8665 / What exchanges of property qualify as like-kind exchanges and are therefore eligible for nonrecognition treatment?

Editor’s Note: The 2017 tax reform legislation limited the nonrecognition treatment provided under IRC Section 1031 to exchanges of real property that is not held primarily for sale.¹ This provision applies to exchanges occurring after December 31, 2017. An exception exists if either (1) the property involved in the exchange was disposed of on or before December 31, 2017, or (2) the property received in the exchange was received on or before December 31, 2017.² The new rules also provide that real property located within the U.S. and foreign real property are not of a like-kind.³

IRC 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 is exchanged solely for property of a “like-kind” to be held for productive use in a trade or business or for investment.⁴ IRC Section 1031 does not provide a permanent exclusion of gain or loss because the taxpayer’s basis in the property exchanged transfers to the exchanged property, becoming the basis of that property.⁵ So if the taxpayer subsequently sells the replacement property, the deferred gain or loss would be recognized.

The phrase “like-kind” refers to the nature or character of the property and not to its grade or quality.⁶ So, whether real property is improved or unimproved is not relevant because virtually all types of real property are deemed to be of the same nature or character. Perhaps for this reason, the Section 1031 nonrecognition provision has been frequently used in connection with exchanges of real property and, under the 2017 tax reform legislation, is now limited to real property exchanges. Interestingly, the regulations provide that a leasehold interest with at least 30 years to run is equivalent to an ownership interest in real property.⁷

Prior to the 2017 tax reform legislation, only certain types of property were eligible for nonrecognition treatment under the rules applicable to like-kind exchanges. Exchanges of stock in trade (or other property held primarily for sale) and stocks, bonds, notes, and other securities or evidences of indebtedness or interest were specifically excluded under Section 1031, even though they might otherwise have qualified as business or investment property.⁸ Additionally, IRC Section 1031(h) specifically excluded exchanges in which at least one of the properties is real property located outside the United States (the 2017 tax reform legislation specifically provides that real property located within the U.S. and foreign real property are not of a like-kind). Similarly, an exchange involving a partnership interest in a real estate partnership is specifically excluded from like-kind exchange treatment.⁹

Though the like-kind exchange rules have always been well-settled in the area of real property, application of the “like-kind” standard (pre-2018) was not so clear with respect to exchanges of personal property. In Revenue Ruling 82-166, the IRS ruled that an exchange of gold bullion (held for investment purposes) for silver bullion (which would also be held for investment purposes) did not qualify as a like-kind exchange, based on the finding that silver and gold are intrinsically different metals and are used in different ways; silver is essentially an industrial commodity while gold is primarily utilized as an investment in itself. Therefore, the IRS reasoned that an investment in one of the metals is fundamentally different from an investment in the other metal.¹⁰ Conversely, the IRS has found that trades of major league player contracts, as well as the exchange of gold bullion for Canadian Maple Leaf gold coins, qualified for like-kind treatment.¹¹

In one example of pre-2018 like-kind exchange treatment, the IRS ruled upon the exchange of intangible property in the form of contract rights under two separate manufacturing and distribution contracts. The IRS found that a taxpayer could exchange rights to manufacture and distribute a certain set of products under one contract with those available to the taxpayer’s subsidiary under a second contract in a like-kind exchange without recognition of gain or loss. Both contracts at issue in this case involved the manufacturing and distribution of a certain set of products, though the contracts covered different territories and had different terms and renewal periods. The IRS found that the contract rights were of a like-kind using a two part test that examined (1) the nature or character of the rights involved and (2) the nature or character of the underlying property to which the agreements relate. Both contracts were in the nature of manufacturing and distribution agreements. While the IRS found that manufacturing and distribution are distinct business activities, and that the rights to each would not be of a like kind, it also found that in the case of the particular products at issue, manufacturing and distribution are historically treated as two aspects of a single business activity, so that the first prong was satisfied. Each agreement covered a group of products that share substantially similar manufacturing and distribution processes. Though the products had different brand names, packaging and appearances, among other differences, these differences impacted the grade or quality of the products, not their nature or character. As a result, the second prong was satisfied and the IRS ruled that the contracts could be transferred in a like-kind exchange.¹²