease provides that, in the event a Vehicle becomes a * * * (as defined in that
section to include loss from destruction, damage beyond repair for use in the Sublessee's
business rental operations, or condemnation or seizure by the government), the Lessee is
required to exercise the * * * Option under * * * with respect to the * * * or, if this option
is no longer available to the Lessee, the Lessee must transfer to * * *, the Lease provides
that any insurance proceeds or other amounts paid with respect to * * * will be retained
by the Lessee, except that any condemnation proceeds received in excess of * * * will be
paid to the Owner Trustee. Any insurance proceeds, awards or other payments received
with respect to a Vehicle in connection with any event not resulting in * * * will be paid
to the Lessee.

Your representatives represent that the Owner Participant has no contractual right to a
return of its equity investment in the Vehicles. Further, no member of the Lessee group or
any other party has a contractual obligation or right to purchase any or all of the Vehicles
except in certain circumstances (for example, the Lessee is required to exercise its * * *
with respect to any Vehicle which becomes a * * * or, if the Lessee elects to terminate
the Lease before the end of the Lease Term, the Owner Trustee may sell the Vehicles to
the Lessee or to the Sublessee if it is the highest bidder).

Your representatives represent that neither the Lessee nor the Sublessee has agreed to
guarantee any indebtedness incurred in connection with the acquisition of the Vehicles by
the Owner Participant. Moreover, neither the Lessee nor the Sublessee has made or will
make, directly or indirectly, any other guarantees as a part or as a result of this lease
transaction. In fact, no indebtedness has been incurred by the Owner Participant directly
in connection with the acquisition of the Vehicles. Pursuant to section 4.08 of Rev. Proc.
75-28, your authorized representatives have submitted the following schedules and
appraisals that detail the dates and amounts of rental payments, profit independent of tax
considerations, cash flow, depreciation of the Vehicles, fair market value of the Vehicles
upon termination of the Lease and an analysis of uneven rent.

In its cover letter dated * * * and its appraisal dated * * * Independent Appraiser
represents that no Vehicle is limited use property. The Independent Appraiser also
represents that the fair market value of the fleet of Vehicles is at least equal to the Owner
Participant's Original Cost of purchasing the fleet. Moreover, the * * * of a Vehicle are
represented as accurate measures of the automobile's fair market value. The Independent
Appraiser further represents that the Vehicles will be useful and useable at the end of the
Lease Term and that the fleet of Vehicles (and each Vehicle) is expected to have a useful
life at least equal to * * *. The appraisal provides that the * * * of the Vehicles, at the end
of the Lease Term, should be between * * * the original cost of the Vehicles and most
likely will be * * * that cost * * *. In addition, the residual value will not be below * * *
of the original cost of the Vehicles if such exchanges occur less frequently than * * * as
amended pursuant to your letter of * * * provides a detailed analysis of the Owner
Participant's equity investment in the Vehicles. * * * analyzes the rent received, any debt
service, fees and other expenditures relating to this transaction on each of * * * in a
schedule that begins on * * * and ends on * * * demonstrates that the Owner Participant's
equity investment in the Vehicles always remains equal to at least 20 percent of the
original cost of the Vehicles.
* * *, as amended pursuant to your letter * * * provides a detailed analysis which
demonstrates that the Owner Participant will receive a profit from the transaction
exclusive of tax benefits. * * * provides that the sum of the (A) rent received * * * the
represented * * * or a total of * * * aggregate debt service, fees, equity investment, and
expenditures * * * by a total excess of * * * as amended pursuant to your letter * * *,
provides a detailed analysis of projected positive cash flow from this lease transaction. *
* * provides that the excess of (A) rent received * * * less (B) debt service, fees and other
expenditures * * * will equal * * * for an annual percentage return on equity of * * * as
amended in your letter of * * * provides an analysis demonstrating that the annual rent to
be paid always will be within a range of 10 percent above or below the average annual
rent computed by dividing the total annual rents payable over the lease term by the
number of years in such term. Thus, you represent that the parties expect to satisfy the
uneven rent test of Rev. Proc. 75-28 for the Lease Term.

* * * Fair Market Sales Value is essentially the cash lump sum that a willing and
informed buyer would pay to a willing and informed seller for the Vehicles in an arm's-
length, "* * *" transaction.

LAW AND ANALYSIS

For Federal income tax determinations of whether an agreement is a true lease and
whether the "lessor" is the owner of the property subject to the lease, the significance of
an equity investment in property to a determination that an investor is an owner for
Federal tax purposes is deeply rooted in the tax law. Frank Lyon Co. v. United States,
435 U.S. 561 (1978); Helvering v. Lazarus, 308 U.S. 252 (1939); Grodt & McKay
Realty, Inc. v. Comm'r, 77 T.C. 1221 (1981). Whether a taxpayer has such an equity
investment is one of several factors to be considered in determining which party to a
lease transaction holds the benefits and burdens of ownership. Among the other factors
are: (1) who holds legal title to the property; (2) the manner in which the parties treat the
transaction; (3) who has control over the property, and the extent of such control; (4) who
bears the risk of loss or damage to the property; and (5) who will receive any benefit
from the operation or disposition of the property. For purposes of Federal income
taxation, a sale of property occurs upon the transfer of the benefits and burdens of
ownership rather than upon the passage of title under state law. Houchins v. Comm'r, 79
T.C. 570 (1982).

In Rev. Rul. 55-540, 1955-2 C.B. 39, the Service has published guidelines for
distinguishing a conditional sales contract from a lease. Section 4 of that ruling provides
factors based on Tax Court precedent that would warrant a finding that, for Federal
income tax purposes, a transaction is a sale and not a lease. The factors most indicative of
a sale include: (1) portions of the periodic payment are made specifically applicable to an
equity interest in the property to be acquired by the lessee; (2) the lessee will acquire title
upon payment of a stated amount of "rentals" which under the contract he is required to
make; (3) the total amount which the lessee is required to pay for a relatively short period
of use [or possession] constitutes an inordinately large proportion of the total sum
required to be paid to secure the transfer of the title; (4) the agreed "rental" payments
materially exceed the current fair rental value (this may be indicative that the payments
include an element other than compensation for the use of the property); (5) the property
may be acquired under a purchase option at a price which is nominal in relation to the
value of the property at the time when the option may be exercised, as determined at the
time of entering into the original agreement, or which is a relatively small amount when
compared with the total payments which are required to be made; and (6) some portion of
the periodic payments is specifically designated as interest or is otherwise readily
recognizable as the equivalent of interest.

In Rev. Proc. 75-21, 1975-1 C.B. 715, and Rev. Proc. 75-28, 1975-1 C.B. 752, as
modified in Rev. Proc. 76-30, 1976-2 C.B. 647, and Rev. Proc. 79-48, 1979-2 C.B. 529,
the Service refined the above factors into a series of "safe harbor" guidelines for
determining whether certain transactions purporting to be leases of property are, in fact,
leases for Federal income tax purposes. In general, Rev. Proc. 75-21 and Rev. Proc. 75-
28 provide the conditions that must be met for a taxpayer in a leveraged lease transaction
to obtain an advance ruling that the transaction is a true lease for Federal income tax
purposes. A "leveraged lease" involves a lessor, a lessee and a lender to the lessor. In a
leveraged lease, the lease is generally a net lease, the lease term covers a substantial part
of the useful life of the property, and the lessee's payments to the lessor are sufficient to
discharge the lessor's payments to the lender. Section 4 of Rev. Proc. 75-21 and section 4
of Rev. Proc. 75-28 set forth the specific information and guideline that must be satisfied
for an advance ruling.

Although the above revenue procedures address leveraged lease transactions and this
transaction does not involve financing, you have submitted a submission that purports to
meet the conditions of those revenue procedures. In addition, a ruling on the true lease
issue is a prerequisite to your second ruling request, * * * that satisfy the nonrecognition
provisions of section 1031 of the Code. The Service recognizes that the conditions of the
revenue procedures are the minimum guidelines that must be met for a transaction to be
considered a true lease. For this reason and because of the uniqueness of this transaction,
the Service will examine your rulings request under Rev. Proc. 75- 21 and Rev. Proc. 75-
28.

Under the facts as represented by your representatives, the transaction described above
satisfies the conditions for an advance ruling under Rev. Proc. 75-21 and Rev. Proc. 75-
28 as a valid or "true" lease. In addition, under the facts as represented, the Owner
Participant satisfies the minimum equity investment requirements of Rev. Procs. 75-21
and 75-28 for treatment as the owner and lessor of the Vehicles * * *. Your
representatives state that legal title to the Vehicles will be held by a Nominee. Under the
above analysis, legal title is not controlling for purposes of determining the true
ownership of property and, in this situation, valid business reasons are represented as the
rationale for this structure. Because significant benefits and burdens of ownership are
held by the Owner Trust, and assuming that the Owner Trust is, for Federal income tax
purposes, a grantor trust, then the Owner Participant, which holds the beneficial interest
in the Owner Trust, will be treated for Federal income tax purposes as the owner and the
lessor of the Vehicles that are or will become subject to the Lease. Accordingly, the
Lessee will be treated as the lessee of the Vehicles that are or become subject to the
Lease.

With respect to Vehicles which become subject to the Master Lease Agreement * * *
for that period of time during which * * * is subject to the Lease, the Owner Participant
will be treated as the owner and the lessor of * * *. With respect to Vehicles that are no
longer subject to the Master Lease Agreement because of the exercise by the Lessee of *
* * the Owner Participant will cease to be treated as the owner or the lessor of * * *.

Section 1031(a)(1) 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.

Section 1.1031(a)-1(c) of the Income Tax Regulations provides that no gain or loss is
recognized if a taxpayer exchanges property held for productive use in his trade or
business for other property of like kind for the same use, such as a truck for a new truck
or a passenger automobile for a new passenger automobile to be used for a like purpose.

The Service in Rev. Rul. 61-119, 1961-1 C.B. 395, addressed the applicability of
section 1031 of the Code where the taxpayer sells to a dealer old equipment used in the
taxpayer's trade or business and then in a separate transaction purchases from that dealer
new equipment of a like kind for use in its trade or business. Rev. Rul. 61-119 concludes
that the sale of the old equipment to the dealer and the purchase of the new equipment
from that dealer is a nontaxable exchange under section 1031, even though, under the
facts of the ruling, the purchaser and the seller executed separate contracts and treated the
purchase and sale as unrelated transactions in their records. The Service found it
significant that the taxpayer's acquisition of new equipment was contingent upon the
dealer's taking the used equipment and granting a trade-in allowance equal to or in excess
of its fair market value. Moreover, the dealer's acceptance of the old equipment was
dependent upon the taxpayer's purchase of the new equipment. Accordingly, the Service
found that the purchase and the sale were reciprocal and thus mutually dependent steps in
a single integrated transaction.

In Redwing Carriers, Inc. v. Tomlinson, 399 F.2d 652 (1968), 68-2 U.S.T.C. 9392,
aff'g, 67-1 U.S.T.C. 9392, the taxpayer, Redwing Carriers, Inc., was a common carrier
engaged in the business of hauling bulk commodities. Trucksales, Inc., a wholly owned
subsidiary of Redwing, was engaged in the business of selling trucks, parts, and
equipment as a franchised dealer for G.M.C. During 1958, Trucksales purchased 28 new
G.M.C. trucks from G.M.C. for cash. At or about the same time Redwing transferred title
to 27 used trucks to G.M.C. for cash. In 1959 and 1961 essentially identical transactions
involving 36 and 14 trucks, respectively, were executed. The same individual was
president and chairman of both Redwing and Trucksales and both corporations used the
same address on checks. Most of the trucks were delivered to Redwing although they
were ostensibly being sold to Trucksales for resale to Redwing.
In Redwing Carriers, Inc. the Fifth Circuit Court of Appeals affirmed the district court's
[67- U.S.T.C. * * * 9392] finding that section 1031 of the Code applied to the purchases
of new trucks and the trade-in of used trucks because a definite contractual
interdependency existed between the sale of new trucks and the trade- in of old trucks.
Citing Rev. Rul. 61-119, 1961-1 C.B. 395, the Fifth Circuit held that the purchases of the
new trucks and the trade-ins of used trucks in each of the three tax years in issue were
mutually dependent transactions for purposes of section 1031 of the Code and section
1031(a)-1(c) of the regulations. The court thus concluded that, although Redwing's
transfers may have been paper sales, they were actual exchanges. Accordingly, the
purchases of the new trucks by the subsidiary, coupled with the separate sales by parent
of its used trucks to the manufacturer, were tax free exchanges under section 1031(a) of
the Code and the company's basis for depreciating the new trucks was the adjusted basis
of the old trucks and not the cost of the new vehicles.

Your representatives represent that both the * * * that are removed from being subject
to the Lease and the substitute * * * that become subject to the Lease pursuant to each
exchange * * * are property held by the Owner Participant for productive use in its trade
or business of * * *. It is further represented that all of the Vehicles that are removed
from being subject to the Lease and their substitute replacement Vehicles are similar type
* * *. Thus the Vehicles that are removed from being subject to the Lease and the * * *
are "like kind" property for purposes of section 1031. Assuming the facts are as
represented and that the replacement Vehicles are identified and received in accordance
with * * * the Lease, each exchange of Vehicles pursuant to * * * the Master Lease
Agreement will be considered to be mutually dependent steps in a single integrated
transaction and thus will be treated as exchanges of property on which no gain or loss
will be recognized to the Owner Participant under section 1031(a)(1) of the Code. See
section 1.1031(a)-1(c) of the Income Tax Regulations; Rev. Rul. 61-119, 1961-1 C.B.
395.

Further, the basis of the * * * will be determined under the basis rules stated in section
1031(d), the regulations thereunder, and Rev. Rul. 68-36, 1968-1 C.B. 357 (the basis of
two properties acquired in an exchange under section 1031 of the Code shall be the same
as the basis of the exchanged property and such basis shall be allocated between the two
properties acquired according to their respective fair market values on the date of the
exchange).

Accordingly, based solely upon the facts and representations submitted by your
authorized representatives, it is concluded that:

1. The Master Lease Agreement will be treated for Federal income


tax purposes as a true lease of the Vehicles thereunder to the
Lessee. The Owner Participant will be treated for Federal
income tax purposes as the owner and the lessor of any Vehicle
during that period of time that that Vehicle is subject to the
Lease. The Lessee will be treated as the lessee of any Vehicle
during the period of time that that Vehicle is subject to the
Lease.
2. The Owner Participant will not recognize any income or gain
pursuant to section 1031 of the Code solely as the result of any
exchange under * * * the Master Lease Agreement of any
Vehicles that are removed by the Lessee from being subject to
the Master Lease Agreement and replaced with Vehicles solely
in kind.

No opinion is expressed or implied regarding the application of any other provisions of


the Code or regulations. This ruling is directed only to the taxpayers who requested it.
Section 6110(j)(3) of the Code provides that it may not be used or cited as precedent.

In accordance with the powers of attorney on file, a copy of this letter is being sent to
each of your authorized representatives. A copy of this letter should be attached to the
Federal income tax returns of the taxpayers for the taxable year in which the transaction
is finalized.

Sincerely yours,
Assistant Chief Counsel

WORKOUTS VIA EXCHANGING: ANOTHER TOOL WORKOUTS


AND DEBT OBLIGATIONS GENERATE INHERENT PROBLEMS
by:Dr. Mark Lee Levine

I. INTRODUCTION:

If a debt obligation is due, the Debtor may attempt to work in some way with the
Creditor. Numerous articles and cases have examined the potential methods of structuring
arrangements between the Debtor and Creditor to "work out" the problem between the
two parties.

The obvious solution of settling the problem between the parties is normally cash.
However, it is just as apparent that the ability to obtain cash is, in many instances in
workout settings, extremely difficult, if not impossible.

Given this scenario, the question is whether another tool, namely a tax-deferred
exchange under Code §1031 (26 U.S.C.A. §1031) may be a means to facilitate a
settlement option

The exchange may involve the Debtor transferring his or her higher-valued (?) and
more leveraged property to a creditor in exchange for other property that might also be
leveraged, but may facilitate the needs of both debtor and creditor, removing each from
one property and placing each into another property (properties).
A. REAL WORLD:
The real world setting is that the circumstances necessary to arrange an exchange may
be extremely difficult. If the debtor and creditor are not on an amiable working basis,
certainly the practicalities will dominate the circumstance and any arrangement, aside
from cash, may be difficult.

The practical point is that no one should be involved in a tax-deferred exchange unless
they meet at least the following four (4) criteria:

1. Debtor must want out of the property the debtor is in.


2. The debtor must want into another property.
3. The debtor must have a large amount of taxable income on the
transaction if it was sold.
4. Finally, the debtor must have a large amount of tax that is due.

@ Copyright by Dr. Mark Lee Levine, Denver, Colorado, l992.


All rights reserved.

(See also the article by Levine, Mark Lee, "Workouts Through Tax-Deferred
Exchanges," Real Estate Workouts & Asset Management (October, 1992).

If all of the four (4) elements noted above are not met, there is no reason to have the
exchange. That is, if the taxpayer-debtor does not want out of the property in question,
there is no reason for the disposition to be considered in an exchange mode.

If the taxpayer-debtor is willing to move out of the existing property, which apparently
is encumbered under the typical scenario with a major debt to a creditor (the workout),
the taxpayer must be willing to move into another property.

The requirement to move into another property is necessary, given that Code §1031
requires an exchange by a taxpayer moving out of one property and into other like-kind
property (trade or business or investment property).

From the tax standpoint, the taxpayer may simply sell one property and purchase
another. However, if the taxpayer desires to obtain the benefits of a tax-deferred
exchange under Code §1031, the taxpayer must exchange to avoid the current taxable
income. Thus, one of the tests noted above is that the taxpayer must have a substantial
amount of taxable income from the disposition. If the taxable income does not exist from
the disposition, there is no reason to structure the transaction as an exchange.

Finally, even though a taxpayer may have a substantial amount of taxable income from
the sale of property, as opposed to an exchange, the taxpayer may not have tax due. The
taxpayer may have sufficient net operating losses that are carried forward to offset any
tax due. Tax credits may also offset the tax obligation. Thus, the 4th criteria mentioned is
the amount of tax that is due must be substantial to thereby encourage a taxpayer to elect
an alternative, such as a tax-deferred exchange, to avoid the tax.
B. APPLICATION OF EXCHANGES TO WORKOUTS:
If the taxpayer could exchange property in a tax-deferred exchange, and if this could
meet the desires and needs of both the debtor and creditor, a tax-deferred exchange might
facilitate both a workout in general and avoidance of the additional tax obligation that
might be generated because of a sale.

One of the obvious points that is often raised in a workout setting is why a taxpayer
would be concerned with "gain," given that it is a workout. In other words, if the property
was valued at $1.5 million, and a loan was taken out at $1 million, one might assume that
there is a substantial amount of equity. This could be the case at a given point in time of
acquisition. However, if through depreciation the basis of the property falls to say
$800,000, and the loan remains at $1 million because of an interest-only loan, there could
be a $200,000 gain if the taxpayer-deeds over (Deed in Lieu) or otherwise settles the
transaction with the creditor by conveying the property to the creditor.

If the taxpayer's adjusted basis is $800,000 and taxpayer is relieved of debt of $1


million, such relief is the effective sales price of the property, thereby generating
$200,000 worth of gain.

Certainly forgiving of debt constitutes taxable income under the Internal Revenue
Code. See Code §61(a)(12). See also Levine, Mark Lee, Real Estate Transactions, Tax
Planning, West Publishing Co., St. Paul, Minnesota (1989).

It is true that in some instances where property is conveyed by a debtor to a creditor,


the gain that might be generated, similar to the example noted above, may be avoided if
the taxpayer-debtor is insolvent. However, the taxpayer normally, to meet the
requirements necessary to exclude gain, must meet an insolvency test under Code §108 to
avoid paying tax on the amount of gain noted above in the example. (There are a number
of requirements to meet the elements to fall within Code §108. The purpose of this note is
not to discuss these in detail. For more on this, see the Levine text, cited earlier.)

If a taxpayer will generate a substantial amount of gain as a result of a workout


relationship, and if Sections, such as Code §108, are not available to avoid tax on that
gain by excluding it, other alternatives must be considered. The use of the tax-deferred
exchange under Code §1031, where the creditor and debtor can work together in
situations that are practical, may work in some settings.

II. CONCLUSION:

Notwithstanding the idealistic approach of a tax-deferred exchange in a workout


relationship, it is obvious that such application of Code §1031 in a workout would be
difficult. Exchanges are difficult in most instances, simply because the parties must
coordinate that many additional matters, and many parties may not comply with the tax-
deferred exchange rules.
It is further complicated by the fact that debtors and creditors normally have a strained
relationship. As such, the are not normally willing to work with each other to transfer
property to each other in a relationship that will accommodate the needs of both parties.

If there is already a default by the debtor to the creditor, there is also a concern by the
creditor to transfer additional property from the creditor to the debtor to work the
exchange. However, in some instances even creditors have property that they desire to
remove from their portfolio. In such circumstances, a workout may be facilitated by an
exchange, even between a debtor and creditor.

As a final and practical note, in many instances there may be debt relief, the concept
mentioned earlier when there is an exchange. As such, this may generate a taxable
amount of income to the debtor and, therefore, defeat the exchange position. As such, the
parties must carefully structure their transaction to meet the needs of both the debtor and
creditor, not only on the workout position, but also on the tax issue.

mxawve.ma
@ Copyright by Dr. Mark Lee Levine, Denver, Colorado, 1992. All rights reserved.

PRIVATE LETTER RULING 9152010

This exchange involved a circumstance where the Taxpayer desired to convert existing
real estate properties to investment-grade properties to allow them to be involved with a
REIT. To make these changes, the Taxpayer was required to transfer certain property and
acquire other investment-grade property. A reorganization was also involved under Code
§368(a)(1)(C), which is an exchange of stock for assets.

Given this complex set of facts and the circumstances involved, the Ruling held in
support of the Taxpayer. The Ruling held that a Real Estate Investment Trust (REIT),
when it acquires the taxpayer in a REIT organization as described above, would be
treated for tax purposes under Code §1031(a)(3) as the transferor of the relinquished
property that is deemed to be transferred before the reorganization.

PRIVATE LETTER RULING 9152010


Section 1031 -- Like-Kind Exchanges
Publication Date: December 27, 1991

Dear ____:
This is in response to the letter submitted by your firm, dated May 3, 1991. On behalf
of Taxpayer, you have requested a private letter ruling on the issue of whether tax
deferred exchange treatment is available, under section 1031 of the Internal Revenue
Code, with respect to the proposed transaction described below.

Taxpayer is a C corporation which was organized to hold and manage real estate for
current income and long-term appreciation. Currently, Taxpayer owns and leases four
separate properties.
After consultation with investment advisors, Taxpayer has adopted a business plan
which is designed to maximize the potential return of investment for its shareholders. The
plan has two main components: (1) to convert existing real estate holdings to properties
that would be considered investment grade by a publicly traded real estate investment
trust (REIT); and (2) to seek to be acquired by a publicly traded REIT. Taxpayer has been
advised that its property, which is located in State Z, would not be considered investment
grade property by a publicly traded REIT. Accordingly, the taxpayer has decided to
exchange the State Z property for other investment-grade real property in a transaction
intended to qualify for like-kind exchange treatment under section 1031 of the Code.
Taxpayer has identified a prospective purchaser for the State Z property and has entered
into an option agreement under the terms of which the purchaser has agreed to cooperate
with the taxpayer in completing a deferred exchange under section 1031(a)(3) of the
Code.

Taxpayer has been advised by its investment banking firm that, under existing
conditions in the securities markets, publicly traded REITs are unable to raise capital
through public offerings to acquire additional properties. For this reason, there are several
publicly traded REITs that have an interest in acquiring Taxpayer, particularly if the
acquiring REIT is permitted to participate in the identification and acquisition of the like-
kind property to be received in the deferred exchange. A transaction structured in this
manner would significantly increase the amount of consideration to be received by the
shareholders of Taxpayer. In the proposed transaction, Taxpayer will be acquired by a
publicly traded REIT following the transfer of the State Z property, but prior to the
acquisition of the like-kind replacement property. The acquisition of taxpayer by the
publicly traded REIT will be effected as a reorganization under section 368(a)(1)(C) of
the Code.

Section 1031(a)(1) of the Code provides that no gain or loss will be recognized on the
exchange of property held for productive use in a trade or business or for investment if
the property is exchanged solely for property of a like kind which is to be held either for
productive use in a trade or business or for investment. Under section 1.1031(a)-1(b) of
the Income Tax Regulations relating to the meaning of the term "like kind," real property
is generally considered to be of a like kind to all other real property, whether or not any
of the real property is improved. However, under section 1031(a)(3) any property
received by the taxpayer (the "replacement property") will be treated as if it is not of a
like kind to the property transferred (the "relinquished property") if the replacement
property (a) is not identified within 45 days of the taxpayer's transfer of the relinquished
property, or (b) is received after the earlier of (i) 180 days after the taxpayer's transfer, or
(ii) the due date of the taxpayer's return for the year in which the taxpayer's transfer
occurred.

Section 368(a)(1)(C) of the Code defines the term "reorganization" to generally include
the acquisition by one corporation, in exchange solely for all or a part of its voting stock
(or in exchange for all or a part of the voting stock of a corporation which is in control of
the acquiring corporation), of substantially all of the properties of another corporation.
Section 381(a) of the Code provides that, in the case of the acquisition of assets of a
corporation by another corporation in a transfer to which section 361 applies, but only if
the transfer is in connection with a reorganization described in subparagraph (A), (C),
(D), (F) or (G) of section 368(a)(1), the acquiring corporation shall succeed to and take
into account, as of the close of the day of transfer, the items of the transferor corporation
described in section 381(c), subject to certain conditions and limitations.

Section 1.381(a)-1(b)(3)(i) of the regulations provides that section 381 does not apply
to the carryover of an item or tax attribute not specified in section 381(c). Section 381(c)
does not refer to like-kind exchanges under section 1031. However, the 1954 legislative
history explains that "[t]he section is not intended to affect the carryover treatment of an
item or tax attribute not specified in the section or the carryover treatment of items or tax
attributes in corporate transactions not described in subsection (a). No inference is to be
drawn from the enactment of this section whether any item or tax attribute may be
utilized by a successor or predecessor corporation under existing law." H.R. Rep. No.
1337, 83rd Cong., 2d Sess. A135 (1954). See also section 1.381(a)-1(b)(3)(i) of the
regulations (to the same effect). In other words, Congress did not intend the tax attributes
listed in section 381(c) of the Code to be the exclusive list of attributes available for
carryover. Moreover, the legislative history reveals that the purpose of section 381 is to
put into practice the policy that "economic realities rather than . . . such artificialities as
the legal form of the reorganization" ought to control in the question of whether a tax
attribute from an acquired corporation is to be carried over to the acquiring one. Section
381 was enacted "to enable the successor corporation to step into the 'tax shoes' of its
predecessor corporation without necessarily conforming to artificial legal requirements
which [then existed at the time of its enactment] under court-made law." See S. Rep. No.
1622, 83rd Cong., 2d Sess. 52 (1954).

The special treatment of like-kind exchanges under section 1031 of the Code has been
explained primarily on two grounds. First, a taxpayer making a like- kind exchange has
received property similar to the property relinquished and therefore has not "cashed in"
on the investment in the relinquished property. In addition, administrative problems may
arise with respect to valuing property which is exchanged solely or primarily for similar
property. See, e.g., Staff of the Joint Committee of Taxation, General Explanation of the
Revenue Provisions of the Deficit Reduction Act of 1984, 98th Cong., 2d Sess. 244-245
(1984); Starker v. United States, 602 F.2d 1341, 1352 (9th Cir. 1979).

The policy concerns which gave rise to section 1031 are no less applicable when the
acquiring corporation, following a section 368(a)(1)(C) reorganization, receives like-kind
replacement property in exchange for relinquished property transferred by the acquired
corporation prior to the reorganization. Accordingly, we conclude that for purposes of
section 1031(a)(3) there is a carryover of tax attributes following a section 368(a)(1)(C)
reorganization. Thus, the intervening reorganization does not prevent the receipt of the
replacement property by the succeeding entity as discussed above from being treated as
received in exchange for the State Z property.
Based solely on the facts as represented and stated above, we rule as follows: A REIT,
which acquires Taxpayer in a reorganization described in section 368(a)(1)(C) of the
Internal Revenue Code, will be treated for purposes of section 1031(a)(3) of the Code as
the distributor or transferor of the relinquished property transferred before the
reorganization in the proposed deferred exchange.

No opinion is expressed as to the tax treatment of this transaction under the provisions
of any other section of the Code or regulations which may be applicable thereto or the tax
treatment of any conditions existing at the time of, or effects resulting from, the
transaction described which are not specifically covered in the above ruling. In particular,
we express no opinion as to whether the transaction in which Taxpayer is acquired
qualifies as a reorganization described in section 368(a)(1)(C) of the Code.

A copy of this letter should be attached to the federal income tax return for the year in
which the transaction in question occurs. This ruling is directed only to the taxpayer who
requested it. Section 6110(j)(3) of the Code provides that it may not be cited as
precedent.

Sincerely
Assistant Chief Counsel

EXCHANGE:

For an interesting discussion of some of the accounting issues that tie with tax-deferred
exchanges, see Hoffman, Michael and McKenzie, Karen, "Real Estate Swaps and
Accountant's Dilemma," Real Estate Review 76 (Winter, 1992).

For a discussion of exchanging assets and undertaking other transfers in connection


with the exchange, see Biblin, Allan, "Can A Like-Kind Exchange Be Combined With
Anther Tax-Free Transaction In Shifting Assets?" 78 Journal of Taxation, Vol. 22
(January, 1993).

PRIVATE LETTER RULING 9352011

This Private Letter Rul. 9352011 approves the reinvestment of proceeds under Code
§1033 to thus avoid the current taxable income by reinvesting. It also discusses the
concept of reinvesting as co-owners, as opposed to a partnership. It supports the deferral
of the income. See also Private Letter Rul. 9352008.

PRIVATE LETTER RULING 9352011


Section 1033 -- Involuntary conversions
September 29, 1993
Publication Date: December 30, 1993

Dear ____:
This is in response to your letter dated May 27, 1993 and supplemental correspondence
dated June 16, 1993, August 5, 1993, September 9, 1993 and September 17, 1993. On
behalf of Taxpayer, you have requested a private letter ruling on whether a proposed
transaction will qualify for a tax-free rollover under the rules of section 1033 of the
Internal Revenue Code. Of the facts submitted by Taxpayer, the following appear to be
the most dispositive of the issues raised:

A, Taxpayer herein, was the fee owner of Blackacre. B, a corporation, is not involved
in the facts of this case except as a partner with A. AB Partnership (a partnership
consisting of A and B as the only partners, with each owning 53% and 47% of the
partnership respectively) was the fee owner of Whiteacre. Blackacre and Whiteacre were
two contiguous tracts of land condemned by the transportation department of State C on
Date D. Gain from the conversion was first realized by A and AB Partnership on or about
the same date that the conversion occurred. A and AB Partnership ultimately received
total awards of $x and $y respectively for their properties. A and AB Partnership now
propose to reinvest all of the proceeds of their condemnation awards to acquire fee title in
Greenacre as tenants in common. Both of the condemned properties were parcels of
improved commercial rental real estate subject to net leases. Both had been held by their
respective owners for a number of years for investment. The replacement property
(Greenacre) will also be improved commercial rental real estate already subject to a net
lease (that was first entered into by lessee and the prior fee owner on Date E) in which the
lessee is responsible for payment of all insurance premiums, general real estate taxes and
special assessments, most of the utility expenses and a significant portion of the repair
costs. Greenacre will be held by A and AB Partnership for investment.

Income and expenses derived from owning Greenacre as tenants in common will be
apportioned pro-rata between A and AB Partnership. There will be no special allocations
of income and expenses between the co-owners.

Section 1033(a) of the Internal Revenue Code provides, in part, that if property, as a
result of requisition or condemnation or the threat or imminence thereof, is involuntarily
converted into money and if the taxpayer during the time specified purchases property
similar or related in service or use to the property so converted, at the election of the
taxpayer, the gain shall be recognized only to the extent the amount realized on such
conversion exceeds the cost of such other property.

Section 1033(g)(1) of the Code provides, in part, that if real property (not including
stock in trade or other property held primarily for sale) held for productive use in a trade
or business or for investment is (as a result of condemnation, or threat or imminence
thereof) compulsorily or involuntarily converted, property of like kind to be held for
productive use in a trade or business or for investment shall be treated as property similar
or related in service or use to the property so converted.

Section 1.1033(g)-1(a) of the Income Tax Regulations includes a cross reference to


section 1.1031(A)-1 as the source for principles for determining whether replacement
property is property of like kind.
Section 1.1031(A)-1(B) of the regulations provides, in part, that, as used in section
1031(A) of the Code, the words "like kind" have reference to the nature or character of
the property and not to its grade or quality. One kind or class of property may not, under
that section, be EXCHANGED for property of a different kind or class. 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. Unproductive real estate
held by one other than a dealer for future use or future realization of the increment in
value is held for investment and not primarily for sale.

Section 1.1031-1(C) of the regulations provides, in part, that no gain or loss is


recognized if a taxpayer who is not a dealer in real estate EXCHANGES city real estate
for a ranch or farm, or EXCHANGES a leasehold of a fee with 30 years or more to run
for real estate, or EXCHANGES improved real estate for unimproved real estate.

According to the above authority, for a disposition to be eligible for nonrecognition


treatment under section 1033(g) of the Code, the property to be replaced must be held for
productive use in a trade or business or for investment (as opposed to being held as stock
in trade or primarily for sale), must be real estate and its disposition must have been by
condemnation or the threat of condemnation or a similar action. In the present case, A
was the sole owner of Blackacre and AB Partnership was the sole owner of Whiteacre.
Both tracts were commercial rental real property that were being held for investment
purposes. The same properties were involuntarily converted by condemnation. The
additional requirement for nonrecognition under section 1033(g) is that the converted
property be timely replaced (within three years) with property of like kind, to be held by
the taxpayer for productive use in a trade or business or for investment. For this purpose,
any interest in real estate is of like kind to any other interest in real estate. In the present
case, A and AB partnership propose to replace their condemned properties with other
commercial rental real property to be held by them, as tenants in common, for
investment.

Concern is expressed that co-ownership of the replacement property could be treated as


a partnership and that the proposed replacement might fail to qualify if the replacement
property is deemed to be an interest in a partnership rather than an interest in real
property. This is a valid concern. Rev. Rul. 57-154, 1957-1 C.B. 262, states that the use
of condemnation proceeds to acquire an interest in a partnership owning and operating
property similar to that condemned would not constitute a qualifying replacement.
However, the Service also recognizes within the same revenue ruling that acquiring a
direct interest in property, similar to the property condemned, as a tenant in common
could qualify as a valid replacement under section 1033 of the Code. Furthermore, the
Service has indicated in other rulings that mere co-ownership of an interest in real
property without providing more than the customary services of maintenance and repair
and collecting of rents will not render a co-ownership a partnership. See Rev. Rul. 75-
374, 1975-2 C.B. 261 (holding that a life insurance company and a REIT, each of which
owns a one-half interest in an apartment project will not be treated as a partnership when
they retain an unrelated corporation under a management contract to furnish customary
tenant services and various additional services for which such manager makes separate
charges, pays all costs incident thereto and retains any profits generated by these
additional services).

In the present case, it is represented that no services, other than those typical of a
landlord, will be furnished by the co-owners. Indeed, the replacement property is already
subject to a net lease under which the lessee is responsible to pay all insurance premiums,
general real estate taxes and special assessments, most of the utility expenses and a
significant portion of the repair costs. Furthermore, income and expenses derived from
owning Greenacre as tenants in common will be apportioned pro-rata between A and AB
Partnership. There will be no special allocations of income and expenses between the co-
owners. Therefore, co-ownership of Greenacre by A and AB Partnership is not, in and of
itself, a partnership.

Consequently, we rule as follows:

1. The condemnation actions by the transportation department of


State C of Blackacre and Whiteacre, owned in fee simple by A
and AB Partnership respectively and held for investment, both
qualified as involuntary conversions within the meaning of
section 1033(a)(1) and (g)(1) of the Code.
2. An amount equal to the entire cash proceeds received on the
condemnations, if reinvested by the recipients as tenants in
common in Greenacre will result in nonrecognition of gain or
loss under section 1033(a) of the Code, subject to the following
conditions:
(a) Taxpayer has made a timely and appropriate election to
defer the resulting gain;
(b) The replacement is timely made; and
(c) The only activities of Taxpayer and the other co-owner
with respect to Greenacre will be to provide only those
customary services of a landlord to the extent specified in
the lease dated Date E, and there are no special allocations
of income and expenses as to Greenacre between the co-
owners.

No opinion is expressed as to the effect of any other section of the Code or regulations
which may be applicable to the facts of this case or concerning the tax treatment of any
conditions existing at the time of, or effects resulting from, the transaction described
which are not specifically covered in the above ruling.

A copy of this letter should be attached to the federal income tax return for the year in
which the transaction in question occurs. This ruling is directed only to the taxpayer who
requested it. Section 6110(j)(3) of the Code provides that it may not be cited as
precedent.
Sincerely,
Assistant Chief Counsel (Income Tax & Accounting)

PASSIVE LOSSES AND NON-TAXABLE TRANSACTIONS:


TECHNICAL ADVICE MEMORANDUM 9739004

This Technical Advice Memorandum (T.A.M.) addressed the question as to whether


passive losses, that were suspended can be utilized in the year in which there is a
disposition of the property that generated the passive losses that were suspended.

The general answer is that such losses can be used on disposition of the property.
However, where that disposition constitutes a nontaxable event, because of the operation
of Code §1034 (sale of the principal residence and reinvestment), or similar sections,
such suspended losses cannot be used.

Although this particular Technical Advice Memorandum did not rule on Code §1031,
the same rule applies for Code §1031 involving suspended losses, as was true with this
Technical Advice Memorandum relative to the sale of a residence. (Note that Code §1034
has been repealed, under the Taxpayer Relief Act of 1997.)

TECHNICAL ADVICE MEMORANDUM 9739004


Internal Revenue Service (I.R.S.)
1997 WL 592927 (I.R.S.)
Issue: September 26, 1997
June 13, 1997

ISSUE

May the taxpayers deduct suspended passive losses allocable to real property that had
been sold by the taxpayers to a related party when the related party disposes of the real
property in a transaction meeting the requirements of section 1034 of the Internal
Revenue Code (the "Code")?

FACTS

The taxpayers, A and B, are husband and wife. A and B owned residential real property
that they used in a passive rental activity. A and B sold this real property to C, their son,
in d. On the date of the sale, A and B had suspended passive losses allocable to the real
property totalling $e. Due to the related party rule of section 469(g)(1)(B), A and B were
unable to free up the suspended passive losses under section 469(g)(1)(A) in the year of
this sale.

During the period between d and f, C used the real property as his principal residence.
On f, C sold the real property to an unrelated third party, and on g, C purchased a new
principal residence. Because C purchased the new principal residence within 2 years of
the date of the sale of the old principal residence, the gain realized by C on the sale of the
real property acquired from A and B was not recognized, pursuant to section 1034.

On their tax return filed for h, the year of the subsequent sale of the real property by C,
A and B% deducted the $e of suspended passive losses allocable to the real property,
pursuant to section 469(g)(1)(A).

LAW AND ANALYSIS

Section 469(a) of the Code disallows passive activity losses and passive activity credits
for the taxable year for individuals, estates, trusts, closely-held C corporations, and
personal service corporations.

Section 469(b) provides that, except as otherwise provided, any loss or credit from an
activity which is disallowed under section 469(a) will be treated as a deduction or credit
allocable to such activity in the next taxable year.

Section 469(c), with exceptions not relevant in this case, defines the term passive
activity as any activity that involves the conduct of any trade or business in which the
taxpayer does not materially participate, and any rental activity.

Section 469(d) provides that the term passive activity loss means the amount (if any) by
which the aggregate losses from all passive activities for the taxable year exceed the
aggregate income from all passive activities for such year.

Section 469(g)(1)(A) provides that if during the taxable year a taxpayer disposes of his
entire interest in a passive activity (or former passive activity), and if all gain or loss
realized on such disposition is recognized, the excess of (i) any loss from such activity for
such taxable year (determined after the application of section 469(b)), over (ii) any net
income or gain for such taxable year from all other passive activities (determined after
the application of section 469(b)), will be treated as a loss which is not from a passive
activity.

Section 469(g)(1)(B) provides that if the taxpayer and the person acquiring the interest
bear a relationship to each other described in section 267(b) or section 707(b), then
section 469(g)(1)(A) will not apply to any loss of the taxpayer until the taxable year in
which such interest is acquired (in a transaction described in section 469(g)(1)(A)) by
another person who does not bear such a relationship to the taxpayer.

Section 267(b)(1) provides that related persons include members of a family, as defined
in section 267(c)(4). Section 267(c)(4) provides that the family of an individual include
only his brothers and sisters (whether by the whole or half blood), spouse, ancestors and
lineal descendants.
Neither final nor temporary Income Tax Regulations have been promulgated under
section 469(g) of the Code. However, S.Rep. No. 313, 99th Cong., 2d Sess., 713, 725-27
(1986), 1986-3 C.B. (Vol. 3) 713, 725-27, in discussing section 469(g), states that

[w]hen a taxpayer disposes of [an] entire interest in a passive activity, the actual
economic gain or loss on [the] investment can be finally determined. Thus, under the
passive loss rule, upon a fully taxable disposition, any overall loss from the activity
realized by the taxpayer is recognized and allowed against income (whether active or
passive income). This result is accomplished by triggering suspended losses upon
disposition.

The reason for this rule is that, prior to a disposition of the taxpayer's interest, it is
difficult to determine whether there has actually been gain or loss with respect to the
activity. For example, allowable deductions may exceed actual economic costs, or may
be exceeded by untaxed appreciation. Upon a taxable disposition, net appreciation or
depreciation with respect to the activity can be finally ascertained....

The type of disposition that triggers full recognition of any loss from a passive activity
is a fully taxable disposition of the taxpayer's entire interest in the activity. A fully
taxable disposition generally includes a sale of the property to a third party at arm's
length, and thus, presumably, for a price equal to its fair market value....

An exchange of the taxpayer's interest in an activity in a nonrecognition transaction,


such as an exchange governed by sections 351, 721, or 1031 in which no gain or loss is
recognized, does not trigger suspended losses. Following such exchange, the taxpayer
retains an interest in the activity, and hence has not realized the ultimate economic gain
or loss on [the] investment in it.

In this case, when A and B sold the real property to C, the suspended losses were not
triggered under section 469 (g)(1)(A), because the sale was not a fully taxable transaction
involving an unrelated party. In order to determine whether A and B may free up these
suspended passive losses in h when C subsequently sells the property to an unrelated
party, the following issue must be resolved: whether this subsequent sale meets the
requirements of a fully taxable transaction, as required by sections 469(g)(1)(A) and (B),
even though C did not recognize all of the gain from this sale by operation of section
1034.

The legislative history for section 469 does not specifically reference section 1034 as an
example of a nonrecognition transaction that will not trigger suspended passive losses
under section 469(g)(1)(A). However, it appears that Congress did not intend the
legislative history to provide an exclusive list of nonrecognition transactions that will not
trigger suspended passive losses. Instead, the statutory language unambiguously states
that all gain or loss realized on a disposition must be recognized in order for the excess
suspended passive losses allocable to the disposed activity to be triggered by section
469(g)(1)(A).
CONCLUSION

Section 469(g)(1)(B) requires that an interest in a passive activity must be disposed of


to an unrelated party in a fully taxable transaction before any suspended passive losses
allocable to the activity will be triggered under section 469(g)(1)(A). We conclude that a
transaction meeting the requirements of section 1034 is not a fully taxable transaction for
purposes of sections 469(g)(1)(A) and (B). Accordingly, we conclude that A and B may
not deduct the suspended passive losses allocable to the disposed of property in h, the tax
year in which C sold the property in a transaction meeting the requirements of section
1034. Instead, the losses will remain suspended until C disposes of the replacement
property (C's new principal residence) to an unrelated party in a fully taxable transaction
(assuming that A and B do not receive passive income from other sources that otherwise
may be used against those losses).

RELATED PARTIES:
TECHNICAL ADVICE MEMORANDUM 9748006

The issue in this Ruling was whether the taxpayer could qualify under Code §1031 for a
deferral where there was a multi-party exchange involving a related party. The Ruling
held that the related party rules prohibited such exchange, showing that the purpose of the
exchange was not to avoid Federal income tax. Therefore, Code §1031 treatment was
denied under the Ruling.

RELATED PARTIES:
TECHNICAL ADVICE MEMORANDUM 9748006

The issue in this Ruling was whether the taxpayer could qualify under Code §1031 for a
deferral where there was a multi-party exchange involving a related party. The Ruling
held that the related party rules prohibited such exchange, showing that the purpose of the
exchange was not to avoid Federal income tax. Therefore, Code §1031 treatment was
denied under the Ruling.

Internal Revenue Service (I.R.S.)


TECHNICAL ADVICE MEMORANDUM 9748006
Issue: November 28, 1997
August 25, 1997

ISSUE:

Whether Taxpayer is entitled to nonrecognition treatment under s 1031(a) of the Code


with respect to his transfer of real property in a multi-party exchange involving Taxpayer,
a related party (Related Party), an unrelated third party (UTP), and a qualified
intermediary (QI)?

FACTS:
Prior to the transaction at issue, Taxpayer held Property X, a 1/3 interest in a parcel of
unimproved land, for investment. Taxpayer's basis in Property X was $a. Related Party,
Taxpayer's mother, held Property Y, a 2/3 interest in the same parcel of unimproved land
as Property X. Property X's fair market value was $e.

UTP wanted to acquire the parcel of unimproved land consisting of Property X and
Property Y. On Date 1, Taxpayer and Related Party entered into a Sale Agreement for the
sale of Property X and Property Y to UTP. On Date 2, Related Party purchased Property
Z for $f, which she used as a personal residence.

In early Year 1, after he had entered into the Sale Agreement with UTP, Taxpayer
decided that he wanted to do a like-kind exchange for other real estate using the proceeds
from the sale of Property X. Taxpayer initially sought to acquire replacement real
property from another unrelated third party, but could not complete negotiations for the
purchase of the replacement real property he wanted in time for the exchange to qualify
under s 1031. On Date 3, after Taxpayer determined that acquisition of this replacement
property was unfeasible, he entered into the Purchase and Sale Agreement with Related
Party to acquire Property Z for $f.

On Date 4, Taxpayer, Related Party, UTP and QI engaged in an exchange transaction


which occurred in the following steps: First, Taxpayer assigned and transferred all of his
rights, title and interest in Property X and his rights and obligations under the Sale
Agreement with UTP to QI. Second, Taxpayer assigned his rights and obligations under
the Purchase and Sale Agreement to acquire Property Z to QI. Third, in accordance with
the Sale Agreement, QI sold Property X to UTP for $e. Fourth, QI paid $e (proceeds
from the sale of Property X) to Related Party and Taxpayer paid an additional $b directly
to Related Party for Property Z. Fifth, Related Party transferred Property Z, via QI, to
Taxpayer. Separate from, but concurrent with, the exchange transaction, UTP paid
Related Party $g to acquire Property Y.

After the exchange, Taxpayer held Property Z for investment, UTP owned Property X,
and Related Party had $f cash. It is assumed that QI is a qualified intermediary as defined
in s 1.1031(k)-1(g)(4)(iii) of the Income Tax Regulations. Thus, if the exchange qualifies
under s 1031 of the Code, Taxpayer recognizes no gain or loss from the transaction and
his new basis in Property Z is $c ($a + $b).

APPLICABLE LAW:

Section 1031(a)(1) of the Internal Revenue Code provides that no gain or loss is
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.

Section 1031(d) of the Code provides that the basis of property acquired in a like-kind
exchange is the same as that of the property exchanged, decreased by the amount of any
money received by the taxpayer and increased in the amount of gain or decreased in the
amount of loss to the taxpayer that was recognized on such exchange.

Section 1.1031(k)-1(g) of the regulations establishes various safe harbors for deferred
exchanges which result in a determination that the taxpayer is not in actual or
constructive receipt of money or other property (not of like kind) for purposes of s
1031(a). One of the safe harbors listed in paragraph (g) is that of the "qualified
intermediary."

Section 1.1031(k)-1(g)(4)(iii) of the regulations defines a qualified intermediary as a


person who (A) is not the taxpayer or a disqualified person and (B) enters into a written
agreement with the taxpayer (the "exchange agreement") and, as required by the
exchange agreement, acquires the relinquished property from the taxpayer, transfers the
relinquished property, acquires the replacement property, and transfers the replacement
property to the taxpayer.

Section 1.1031(b)-2(a) of the regulations provides that in the case of simultaneous


transfers of like-kind properties involving qualified intermediaries (as defined in s
1.1031(k)-1(g)(4)(iii)), the qualified intermediary is not considered the agent of the
taxpayer for purposes of s 1031(a). In such a case, the transfer and receipt of property by
the taxpayer through a qualified intermediary is treated as an exchange.

Section 1031(f)(1) of the Code provides that if a taxpayer exchanges property with a
related person, resulting in nonrecognition of gain or loss under this section with respect
to the exchange, and if within two years of such exchange the related person or the
taxpayer disposes of the property received in the exchange, there is no nonrecognition of
gain or loss under s 1031 to the taxpayer with respect to such exchange. Any gain or loss
recognized by the taxpayer by reason of s 1031(f)(1) is taken into account as of the date
such latter disposition occurs.

Section 1031(f)(2) of the Code provides that for purposes of paragraph (f)(1), there
shall not be taken into account any disposition (A) after the earlier of the death of the
taxpayer or the death of the related person, (B) in a compulsory or involuntary conversion
(within the meaning of s 1033) if the exchange occurred before the threat or imminence
of such conversion, or (C) with respect to which it is established to the satisfaction of the
Secretary that neither the exchange nor such disposition had as one of its principal
purposes the avoidance of Federal income tax.

Section 1031(f)(3) of the Code provides that the term "related person" means any
person bearing a relationship to the taxpayer described in s 267(b) or s 707(b)(1).

Section 1031(f)(4) of the Code provides that s 1031 shall not apply to any exchange
which is part of a transaction (or series of transactions) structured to avoid the purposes
of s 1031(f).

ANALYSIS:
The rationale for permitting taxpayers to defer gain or loss when they exchange like-
kind properties is the perception that such recognition is inappropriate for taxpayers
remaining invested in the same kind or class of property. No "cashing out" of the
investment has occurred. See H.R.Rep. No. 101-247, 101st Cong., 1st Sess. 1340 (1989).

However, prior to the enactment of s 1031(f), a taxpayer could, in effect, "cash out" its
investment without recognizing gain by structuring the disposition as a like-kind
exchange with a related party. By doing this, the taxpayer could shift high basis from the
property the taxpayer wished to retain to low basis property the taxpayer wished to sell.
The House Budget Committee Report accompanying the enactment of s 1031(f)
recognized that related parties have engaged in like-kind exchanges of high basis
property for low basis property in anticipation of the sale of the low basis property. The
exchange would then position the parties to avoid or substantially reduce the recognition
of gain on the subsequent sale.

Section 1031(f) is thus intended to deny nonrecognition treatment for transactions in


which related parties make like-kind exchanges of high basis property for low basis
property in anticipation of the male of the low basis property. The committee determined
that "if a related party exchange is followed shortly thereafter by a disposition of the
property, the related parties have, in effect, 'cashed out' of the investment, and the
original exchange should not be accorded nonrecognition treatment." H.R.Rep. No. 247,
101st Cong.1st Sess. 1340 (1989) (emphasis added). The committee thus treats the
related parties in these transactions as a single taxpayer, and the subsequent disposition of
exchange property by one related party as a "cashing out" by the other related party.

In this case, Taxpayer disposed of Property X through a qualified intermediary QI and


through the same qualified intermediary acquired Property Z from Related Party. The
economic result of this series of transactions is identical to what would have occurred in a
direct exchange of Property X for Property Z between Taxpayer and Related Party,
followed by a sale of Property X by Related Party to UTP. In both cases and after all
steps are concluded, Taxpayer owns Property Z with a basis of $c, Related Party has sale
proceeds of $f (but no gain because of Related Party's $f basis in Property Z), and UTP
owns Property X. However, due to the application of s 1031(f), Taxpayer would
recognize gain of $d in the case of the direct exchange.

Congress enacted s 1031(f)(4) to prevent related parties from circumventing subsection


(f)(1) through, among other means, the structuring of transactions to involve unrelated
parties. As an example, the committee report states that "if a taxpayer, pursuant to a
prearranged plan, transfers property to an unrelated party who then exchanges the
property with a party related to the taxpayer within 2 years of the previous transfer in a
transaction otherwise qualifying under section 1031, the related party will not be entitled
to nonrecognition treatment under section 1031." H.R.Rep. No. 101-247 at 1341.

The deferred exchange regulations in s 1.1031(k)-1 provide for the use of a qualified
intermediary as one way to effect a like-kind exchange. However, a qualified
intermediary is not entitled to better treatment than the unrelated party referred to in the
House Budget Committee Report. Thus, the mere interposition of a qualified
intermediary will not correct a transaction otherwise flawed under s 1031(f)(1).

Taxpayer argues that there was no tax avoidance motive to the exchange because no
such motive existed at the time that Taxpayer and Related Party entered into the Sale
Agreement with UTP. Taxpayer asserts that the fact that Related Party did not own
Property Z at the time that the Sale Agreement was entered into and that there was no
commitment or obligation on his part to transfer Property X to Related Party is evidence
of the lack of tax avoidance motive in the exchange. However, nothing in the statute or
legislative history suggests that the only appropriate time for determining the existence of
a tax avoidance motive is the time that the related parties first commit to sell the low
basis property (Properties X and Y). Nor does the example in House Budget Committee
Report assume (and thereby require for application of s 1031(f)(4)), as Taxpayer argues,
that there is a pre-arranged plan among the related parties and the unrelated third party
and a pre-existing commitment or understanding at the inception of the arrangement that
the related parties were going to exchange their property interests.

Taxpayer also asserts that the fact that UTP, instead of Related Party, could have
acquired Property Z and exchanged this property with Taxpayer for Property X under s
1031 is additional evidence of the lack of Taxpayer's tax avoidance motive.

Taxpayer further argues that the transaction was initially structured as an exchange
with unrelated parties and therefore was not structured to avoid the related party rules.
Taxpayer initially sought to acquire replacement real property from another unrelated
third party, but was unable to acquire the real property he wanted in time for the
exchange to qualify under s 1031. Only after Taxpayer failed to acquired replacement
property from an unrelated third party did he enter into the Purchase and Sale Agreement
with Related Party to acquire Property Z. Thus, since the transaction was not "structured"
to avoid the related party rules, Taxpayer asserts that s 1031(f)(4) does not apply.

Taxpayer has offered no explanation for the use of the qualified intermediary in this
transaction. As noted above, the direct exchange of Property X for Property Z, followed
by the sale of Property X to UTP would have been in violation of s 1031(f)(1) and would
have caused Taxpayer to recognize gain in the amount of $d. It is apparent that Taxpayer
and Related Party utilized a qualified intermediary for the sole purpose of avoiding the
related party rules of s 1031(f). It is this aspect of the transaction's structure that
manifests Taxpayer's intent to avoid application of the related party rules. Moreover, the
mere possibility of the existence of alternative schemes (that would qualify under s
1031(a)) to accomplish the same end result does not negate Taxpayer's intention in
undertaking the exchange that actually occurred. Thus, Taxpayer's exchange of Property
X for Property Z is part of a transaction structured to avoid the purposes of s 1031(f)
within the meaning of s 1031(f)(4).

Section 1031(f)(2)(C) provides an exception to the disqualification of a related party


exchange for s 1031(a) nonrecognition treatment under s 1031(f)(1). Although this
exchange is not a related party exchange because of the use of the qualified intermediary
QI, Taxpayer argues that the exchange did not have as one of its principal purposes the
avoidance of Federal income tax as provided in s 1031(f)(2)(C) and therefore should
qualify for nonrecognition treatment under s 1031(a) despite the application of s
1031(f)(4). However, in this case there into need to determine whether s 1031(f)(2)(C) is
also an exception to s 1031(f)(4), since Taxpayer has not established that the exchange
did not have as one of its principal purposes the avoidance of Federal income tax.

Under these facts, Taxpayer has not demonstrated that use of the qualified intermediary
QI was not to avoid the purposes of the related party rules of s 1031(f). Accordingly,
pursuant to s 1031(f)(4), Taxpayer's exchange of Property X for Property Z with the
qualified intermediary QI is not eligible for nonrecognition treatment under s 1031(a).

CONCLUSION:

Taxpayer is not entitled to nonrecognition treatment under s 1031(a) with respect to his
transfer of Property X in a multiparty exchange involving Taxpayer, a related party
(Related Party), an unrelated third party (UTP), and a qualified intermediary (QI).

A copy of this technical advice memorandum is to be given to Taxpayer. Section


6110(j)(3) of the Code provides that it may not be used or cited as precedent.

This document may not be used or cited as precedent. Section 6110(j)(3) of the Internal
Revenue Code.

PRIVATE LETTER RULING 9352008

This Ruling involved an involuntary conversion of land by means of condemnation,


and, therefore, brought into play the meaning of like-kind inasmuch as Code §1033(g)
and Code §1031 utilized this language.

The Ruling examined the concern by the Petitioner as to whether co-ownership of


replacement property could be treated as a partnership, and, therefore, deny proper
treatment for replacement.

Although some types of combined ownership might be partnerships, the Ruling


emphasized that one can own as a co-owner and not be a partnership. This was the case in
the given holding, and it was held to meet the requirements for reinvestment under Code
§1033.

For a similar Ruling on involuntary conversions and the question of proper


reinvestment, see also Private Letter Rul. 9352011.

PRIVATE LETTER RULING 9352008


Section 1033 -- Involuntary conversions
September 29, 1993
Publication Date: December 30, 1993
Dear ____:
This is in response to your letter dated May 27, 1993 and supplemental correspondence
dated June 16, 1993, August 5, 1993, September 9, 1993 and September 17, 1993. On
behalf of Taxpayer, you have requested a private letter ruling on whether a proposed
transaction will qualify for a tax-free rollover under the rules of section 1033 of the
Internal Revenue Code. Of the facts submitted by Taxpayer, the following appear to be
the most dispositive of the issues raised:

A was the fee owner of Blackacre. B, a corporation, is not involved in the facts of this
case except as a partner with A. Taxpayer herein is AB Partnership, a partnership
consisting of A and B as the only partners, with each owning 53% and 47% of the
partnership respectively. AB Partnership was the fee owner of Whiteacre. Blackacre and
Whiteacre were two contiguous tracts of land condemned by the transportation
department of State C on Date D. Gain from the conversion was first realized by A and
AB Partnership on or about the same date that the conversion occurred. A and AB
Partnership ultimately received total awards of $x and $y respectively for their properties.
A and AB Partnership now propose to reinvest all of the proceeds of their condemnation
awards to acquire fee title in Greenacre as tenants in common. Both of the condemned
properties were parcels of improved commercial rental real estate subject to net leases.
Both had been held by their respective owners for a number of years for investment. The
replacement property (Greenacre) will also be improved commercial rental real estate
already subject to a net lease (that was first entered into by lessee and the prior fee owner
on Date E) in which the lessee is responsible for payment of all insurance premiums,
general real estate taxes and special assessments, most of the utility expenses and a
significant portion of the repair costs. Greenacre will be held by A and AB Partnership
for investment. Income and expenses derived from owning Greenacre as tenants in
common will be apportioned pro-rata between A and AB Partnership. There will be no
special allocations of income and expenses between the co-owners.

Section 1033(a) of the Internal Revenue Code provides, in part, that if property, as a
result of requisition or condemnation or the threat or imminence thereof, is involuntarily
converted into money and if the taxpayer during the time specified purchases property
similar or related in service or use to the property so converted, at the election of the
taxpayer, the gain shall be recognized only to the extent the amount realized on such
conversion exceeds the cost of such other property.

Section 1033(g)(1) of the Code provides, in part, that if real property (not including
stock in trade or other property held primarily for sale) held for productive use in a trade
or business or for investment is (as a result of condemnation, or threat or imminence
thereof) compulsorily or involuntarily converted, property of like kind to be held for
productive use in a trade or business or for investment shall be treated as property similar
or related in service or use to the property so converted.

Section 1.1033(g)-1(a) of the Income Tax Regulations includes a cross reference to


section 1.1031(A)-1 as the source for principles for determining whether replacement
property is property of like kind.
Section 1.1031(A)-1(B) of the regulations provides, in part, that, as used in section
1031(A) of the Code, the words "like kind" have reference to the nature or character of
the property and not to its grade or quality. One kind or class of property may not, under
that section, be EXCHANGED for property of a different kind or class. 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. Unproductive real estate
held by one other than a dealer for future use or future realization of the increment in
value is held for investment and not primarily for sale.

Section 1.1031-1(C) of the regulations provides, in part, that no gain or loss is


recognized if a taxpayer who is not a dealer in real estate EXCHANGES city real estate
for a ranch or farm, or EXCHANGES a leasehold of a fee with 30 years or more to run
for real estate, or EXCHANGES improved real estate for unimproved real estate.

According to the above authority, for a disposition to be eligible for nonrecognition


treatment under section 1033(g) of the Code, the property to be replaced must be held for
productive use in a trade or business or for investment (as opposed to being held as stock
in trade or primarily for sale), must be real estate and its disposition must have been by
condemnation or the threat of condemnation or a similar action. In the present case, A
was the sole owner of Blackacre and AB Partnership was the sole owner of Whiteacre.
Both tracts were commercial rental real property that were being held for investment
purposes. The same properties were involuntarily converted by condemnation. The
additional requirement for nonrecognition under section 1033(g) is that the converted
property be timely replaced (within three years) with property of like kind, to be held by
the taxpayer for productive use in a trade or business or for investment. For this purpose,
any interest in real estate is of like kind to any other interest in real estate. In the present
case, A and AB partnership propose to replace their condemned properties with other
commercial rental real property to be held by them, as tenants in common, for
investment.

Concern is expressed that co-ownership of the replacement property could be treated as


a partnership and that the proposed replacement might fail to qualify if the replacement
property is deemed to be an interest in a partnership rather than an interest in real
property. This is a valid concern. Rev. Rul. 57-154, 1957-1 C.B. 262, states that the use
of condemnation proceeds to acquire an interest in a partnership owning and operating
property similar to that condemned would not constitute a qualifying replacement.
However, the Service also recognizes within the same revenue ruling that acquiring a
direct interest in property, similar to the property condemned, as a tenant in common
could qualify as a valid replacement under section 1033 of the Code. Furthermore, the
Service has indicated in other rulings that mere co-ownership of an interest in real
property without providing more than the customary services of maintenance and repair
and collecting of rents will not render a co-ownership a partnership. See Rev. Rul. 75-
374, 1975-2 C.B. 261 (holding that a life insurance company and a REIT, each of which
owns a one-half interest in an apartment project will not be treated as a partnership when
they retain an unrelated corporation under a management contract to furnish customary
tenant services and various additional services for which such manager makes separate
charges, pays all costs incident thereto and retains any profits generated by these
additional services).

In the present case, it is represented that no services, other than those typical of a
landlord, will be furnished by the co-owners. Indeed, the replacement property is already
subject to a net lease, under which the lessee is responsible to pay all insurance
premiums, general real estate taxes and special assessments, most of the utility expenses
and a significant portion of the repair costs. Furthermore, income and expenses derived
from owning Greenacre as tenants in common will be apportioned pro-rata between A
and AB Partnership. There will be no special allocations of income and expenses between
the co-owners. Therefore, co-ownership of Greenacre by A and AB Partnership is not, in
and of itself, a partnership.

Consequently, we rule as follows:

1. The condemnation actions by the transportation department of


State C of Blackacre and Whiteacre, owned in fee simple by A
and AB Partnership respectively and held for investment, both
qualified as involuntary conversions within the meaning of
section 1033(a)(1) and (g)(1) of the Code.
2. An amount equal to the entire cash proceeds received on the
condemnations, if reinvested by the recipients as tenants in
common in Greenacre will result in nonrecognition of gain or
loss under section 1033(a) of the Code, subject to the following
conditions:
(a) Taxpayer has made a timely and appropriate election to
defer the resulting gain;
(b) The replacement is timely made; and
(c) The only activities of Taxpayer and the other co-owner
with respect to Greenacre will be to provide only those
customary services of a landlord to the extent specified in
the lease dated Date E, and there are no special allocations
of income and expenses as to Greenacre between the co-
owners.

No opinion is expressed as to the effect of any other section of the Code or regulations
which may be applicable to the facts of this case or concerning the tax treatment of any
conditions existing at the time of, or effects resulting from, the Transaction described
which are not specifically covered in the above ruling.

A copy of this letter should be attached to the federal income tax return for the year in
which the transaction in question occurs. This ruling is directed only to the taxpayer who
requested it. Section 6110(j)(3) of the Code provides that it may not be cited as
precedent. Sincerely, Assistant Chief Counsel (Income Tax & Accounting)
SPECIAL VALUATION: CODE §2032A:
EXCHANGING
PRIVATE LETTER RULING 9503015

This Private Letter Ruling involves the application of an exchange and whether such
action constitutes a disposition under Code §2032A, thereby generating the postponed
estate tax.

The Ruling holds that the exchange would not be considered a disposition for purposes
of Code §2032(C); thus, there is no disposition that generates the postponed estate tax.

PRIVATE LETTER RULING 9503015


Section 2032A:
Valuation of certain farm, etc., real property
October 21, 1994
Publication Date: January 20, 1995

Dear ____:
This is in reply to your October 11, 1994 letter and other correspondence in which you
request a ruling on the application of s 2032A(c) of the Internal Revenue Code to
property for which a special use valuation election has been made. With respect to your
request for a ruling concerning a partial revocation of the election, we are declining to
respond to that ruling request. Sec. 5.09 of Rev. Proc. 94-1, 1994-1 C.B. 10, 20.

The decedent died owning undivided interests in six ranches and farms. For example,
he owned undivided interests in each of Ranch A, Ranch B, Ranch C, and Ranch D. An
election was made under s 2032A for the property subject to each of these interests.
These particular interests are held by A.

B and C each own undivided interests in Ranch A, Ranch B, Ranch C, and Ranch D.
Although they are also qualified heirs, they acquired these interests before the decedent's
death. These interests were not includible in the decedent's gross estate and,
consequently, are not subject to the election.

In order to obtain mortgage financing for the ranching operation, B and C propose to
enter into an EXCHANGE agreement with A under which B and C will transfer to A all
or part of these interests that they own in Ranch A and Ranch B. In EXCHANGE, A will
transfer to B and C part of the undivided interests A now holds in Ranch C and Ranch D.

The EXCHANGE will result in A acquiring an additional undivided interest in Ranch


A and outright ownership of Ranch B. This property will be subject to the election and
lien. B and C will own Ranch C and Ranch D outright, and this property will not be
subject to the election and lien.
You have asked whether the EXCHANGE will satisfy the requirements of s 2032A(i)
so as not to be considered a disposition of the property for which the s 2032A election
was made.

Section 2032A(a) provides that, if the executor elects the application of s 2032A and
files the agreement, then, for purposes of the estate tax, the value of qualified real
property shall be its value for the use under which it qualifies as qualified real property.

Section 2032A(c)(1) provides that, if, within 10 years after the decedent's death, the
qualified heir disposes of any interest qualified real property or ceases to use the property
for the qualified use, there is imposed an additional estate tax.

Section 2032A(i) provides that, if an interest in qualified real property is


EXCHANGED solely for an interest in qualified EXCHANGE property in a transaction
that qualifies under s 1031, no tax shall be imposed by subsection (c) by reason of the
EXCHANGE. The term "qualified EXCHANGE property" means real property which is
to be used for the qualified use under which the real property EXCHANGED therefor
originally qualified for special use valuation.

In the present case, the proposed EXCHANGE will result in an interest in qualified real
property being EXCHANGED for an interest in qualified EXCHANGE property.
Assuming that i) the value of the interests transferred by A is equal to the value of the
property that A will receive, and 2) each of the other requirements of s 1031 are satisfied,
the EXCHANGE will not be considered a disposition for purposes of s 2032A(c).

Except as we have specifically ruled herein we express no opinion on the federal tax
consequences of the transaction under the cited provisions or under any other provisions
of the Code.

This ruling is directed to the taxpayer who request it. Section 6110(j)(3) provides that it
may not be used or cited as precedent. Temporary or final regulations pertaining to one or
more of the issues addressed in this ruling have not yet been adopted. Therefore, this
ruling will be modified or revoked by adoption of temporary regulations, to the extent the
regulations are inconsistent with any conclusions int he ruling See s 11.04 of Rev. Proc.
94-1, 1994-1 I.R.B. 10, 39. However, when the criteria in s 11.05 of Rev. Proc. 94-1 are
satisfied, a ruling is not revoked or modified retroactively, except in rare or unusual
circumstances. Sincerely yours, Assistant Chief Counsel (Passthroughs and Special
Industries) By * * * *

EXCHANGE OF TAX-EXEMPT USE PROPERTY:


PROPOSED REGULATIONS
95 WL 232130

The following Proposed Regulations emphasizes the concern with tax-exempt use
property relative to exchanging.
PROPOSED RULES
DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[IA-18-95]
RIN 1545-AT33
60 FR 19868-01
Lease Term; EXCHANGES of Tax-Exempt Use Property
Friday, April 21, 1995

AGENCY: Internal Revenue Service (IRS), Treasury.


ACTION: Notice of proposed rulemaking and notice of public hearing.

SUMMARY:
This document contains proposed regulations relating to * * * * The proposed
regulations also provide guidance regarding certain like-kind EXCHANGES among
related parties involving tax- exempt use property. * * * *

This document contains proposed amendments to the Income Tax Regulations (26 CFR
part 1) relating to the depreciation of tax-exempt use property under section 168 of the
Internal Revenue Code (Code). Section 168(h) provides rules relating to the definition of
tax-exempt use property. Section 168(i)(3) provides rules for determining a lease term for
purposes of section 168. These proposed regulations provide guidance relating to certain
EXCHANGES of tax- exempt use property among related parties and the determination
of lease term under certain circumstances.

Explanation of Provisions
Like-Kind EXCHANGES

The proposed regulations also addresses certain transactions between related persons
that are designed to circumvent the tax-exempt use property rules. For example, a
taxpayer might purchase tax-exempt use property for $100x and then promptly transfer
the property to a related person in EXCHANGE for like-kind property of an equal value
that has a zero basis and is not tax-exempt use property (the taxable property). If the
EXCHANGE qualifies for nonrecognition treatment under section 1031 as to the related
person, the related person recognizes none of its gain with respect to the taxable property
and takes the tax-exempt use property with a zero basis. At the same time, the taxpayer
has a $100x basis in the taxable property. The desired net tax result of the transaction is
that a new investment in property that is properly subject to the ADS becomes subject to
GDS.

To address this situation, the proposed regulations provide that property (tainted
property) transferred directly or indirectly to the taxpayer by a related person (the related
party) as part of, or in connection with, a transaction described in section 1031 where the
related party receives tax- exempt use property (related tax-exempt use property) will, if
the tainted property is subject to an allowance for depreciation, be treated in the same
manner as the related tax-exempt use property for purposes of determining the allowable
depreciation deduction under section 167(a). Under this rule, the tainted property is
depreciated by the taxpayer over the remaining recovery period of, and using the same
depreciation method and convention as that of, the related tax-exempt use property.

This rule is subject to certain limitations. In general, the rule applies only with respect
to so much of the taxpayer's basis in the tainted property as does not exceed the
taxpayer's adjusted basis in the related tax-exempt use property prior to the transfer. Any
excess of the taxpayer's basis in the tainted property over its adjusted basis in the related
tax-exempt use property prior to the transfer is treated as property to which the rule does
not apply. Moreover, the rule does not apply to so much of the taxpayer's basis in the
tainted property as is subject to section 168(i)(7).

The proposed regulations provide that related tax-exempt use property includes
property that does not become tax-exempt use property (as defined in section 168(h))
until after the transfer if, at the time of the transfer, it was intended that the property
become tax-exempt property. Moreover, in the circumstances described in the preceding
sentence, the related tax-exempt use property will be treated as having, prior to the
transfer, a lease term equal to the term of any lease that causes such property to become
tax-exempt use property.

The proposed regulations only apply with respect to direct or indirect transfers of
property involving related persons where (1) section 1031 applies to any party, and (2) a
principal purpose of the transfer is to avoid or limit the application of ADS. For purposes
of this rule, a person is related to another person if they bear a relationship specified in
section 267(b) or section 707(b)(1).

Before these proposed regulations are adopted as final regulations, consideration will
be given to any written comments (a signed original and eight (8) copies) that are
submitted timely to the IRS. All comments will be available for public inspection and
copying.

EXCHANGES: DEPRECIATION AND TAX-EXEMPT PROPERTY:


REGULATION

The following involved Proposed Regulation §1.169(h)-1, like-kind exchanges


involving tax-exempt use property. This Section addressed the issue of Code §1031,
where there are related parties involved, as well as depreciation issues, all overlapping
with the potential of an exchange.

CODE OF FEDERAL REGULATIONS


TITLE 26--INTERNAL REVENUE
CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF
THE TREASURY
SUBCHAPTER A--INCOME TAX
PART 1--INCOME TAXES
NORMAL TAXES AND SURTAXES
COMPUTATION OF TAXABLE INCOME
ITEMIZED DEDUCTIONS FOR INDIVIDUALS AND CORPORATIONS
26 CFR s 1.168(h)-1
26 C.F.R. § 1.168(h)-1
Current through November 6, 1997; 62 FR 60138 § 1.168(h)-1 Like-kind exchanges
involving tax-exempt use property.
(a) Scope.
(1) This section applies with respect to a direct or indirect transfer
of property among related persons, including transfers made
through a qualified intermediary (as defined in § 1.1031(k)-
1(g)(4)) or other unrelated person, (a transfer) if--
(i) Section 1031 applies to any party to the transfer or to any
related transaction; and
(ii) A principal purpose of the transfer or any related
transaction is to avoid or limit the application of the
alternative depreciation system (within the meaning of
section 168(g)).
(2) For purposes of this section, a person is related to another
person if they bear a relationship specified in section 267(b) or
section 707(b)(1).
(b) Allowable depreciation deduction for property subject to this
section--
(1) In general. Property (tainted property) transferred directly or
indirectly to a taxpayer by a related person (related party) as
part of, or in connection with, a transaction in which the
related party receives tax-exempt use property (related tax-
exempt use property) will, if the tainted property is subject to
an allowance for depreciation, be treated in the same manner
as the related tax-exempt use property for purposes of
determining the allowable depreciation deduction under
section 167(a). Under this paragraph (b), the tainted property
is depreciated by the taxpayer over the remaining recovery
period of, and using the same depreciation method and
convention as that of, the related tax-exempt use property.
(2) Limitations--
(i) Taxpayer's basis in related tax-exempt use property. The
rules of this paragraph (b) apply only with respect to so
much of the taxpayer's basis in the tainted property as does
not exceed the taxpayer's adjusted basis in the related tax-
exempt use property prior to the transfer. Any excess of the
taxpayer's basis in the tainted property over its adjusted
basis in the related tax-exempt use property prior to the
transfer is treated as property to which this section does not
apply. This paragraph (b)(2)(i) does not apply if the related
tax-exempt use property is not acquired from the taxpayer
(e.g., if the taxpayer acquires the tainted property for cash
but section 1031 nevertheless applies to the related party
because the transfer involves a qualified intermediary).
(ii) Application of section 168(i)(7). This section does not
apply to so much of the taxpayer's basis in the tainted
property as is subject to section 168(i)(7).
(c) Related tax-exempt use property.
(1) For purposes of paragraph (b) of this section, related tax-
exempt use property includes--
(i) Property that is tax-exempt use property (as defined in
section 168(h)) at the time of the transfer; and
(ii) Property that does not become tax-exempt use property
until after the transfer if, at the time of the transfer, it was
intended that the property become tax-exempt use
property.
(2) For purposes of determining the remaining recovery period of
the related tax-exempt use property in the circumstances
described in paragraph (c)(1)(ii) of this section, the related tax-
exempt use property will be treated as having, prior to the
transfer, a lease term equal to the term of any lease that causes
such property to become tax-exempt use property.
(d) Examples.The following examples illustrate the application of
this section. The examples do not address common law
doctrines or other authorities that may apply to
recharacterize or alter the effects of the transactions
described therein. Unless otherwise indicated, parties to
the transactions are not related to one another.
Example1. X owns all of the stock of two subsidiaries, B and
(i) Z. X, B and Z do not file a consolidated federal
income tax return. On May 5, 1995, B purchases
an aircraft (FA) for $1 million and leases it to a
foreign airline whose income is not subject to
United States taxation and which is a tax-exempt
entity as defined in section 168(h)(2). On the same
date, Z owns an aircraft (DA) with a fair market
value of $1 million, which has been, and continues
to be, leased to an airline that is a United States
taxpayer. Z's adjusted basis in DA is $0. The next
day, at a time when each aircraft is still worth $1
million, B transfers FA to Z (subject to the lease to
the foreign airline) in exchange for DA (subject to
the lease to the airline that is a United States
taxpayer). Z realizes gain of $1 million on the
exchange, but that gain is not recognized pursuant
to section 1031(a) because the exchange is of like-
kind properties. Assume that a principal purpose of
the transfer of DA to B or of FA to Z is to avoid
the application of the alternative depreciation
system. Following the exchange, Z has a $0 basis
in FA pursuant to section 1031(d). B has a $1
million basis in DA.
(ii) B has acquired property from Z, a related person;
Z's gain is not recognized pursuant to section
1031(a); Z has received tax-exempt use property as
part of the transaction; and a principal purpose of
the transfer of DA to B or of FA to Z is to avoid
the application of the alternative depreciation
system. Accordingly, the transaction is within the
scope of this section. Pursuant to paragraph (b) of
this section, B must recover its $1 million basis in
DA over the remaining recovery period of, and
using the same depreciation method and
convention as that of, FA, the related tax-exempt
use property.
(iii) If FA did not become tax-exempt use property
until after the exchange, it would still be related
tax-exempt use property and paragraph (b) of this
section would apply if, at the time of the exchange,
it was intended that FA become tax-exempt use
property.
Example2. X owns all of the stock of two subsidiaries, B and
(i) Z. X, B and Z do not file a consolidated federal
income tax return. B and Z each own identical
aircraft. B's aircraft (FA) is leased to a tax-exempt
entity as defined in section 168(h)(2) and has a fair
market value of $1 million and an adjusted basis of
$500,000. Z's aircraft (DA) is leased to a United
States taxpayer and has a fair market value of $1
million and an adjusted basis of $10,000. On May
1, 1995, B and Z exchange aircraft, subject to their
respective leases. B realizes gain of $500,000 and
Z realizes gain of $990,000, but neither person
recognizes gain because of the operation of section
1031(a). Moreover, assume that a principal
purpose of the transfer of DA to B or of FA to Z is
to avoid the application of the alternative
depreciation system.
(ii) As in Example 1, B has acquired property from Z,
a related person; Z's gain is not recognized
pursuant to section 1031(a); Z has received tax-
exempt use property as part of the transaction; and
a principal purpose of the transfer of DA to B or of
FA to Z is to avoid the application of the
alternative depreciation system. Thus, the
transaction is within the scope of this section even
though B has held tax-exempt use property for a
period of time and, during that time, has used the
alternative depreciation system with respect to
such property. Pursuant to paragraph (b) of this
section, B, which has a substituted basis
determined pursuant to section 1031(d) of
$500,000 in DA, must depreciate the aircraft over
the remaining recovery period of FA, using the
same depreciation method and convention. Z holds
tax-exempt use property with a basis of $10,000,
which must be depreciated under the alternative
depreciation system.
(iii) Assume the same facts as in paragraph (i) of this
Example 2, except that B and Z are members of an
affiliated group that files a consolidated federal
income tax return. Of B's $500,000 basis in DA,
$10,000 is subject to section 168(i)(7) and
therefore not subject to this section. The remaining
$490,000 of basis is subject to this section. But see
§ 1.1502-80(f) making section 1031 inapplicable to
intercompany transactions occurring in
consolidated return years beginning on or after July
12, 1995.
(e) Effective date. This section applies to transfers made on or after
April 20, 1995.

[T.D. 8667, 61 FR 18676, April 29, 1996]


26 C. F. R. § 1.168(h)-1
26 CFR § 1.168(h)-1

PENALTIES: ATTEMPTED EXCHANGE WITHOUT SUPPORT CAN


BE SUBJECT TO FRAUD, PENALTIES: ZURN

The taxpayer attempted various transactions, with the hopeful result of reducing the
overall tax liability. One of the transactions involved was an attempt to qualify under
Code §1031. The transactions in large part were held to go against the taxpayer, and
additional tax resulted. The taxpayer was also faced with additional penalties for
negligence and fraud in the actions to reduce taxes.

The exchange issue related to whether negligent penalties and other charges could be
asserted when one attempted to undertake a Code §1031 transaction.
The Court concluded that there was little support for the taxpayer's position, and
penalties could be sustained against the taxpayer.

Stanley P. ZURN, Petitioner,


v.
COMMISSIONER OF INTERNAL REVENUE, Respondent.

No. 163-93.
United States Tax Court.
T.C. Memo. 1996-386
1996 WL 469713 (U.S.Tax Ct.),
72 T.C.M. (CCH) 440, T.C.M. (P-H) 96,386
Aug. 20, 1996.

MEMORANDUM OPINION

GERBER, Judge:
Respondent determined deficiencies in and additions to, and a penalty on, petitioner's
Federal income tax as follows:

After concessions, the issues remaining for our consideration are: (6) whether petitioner
is liable for an addition to tax for fraud or, alternatively, an addition to tax for negligence
and/or delinquency for any of the 1985 through 1988 taxable years;

Background [FN1]

For convenience, findings of fact and legal discussion are being combined for related
issues. Petitioner resided in Los Angeles, California, at the time the petition in this case
was filed. Petitioner, a high school graduate, completed some college on a part-time
basis. Petitioner was employed by the City of Los Angeles, Bureau of Street
Maintenance, as a construction crew supervisor. The job involved the use of heavy, off-
road paving and concrete equipment. Petitioner retired from his city job in 1980 and
entered the real estate business.

Petitioner was successful in the real estate business and had accumulated in excess of
20 rental properties by the close of 1989.

Issue 6. Whether Petitioner Is Liable for Additions To Tax for Fraud or, in
the Alternative, Additions to Tax for Negligence and Delinquency

Respondent determined an addition to tax for fraud in each of the 5 taxable years
before the Court. In addition to the issues on which fact findings have already been made,
respondent relies on stipulated matters which were resolved due to petitioner's
concessions.
During July 1988, petitioner negotiated the sale of the 3071 Harrington real property
(Harrington property) and entered into an escrow agreement with Hanmi Escrow Co.
(Hanmi). During August 1988, petitioner negotiated the sale of the 1149 Virgil real
property (Virgil property) and entered into an escrow agreement with Acme Escrow Co.
(Acme). During September 1988, petitioner entered into agreements designed to structure
a delay of the exchange of the Harrington and Virgil properties with Fountain Exchange
(Fountain). Fountain was to take title to the Harrington and Virgil properties and act as
seller but would hold the sale proceeds until petitioner could find replacement property to
make it appear as though a like-kind exchange under section 1031 had occurred within
the time allowed by the Internal Revenue Code. The deferred proceeds of sale were held
by Fountain for about 6 months and then paid to Star Global.

Marilyn Russello and her husband owned Acme and Fountain. Their business was to
accommodate sellers of property by facilitating what appeared to be a direct exchange in
order to give sellers the opportunity to find replacement property and also to claim
nonrecognition treatment for any gain from the sale. This is accomplished by Fountain's
acquiring title and receiving the proceeds of sale from the first property being sold.
Fountain holds title for an instant, and then the title is passed to the actual buyer from
Fountain's client (true seller). Within 45 days Fountain's client identifies an "up-leg"
property, and, within 180 days, closes the second escrow at which Fountain disburses
proceeds of the first sale in accord with Fountain's client's instructions.

Using this approach, petitioner deeded the Virgil and Harrington properties to Fountain,
which, in turn, deeded the properties to the actual buyers. Petitioner then located a
replacement property, and during March 1989 Fountain was instructed by petitioner to
transfer the $258,351.54 proceeds from the sale of Virgil and Harrington to Star Global to
purchase the "up-leg" property, a 25-percent interest in property known as "Protective
Community Land and Oil Corp. Tract, Lot no. 2160" (lot 2160). In some manner the title
to the interest in lot 2160 went through a person named Bob Welch (Mr. Welch) to
Fountain, which appeared to have exchanged the lot 2160 with petitioner for the Virgil
and Harrington properties.

Mr. Welch, a licensed general contractor, had a business relationship with petitioner
and acted as his agent for investment purposes. Mr. Welch ran the day-to-day affairs of
and owned Star Global, which was involved in imports and exports. Late in 1987,
petitioner began investing capital in Star Global, and he continued for a short time,
concluding when no profitable deals occurred. After the Star Global import activity was
concluded, Mr. Welch and petitioner continued to use the Star Global bank account on
which only Mr. Welch was a signatory.

Beginning in 1981, Mr. Welch and Robert Jose Hernandez (Mr. Hernandez) were
engaged in a joint real property investment relationship. Initially, Mr. Hernandez had
purchased lot 2160 for $500 cash, and later it was acquired by Mr. Welch through some
type of exchange with Mr. Hernandez. Lot 2160 consists of about 5 acres of desert land
about 100 miles north of Los Angeles. Mr. Welch approached petitioner with the idea of
acquiring lot 2160 as the "up-leg" property in the section 1031 exchange.
When Mr. Welch received the $258,351.54 check through Star Global, he converted it
into several cashier's checks that were used for the following purposes: (1) Payments to
finance a magazine Mr. Welch was working on; (2) payments to Mr. Welch's contracting
company; (3) payments to petitioner's new wife; and (4) payments to Mr. Welch's wife.
No part of the $258,351.54 was invested on behalf of petitioner.

About 1 month after the closing on the lot 2160 property, petitioner became suspicious
about its value, and he came to the conclusion that lot 2160 was worthless. After Mr.
Welch was confronted by petitioner, Mr. Welch, during the summer of 1989, gave
petitioner one-half of Mr. Welch's one-half interest (a 25-percent interest) in Mr. Welch's
magazine, in which approximately $1 million had been invested, mostly by an individual
other than Mr. Welch and petitioner. Petitioner continued to associate with Mr. Welch,
and about a month or two later, Mr. Welch invested an additional $200,000 of petitioner's
newly advanced funds in a different investment.

After Mr. Welch learned during November 1991 that petitioner was being audited by
respondent, he attempted to record the quitclaim deed from Mr. Hernandez to himself for
the interest in lot 2160. Mr. Welch testified that he realized $165,000 of gain from the
sale of lot 2160, but he did not report the transaction on his 1989 Federal tax return. Mr.
Welch explained that he did not report the sale of lot 2160 because petitioner's
$258,351.54 was ultimately invested in Mr. Welch's magazine.

Petitioner, on his 1989 Federal income tax return, reported a "Tax-Deferred Exchange"
under section 1031, reflecting the lot 2160 property with a $305,000 fair market value, as
the property received in the exchange. Petitioner reflected a $44,596 basis in lot 2160,
and no gain was recognized from the sale of the Virgil and Harrington properties.
Petitioner's 1989 return was filed after petitioner became aware that lot 2160 had virtually
no value.

Petitioner sold real property at 508 Marsalis during 1984 and reported the sale on the
installment basis. For the 1985 through 1989 taxable years, petitioner was entitled to and
received interest on the note connected with the 508 Marsalis sale, but he failed to report
any of the interest on his 1985 through 1987 income tax returns. Petitioner reported only
one-half of the interest received for 1988 and 1989. When confronted by respondent's
agent concerning the interest, petitioner told the agent that he was receiving only one-half
of the interest. The agent obtained copies of checks from the buyer of 508 Marsalis which
reflected that petitioner was paid the full amount of interest for 1988 and 1989. In several
other respects petitioner's responses to respondent's agent were false and/or misleading
and shown to be so by third- party investigation by the agent.

Petitioner received and failed to report interest income for 1985, 1986, 1987, 1988, and
1989 in the amounts of $22,822, $33,372, $34,052, $17,321, and $7,712, respectively.
Petitioner received and failed to report rental income for 1985, 1986, 1987, 1988, and
1989 in the amounts of $15,693, $19,601, $13,859, $3,046, and $9,703, respectively.
Petitioner failed to report income from the sale of real properties for 1985, 1986, 1987,
1988, and 1989 in the amounts of $7,884, $18,792, $4,887, $277,646, and $258,163,
respectively. Petitioner was entitled to, although he did not claim, a $179,905 passive loss
deduction for 1989 as a result of his $200,000 investment with Welch.

Petitioner did not keep complete or accurate records of his business activity during the
years in issue. Petitioner kept no books of original entry, checkbook records, or other
organized set of books. For purposes of preparing his Federal income tax returns,
petitioner would provide his return preparer, who was a certified public accountant, with
receipts and various papers in shoe boxes. The return preparer required petitioner to make
schedules, and, ultimately, the returns prepared for petitioner were based on the
unaudited and unverified information presented by petitioner.

Discussion

Respondent determined that petitioner is liable for an addition to tax or penalty for
fraud in each of the taxable years in issue. For 1985, section 6653(b)(1) provides for a 50-
percent addition to tax if any part of the underpayment is due to fraud, and section
6653(b)(2) provides for an addition equal to 50 percent of the interest payable on the
portion of the underpayment attributable to fraud. For 1986 and 1987, section
6653(b)(1)(A) provides for a 75-percent addition to tax on the portion of the
underpayment attributable to fraud, and section 6653(b)(1)(B) provides for an addition
equal to 50 percent of the interest payable on such portion. Finally, for 1988 and 1989,
sections 6653(b)(1) and 6663(a), respectively, provide for a 75-percent addition to tax or
penalty on the portion of the underpayment that is attributable to fraud. Fraud is defined
as an intentional wrongdoing designed to evade tax believed to be owing. Powell v.
Granquist, 252 F.2d 56 (9th Cir.1958); Miller v. Commissioner, 94 T.C. 316, 332 (1990).

Respondent has the burden of proving by clear and convincing evidence that an
underpayment exists for each of the years in issue and that some portion of the
underpayment is due to fraud. Sec. 7454(a); Rule 142(b). To meet this burden,
respondent must show that petitioner intended to evade taxes known to be owing by
conduct intended to conceal, mislead, or otherwise prevent the collection of taxes.
Stoltzfus v. United States, 398 F.2d 1002 (3d Cir.1968); Webb v. Commissioner, 394
F.2d 366 (5th Cir.1968), affg. T.C.Memo. 1966-81; Rowlee v. Commissioner, 80 T.C.
1111, 1123 (1983).

The existence of fraud is a question of fact to be resolved upon consideration of the


entire record. Estate of Pittard v. Commissioner, 69 T.C. 391 (1977); Gajewski v.
Commissioner, 67 T.C. 181, 199 (1976), affd. without published opinion 578 F.2d 1383
(8th Cir.1978). Fraud is not to be imputed or presumed, but it must be established by
some independent evidence of fraudulent intent. Beaver v. Commissioner, 55 T.C. 85, 92
(1970); Otsuki v. Commissioner, 53 T.C. 96 (1969). Fraud may not be found under
"circumstances which at the most create only suspicion." Davis v. Commissioner, 184
F.2d 86, 87 (10th Cir.1950); Petzoldt v. Commissioner, 92 T.C. 661, 700 (1989).
However, fraud may be proved by circumstantial evidence and reasonable inferences
drawn from the facts because direct proof of the taxpayer's intent is rarely available.
Spies v. United States, 317 U.S. 492 (1943); Rowlee v. Commissioner, supra; Stephenson
v. Commissioner, 79 T.C. 995 (1982), affd. per curiam 748 F.2d 331 (6th Cir.1984). The
taxpayer's entire course of conduct may establish the requisite fraudulent intent. Stone v.
Commissioner, 56 T.C. 213, 223-224 (1971); Otsuki v. Commissioner, supra at 105-106.
The intent to conceal or mislead may be inferred from a pattern of conduct. See Spies v.
United States, supra at 499.

Courts have relied on several indicia of fraud in considering the fraud addition in tax
cases. Although no single factor may necessarily be sufficient to establish fraud, the
existence of several indicia may be persuasive circumstantial evidence of fraud. Solomon
v. Commissioner, 732 F.2d 1459, 1461 (6th Cir.1984), affg. per curiam T.C.Memo. 1982-
603; Beaver v. Commissioner, supra at 93.

Circumstantial evidence that may give rise to a finding of fraudulent intent includes: (1)
Understatement of income, (2) inadequate records, (3) failure to file tax returns, (4)
implausible or inconsistent explanations of behavior, (5) concealment of assets, (6)
failure to cooperate with tax authorities, (7) filing false Forms W-4, (8) failure to make
estimated tax payments, (9) dealing in cash, (10) engaging in illegal activity, and (11)
attempting to conceal illegal activity. Bradford v. Commissioner, 796 F.2d 303, 307 (9th
Cir.1986), affg. T.C.Memo. 1984-601; see Douge v. Commissioner, 899 F.2d 164, 168
(2d Cir.1990). These "badges of fraud" are nonexclusive. Miller v. Commissioner, supra
at 334. The taxpayer's background and the context of the events in question may be
considered as circumstantial evidence of fraud. United States v. Murdock, 290 U.S. 389,
395 (1933); Spies v. United States, supra at 497; Plunkett v. Commissioner, 465 F.2d
299, 303 (7th Cir.1972), affg. T.C.Memo. 1970-274.

Respondent based a determination of fraud on the following general indicia:

(1) Petitioner's sophistication,


(2) his relationship with his return preparer,
(3) his propensity to deal in cash,
(4) his conduct with respondent's agent,
(5) his credibility,
(6) the "fraudulent" alimony deduction, and
(7) a 5-year pattern of underreported income.

Petitioner admits that he may have made errors in the reporting of his income, but that
errors were made for and against his own interests. Further, petitioner paints himself as
an unsophisticated individual who relied on professionals for the preparation of his tax
returns. Although petitioner failed to claim one substantial item which was beneficial to
him, the record otherwise reflects a pattern of understatement attributable to unreported
income, misrepresentation, and design.

Although petitioner was not specifically educated in accounting and tax matters, he was
a successful and effective businessman involved in numerous real estate transactions and
complex business transactions. His mistrust of lawyers and failure to document his
transactions cannot be attributed to inadvertence or mere negligence in the setting of this
case. Petitioner made misrepresentations to respondent's agent during the conduct of the
audit. He also reported a transaction reflecting nonrecognition of gain from the sale of
two parcels of realty which he knew to be incorrect and deceptive. The purported section
1031 item involved a series of steps designed to falsely defer gain on transactions which
did not meet the requirements of the statute. In addition, the information supplied to the
preparer as reflected in the return was, to petitioner's knowledge, incorrect and
misleading.

Petitioner contends that he relied on his return preparer regarding these matters,
including the section 1031 exchange. His return preparer, however, simply reported the
information provided by petitioner. In that regard petitioner knew that the lot 2160
property was of nominal value and, still, he provided the return preparer with information
reflecting that the fair market value of the exchanged property (lot 2160) was $305,000.
The amount of value provided was designed to permit the wrongful deferral of several
hundred thousand dollars of taxable gain. These are not matters that occurred
inadvertently or on a one-time basis. Petitioner also consistently failed to report
substantial amounts of income.

Petitioner's failure to keep books was part of his design to hide or obscure his numerous
and successful transactions in operating and trading real property. It is also likely that
petitioner's anonymous involvement with Ms. Jackson and the road contracts was a
deception to permit petitioner to participate in a minority and/or woman's preferential
program. Petitioner did suffer a loss in his transactions with Ms. Jackson as well as his
transactions with Mr. Welch. The losses incurred in these transactions were funded with
income from petitioner's successful real estate activity, some of which was not reported
to respondent. Petitioner was knowledgeable about and in control of his real estate
activity. Interest income and gains on sales were consistently understated on petitioner's
returns for each of the years before the Court.

We accordingly sustain respondent's determination that a part of the understatement for


the taxable year 1985 was due to fraud. With respect to the 1986, 1987, 1988, and 1989
taxable years, the unreported income from interest, rent, and the sale of property are due
to fraud. For the 1986 taxable year, the unreported income (adjustment "g." on Form
5278 of the notice of deficiency) is also due to fraud. With respect to the 1989 taxable
year, the item of increased income attributable to the section 1031 gain is also due to
fraud. Because we have found that petitioner is liable for fraud for each of the taxable
years in issue, it is unnecessary to consider whether he is liable for additions to tax for
negligence or delinquency for the 1985 through 1988 taxable years.

Regarding the 1989 taxable year, it is unnecessary to consider the accuracy- related
penalty under section 6662 because we have found that petitioner is liable under section
6663(a).

With respect to the addition to tax for delinquency under section 6651(a)(1) for the
1989 taxable year, that issue is not preempted by our section 6663(a) finding. Petitioner's
1989 Federal income tax return was not filed until November 29, 1990. Petitioner bears
the burden of showing that respondent's determination of the addition to tax for failure to
timely file is in error. Petitioner did not show that he obtained extensions to file beyond
the normal April 15, 1990, date or that he had reasonable cause for filing beyond the
required date. Accordingly, petitioner is liable for the section 6651(a)(1) addition for the
1989 taxable year.

Issue 7. Whether Petitioner Is Liable for the Substantial Understatement Addition to


Tax Under Section 6661 for 1985, 1986, 1987, or 1988

Section 6661 provides for a 25-percent addition to tax on any substantial


understatement. Pallottini v. Commissioner, 90 T.C. 498 (1988). A substantial
understatement is one that exceeds the greater of 10 percent of the tax required to be
shown on the return or $5,000. Sec. 6661(b)(1). The amount of an understatement, for
purposes of section 6661, is to be reduced by the portion attributable to any item for
which there was substantial authority or any item which was adequately disclosed. Sec.
6661(b)(2)(B).

Petitioner, on brief, made scant reference to section 6661. He argues that he believed
that he had no tax liability and/or that he relied on his accountant on the section 1031
transaction, which he believed to be adequately disclosed. As to petitioner's first position
that he believed that he had no tax liability, we have difficulty reconciling that position
with the record.

Concerning the possibility of an adequate disclosure, petitioner singles out the section
1031 transaction. Curiously, respondent did not determine an addition to tax under
section 6661 for the 1989 taxable year, the one in which the section 1031 transactions
were disclosed.

Accordingly, we find that, for the taxable years 1985 through 1988, petitioner did not
show error regarding respondent's determination that section 6661 is applicable, and we
sustain the additions to tax under that section for each such year in which the
understatement of tax, as recomputed pursuant to our opinion, exceeds the threshold
amount of section 6661(b)(1).

To reflect the foregoing and considering concessions of the parties,


Decision will be entered under Rule 155. * * * *

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