Tax Update Blog: Permalink

« Previous · Tax Update Blog Home · Next »

HOW TO FIND IF IT'S LIKE-KIND

August 13, 2004

In the misty early days of the tax law, Congress saw fit to exclude from tax the gains from exchanges of "like-kind" property. While the provisions have been trimmed back on occasion, these transactions, now known as "Section 1031" exchanges, still are available for a remarkably broad range of property.

In strictly economic terms, these rules make no sense - a gain is a gain, whether paid in cash or widgets, and they should be taxed - or not taxed - the same way. But let's not fret about broader policy implications when it's time to use a perfectly-good tax break.

HOW IT WORKS.

If a transaction qualifies under Section 1031 of the tax code, no gain is recognized if only "like-kind" property is involved. The "basis" of the property (its cost, adjusted for any depreciation) of the property given up in the exchange becomes the basis of the property received. This means the gain isn't permanently avoided; it instead is deferred until the property received in the exchange is sold.

If cash or other non like-kind property is involved ("boot"), gain is recognized to the extent of boot received. No losses are allowed in like-kind exchanges.

Section 1031 isn't a "rollover" provision. If you receive cash, you can't qualify for like-kind treatment by using the cash to buy replacement like-kind property. The tax law does allow escrows and intermediaries to receive cash on the taxpayer's behalf for a limited time without losing Section 1031 treatment.

WHAT IS LIKE-KIND?

Property qualifies for Section 1031 treatment only if it is held or used in a trade or business, or for investment. This means personal use property doesn't qualify. The tax law also specifically prevents the use of Section 1031 to defer gain on inventory (including inventory of real estate "dealers"), stocks, securities, debt instruments, partnership interests, interests in trusts, and "choses in action."

That leaves a lot of things that do qualify under Section 1031.

Real estate is usually easy to qualify as "like-kind." The tax law considers most real estate to be "like-kind." For example, a factory building in an urban industrial zone would be considered "like-kind" to farmland, and an apartment building would be like-kind to timber acreage held for investment.

PERSONAL PROPERTY - NAICS RULES

Personal property is another matter. The only guidance the tax code itself provides for whether personal property qualifies is the statement "... livestock of different sexes are not property of a like kind." While clear and concise, this statement doesn't much help to determine whether you can swap a packaging machine for a forklift.

Court decisions and Treasury regulations have fleshed out the definition of "like-kind" over the past 86 years. A few years back the Treasury greatly simplified things by ruling that items in the same four-digit "Standard Industrial Classification" code issued by the Commerce Department would be considered "like-kind." The Commerce Department failed to cooperate, dropping the SIC system in 1997 and replacing it with the "North American Industry Classification System" (NAICS).

Yesterday the Treasury issued new regulations to replace the SIC codes with the NAICS codes. The NAICS codes are available on the Internet here. Items within the same six-digit NAICS code are considered automatically to be like-kind if they begin with the number 31, 32 and 33. For example, "Cabs for construction machinery manufacturing" are like-kind to "Log debarking machinery, portable, manufacturing" because they are both classified in the NAICS 333120 class.

These "safe-harbor" rules don't apply to NAICS classes ending in "9" - that is, "miscellaneous" items - but taxpayers are allowed to argue that such items are like kind anyway.

BE CAREFUL OUT THERE!

The like-kind exchange rules have many procedural traps. The rules allowing excrows and intermediaries are technical and unforgiving of errors. Special rules can make it difficult for exchanges between related parties to qualify. If you want to qualify for Section 1031 treatment, be sure to contact your tax advisor.

      Bookmark: del.icio.us • Digg • reddit