One of the fundamental rules of a 1031 Exchange is that the properties exchanged must be of “like-kind”. Given the importance of this rule, understanding what qualifies as “like-kind” is imperative to using a 1031 Exchange to your advantage. If the transaction qualifies for Section 1031 Exchange treatment though, the capital gains tax obligation can be deferred, potentially saving a substantial amount of money that can then be re-invested.
Courts across the country, including the U.S. Supreme Court, have been hammering away at the definition of “like-kind” for decades trying to clarify its meaning for taxpayers. Although there are many firmly established rules with regard to what constitutes a LKE, gray areas remain.
Real vs Personal Property
One firmly established criteria for a transaction to fit the like kind exchange rules is that real property cannot be exchanged for personal property per Rev. Rul. 59-229. In that case, the taxpayers entered into an exchange that involved farm lands, farm buildings, residences, all held for more than six months, and unharvested crops. The ruling clarified that the residences that were part of the exchange must be treated as a separate transaction since they were clearly personal property and, therefore, cannot be part of a LKE. For this reason, anyone who is considering entering into a 1031 Exchange where part of the property could be considered personal, not real, should clarify how the property will be treated prior to entering into the transaction. Another clear rule is that real property located outside the United States cannot be exchanged for real property located inside the United States, despite otherwise meeting the “like-kind” requirements pursuant to I.R.C. 1.1031(h).
States Define Personal and Real Property
Although it is clear that personal property cannot be exchanged for real property, that does not resolve the debate entirely as state courts often define personal and real property differently. In addition, simply clarifying that the properties to be exchanged are both real property does not suffice in and of itself to qualify the transaction for 1031 Exchange treatment. The U.S. Supreme Court, as well as the Tax Court, have generally deferred to the states to define personal and real property Aquilino v. United States, 363 U.S. 509 (1960); however, they have both been known to reign in a state when they feel a definition is over-reaching or needs clarification as in Wiechens v. United States, 228 F. Supp. 2d 1080 (D. Az. 2002).
Water Rights
In Wiechens, the taxpayer exchanged water rights for a fee simple in farm land. Although the court acknowledged that water rights are an interest in real property, the court found the two interests were not similar enough since the rights to the water were narrowly restricted in priority, quantity and duration and therefore not eligible for a LKE. In that case, the court held that factors that warrant consideration when determining whether property is personal or real include “the respective interests in the physical properties, the nature of the title conveyed, the rights of the parties, and the duration of the interests.” Id. at 1085.
LKE Gray Areas
Not surprisingly, the remaining grey areas in a LKE tend to surround exchanges similar to that in Wiechens where mineral, gas, water or timber rights are at issue given the various ways in which rights to these types of property can be conveyed and restricted. Although the court offered factors that would be considered in determining whether any two properties were alike enough to qualify for a 1031 Exchange, it fell short of offering a precise roadmap for analyzing the factors to ensure that an exchange will qualify. In addition, the possibility that a federal court will reject a state court analysis with regard to whether a property is real or personal is most likely to be found among rights to these types of property which can further confound the analysis of a proposed exchange.
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