Gains & Losses
The like-kind exchange rules may allow taxpayers to defer gain (or loss) realized on the exchange of property. Qualifying for like-kind exchange treatment becomes more complicated if the property exchanged is “underwater”—that is, the debt on the property exceeds its fair market value (FMV). The IRS concluded in a letter ruling that the exchange of underwater property with the lender in satisfaction of the debt could qualify for like-kind exchange treatment. This item considers what this ruling means for taxpayers in similar situations.
A taxpayer that sells investment property or property held for productive use in its trade or business may be able to defer the recognition of any gain (or loss) realized on the sale for federal income tax purposes if the sale is structured as part of a like-kind exchange under Sec. 1031. In general, to qualify for deferral under Sec. 1031, the proceeds from the sale of the property must be timely reinvested in like-kind property.
What if the taxpayer has no net equity in the relinquished property or the property is underwater? The taxpayer will receive no proceeds (other than relief from indebtedness) from the disposition of the property to reinvest in like-kind property. Can a taxpayer still use the like-kind exchange rules of Sec. 1031 to defer the gain realized on the transfer of underwater property to the lender in satisfaction of a nonrecourse debt? This item discusses a recent letter ruling issued by the IRS regarding the exchange of underwater property by a taxpayer under Sec. 1031. The recent letter ruling and this item discuss property encumbered by a nonrecourse liability. Additional analysis may be required if the liability is recourse.
Example: A holds Property X for productive use in its trade or business. The FMV of Property X is $100, and it is subject to a nonrecourse liability of $125. A ’s tax basis in Property X is $80. A has entered into an agreement with the lender on the nonrecourse liability to return Property X to the lender in full satisfaction of the nonrecourse liability. A ’s net equity in Property X is zero. A will realize $45 of gain ($125 amount realized less $80 basis) on the disposition to the lender. Can A structure the disposition of Property X to the lender as a like-kind exchange under Sec. 1031 and, thus, defer for federal income tax purposes the recognition of gain realized on the disposition?
In general, Sec. 1001(c) requires a taxpayer to recognize the amount of gain (or loss) realized on the sale or exchange of property for federal income tax purposes. Sec. 1031, however, provides an exception to this general rule and allows a taxpayer to defer the gain (or loss) realized on an exchange of certain property held for productive use in a trade or business or for investment, if the property is exchanged for like-kind property that is also held for productive use in a trade or business or for investment.
In the most common like-kind exchange (a deferred like-kind exchange), the taxpayer sells its relinquished property to one person (the buyer) before acquiring the replacement property from a different person (the seller). To qualify for deferral under Sec. 1031, the taxpayer must structure the deferred like-kind exchange to satisfy the requirements of Sec. 1031(a)(3) and Regs. Sec. 1.1031(k)-1. If satisfied, these rules convert the sale/reinvestment transaction into an “exchange” for federal income tax purposes. (A full discussion of the deferred like-kind exchange rules under Sec. 1031 is beyond the scope of this item.)
One requirement for a deferred like-kind exchange is that the taxpayer must not actually or constructively receive the proceeds from the sale of the relinquished property prior to investing the proceeds in the replacement property. To avoid actual or constructive receipt, in most deferred like-kind exchanges, the taxpayer hires a qualified intermediary (QI), an independent party that holds the sale proceeds until replacement property is acquired.
If a taxpayer uses a QI in its deferred like-kind exchange, the taxpayer and the QI enter into a written exchange agreement that outlines the terms of the transaction. The written exchange agreement must require the QI to (1) acquire the relinquished property from the taxpayer; (2) transfer the relinquished property to the buyer; (3) acquire the replacement property from the seller; and (4) transfer the replacement property to the taxpayer. The QI holds the sales proceeds from the relinquished property until the proceeds are reinvested in the replacement property (Regs. Sec. 1.1031(k)-1(g)(4)(iii)(B)). The exchange agreement must specifically limit the taxpayer’s ability to benefit from the proceeds until reinvestment (Regs. Sec. 1.1031(k)-1(g)(6)).
In a typical deferred like-kind exchange, the taxpayer negotiates and enters into the sales contract with a buyer for the relinquished property. To implement the terms of the exchange agreement with the QI, after executing the sales agreement with the buyer, the taxpayer assigns its rights under the sales agreement to the QI and notifies all parties to the sales agreement (e.g., the buyer) in writing of the assignment on or before the date of sale. As a result of this assignment, the QI is treated as entering into the sales contract with the buyer for purposes of Sec. 1031. If the relinquished property is transferred pursuant to that sales contract, the QI is treated as having acquired and transferred the relinquished property for purposes of Sec. 1031 (Regs. Sec. 1.1031(k)-1(g)(4)(v)).
What if, as in the example above, the taxpayer has no equity in the relinquished property? Does the taxpayer have “property” that it can exchange under Sec. 1031? If the taxpayer is entitled to no proceeds from the buyer (or the lender as in the example above) under the sales contract, does the taxpayer have rights under the agreement that it can assign to a QI?
Letter Ruling 201302009
In Letter Ruling 201302009, the IRS concluded that the QI safe harbor is available for a taxpayer holding underwater property. In the ruling, the taxpayer owned 100% of the interests in a limited liability company (LLC) that was a disregarded entity. The LLC owned real property that was encumbered by a nonrecourse liability. At the time of the transaction, the outstanding balance of the nonrecourse liability exceeded the real property’s FMV (i.e., the real property was underwater).
The taxpayer and its lender entered into a transfer agreement under which the taxpayer agreed to transfer the real property to the lender subject to the debt. The taxpayer proposed to structure the transfer of the real property to the lender as the disposition of relinquished property in a deferred like-kind exchange under Sec. 1031. Prior to transferring the real property to the lender, the taxpayer proposed assigning a QI its rights under the transfer agreement and giving written notice of the assignment to the lender. The taxpayer indicated that it would subsequently enter into a contract for the acquisition of like-kind replacement property and would assign its rights under the purchase contract to the QI. The QI would then acquire the replacement property with cash the taxpayer provided to the QI or from debt and would transfer the replacement property to the taxpayer. Finally, the taxpayer indicated that the replacement property’s FMV would be approximately equal to the total amount of the outstanding principal on the debt.
The IRS ruled that the taxpayer’s assignment of its rights in the transfer agreement to the QI would be a transfer of relinquished property for purposes of determining whether there is an “exchange of property held for productive use in a trade or business or for investment” under Sec. 1031, notwithstanding that the real property’s FMV would be less than the principal amount of the outstanding nonrecourse debt. Accordingly, the IRS concluded in the letter ruling that the taxpayer could effectuate a valid assignment of rights to a QI, even though the taxpayer was entitled to no property from the “buyer” (i.e., the lender) under the agreement. The taxpayer would still be considered to have transferred relinquished property in a transaction that could be structured as a like-kind exchange under Sec. 1031.
Private letter rulings cannot be cited as precedent and are not binding on the IRS for any taxpayer other than the taxpayer to whom the ruling was issued (Sec. 6110(k)(3)). Thus, the IRS could reach a different conclusion in the future on the same or similar facts. Nevertheless, letter rulings are helpful in determining the IRS’s current position on a particular issue.
In this case, Letter Ruling 201302009 suggests that it is not necessary for a taxpayer to have positive net equity in a property to defer gain recognition under Sec. 1031. Assuming the requirements of Sec. 1031 are otherwise met, if a taxpayer disposes of the over-encumbered relinquished property using a QI and timely acquires like-kind replacement property that has an FMV at least equal to the nonrecourse debt to which the relinquished property was subject, Letter Ruling 201302009 indicates that it may be possible to structure the disposition of underwater property as part of a like-kind exchange under Sec. 1031.
Mary Van Leuven is senior manager, Washington National Tax, at KPMG LLP in Washington, D.C.
For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with KPMG LLP. This article represents the views of the author or authors only and does not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.