Editor: Michael Dell, CPA
Gains & Losses
In Chief Counsel Advice (CCA) 201238027, the IRS concluded that state law property classification does not control whether exchanged properties are considered of “like kind” for purposes of Sec. 1031. Rather, federal income tax law controls and requires consideration of all facts and circumstances, including state law and federal tax law classifications, as appropriate.
Facts and Analysis
For an exchange of properties to qualify for deferral treatment under the like-kind exchange rules of Sec. 1031, the properties must be of like kind. Regs. Sec. 1.1031(a)-1(b) states that the words “like kind” refer to the nature or character of the property and not to its grade or quality, and that one kind or class of property may not be exchanged for property of a different kind or class. The regulation also notes that 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.
CCA 201238027 offers four examples to illustrate whether state law characterizations of property as real or personal affect whether the property is of like kind. Example 1 involves an exchange of a natural gas pipeline in State 1 (constructed along a right of way on real property) that is classified as personal property in State 1 for a State 2 natural gas pipeline that is classified as real property in State 2.
While in some cases courts have looked to state law classifications of property as real or personal in determining whether exchange property is of like kind, the IRS explained, the courts have relied on more than just state law classifications in their analysis. The IRS pointed out that other cases demonstrate that the like-kind determination is a question of federal law rather than state law, and that relying solely on state property classifications can lead to absurd results. Thus, state law property classifications do not determine whether property is of like kind; rather, the determination is a federal one that considers all facts and circumstances.
Accordingly, the IRS concluded in Example 1 that the state law characterization of the pipelines does not override the basic nature and character of the property involved. The pipelines are of the same nature and character and, thus, are of like kind for purposes of Sec. 1031. The IRS also explained that the pipelines are treated as real property because they are inherently permanent structures that are affixed to land and, thus, when applying the multiple property exchange rules of Regs. Sec. 1.1031(j)-1, taxpayers should include the pipelines in the real property exchange group.
Example 2 illustrates that a steam turbine (used for the commercial production of electricity) attached as a fixture to a building and treated as real property under state law is of like kind to a similar steam turbine located in another state that is treated as personal property in that state. The IRS also explained that the steam turbines are machinery and, thus, personal property for purposes of the like-kind exchange rules. Example 3 illustrates that a steam turbine classified under state law as real property is not of like kind to raw land. Example 4 illustrates an exchange involving both pipelines and a steam turbine. To the extent the exchange consisted of the pipelines, the property qualified as like-kind, but the steam turbine did not qualify.
Case law and administrative guidance addressing the like-kind standard of Sec. 1031 have often referred to state law property classifications, especially when considering exchanges of real property. However, the authorities were often unclear as to the exact role state law played in determining whether properties at issue were of a like kind, and which state law was relevant (e.g., those relating to property tax, sales tax, intestacy, etc.). This guidance should help taxpayers and advisers avoid absurd results from basing the like-kind determination solely on state law classifications.
Michael Dell is a partner with Ernst & Young LLP in Washington, D.C.
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