Applicability of Sec. 1031 in Exchange of Agreements

Editor: Mark G. Cook, CPA, MBA, CGMA

A business might have many reasons to dispose of one or more of its assets and replace those assets with different but similar assets. This exchange of assets is frequently done by selling off assets and then purchasing others; however, this method of exchanging property may be inadvisable because of the possible taxable gain it could generate. A common business practice for avoiding that taxable gain is to engage in what is known as a Sec. 1031 exchange.

Sec. 1031 Exchange

A Sec. 1031 exchange, otherwise known as a 1031 exchange or like-kind exchange, occurs if, within 180 days, an asset being relinquished is replaced (i.e., exchanged) with an asset of like kind. Under Sec. 1031(a)(1), no gain or loss is recognized in this type of exchange and, therefore, it is not a taxable event. Instead, the basis of the newly acquired asset is adjusted to the amount of the basis of the relinquished property, decreased by any money the taxpayer might have received as well as by the amount of gain or loss that was created by the exchange. For purposes of this type of exchange, like-kind refers to the nature, character, or class of the property being exchanged but not necessarily to the grade or quality of the property. An example of a 1031 transaction would be the exchange of one rental building for another rental building.

Intangible Sec. 1031 Exchange

While 1031 exchanges are commonly done with tangible property, this Code section also applies to certain types of intangible property. The 1031 exchange rules for intangible property are slightly different from those for tangible property. Regs. Sec. 1.1031(a)-2(c)(1) provides that for intangible property, the nature or character of the rights to the property are considered, as well as the nature or character of the underlying property to which that intangible property relates. Regs. Sec. 1.1031(a)-2(c)(3) provides two examples that explain the distinction: (1) The taxpayer exchanges the copyright on one novel for the copyright on another novel, which would qualify as like-kind, or (2) the taxpayer exchanges the copyright on a novel for the copyright on a song, which would not qualify as like-kind.

In addition to the common intangibles of copyrights, trademarks, and patents, certain types of business agreements can fall under the umbrella of intangible property for purposes of Sec. 1031 exchanges. An exchange of business agreements, such as manufacturing or distribution agreements, qualify under Sec. 1031 for nonrecognition of gain or loss on the exchange if two requirements are met: (1) The rights under the agreements to be transferred in the exchange are of like kind, and (2) the nature or character of the underlying property to which the business agreement relates are of like kind.

If the terms of the business agreements to be exchanged are substantially similar, this would qualify the exchange as like-kind under the first requirement for an exchange of intangible property. The second requirement for intangible property is met if the underlying property subject to the agreement is of like kind. For instance, the exchange of distribution agreements whose manner of distribution is substantially similar and that have a largely common set of customers would qualify as a like-kind exchange. If both requirements are met, the exchange of business agreements will qualify for nonrecognition of gain or loss.

It should be noted that the intangibles of goodwill or going concern value of a business are not of like kind to the goodwill or going concern value of another business under Regs. Sec. 1.1031(a)-2(c)(2).

EditorNotes

Mark Cook is a partner with SingerLewak LLP in Irvine, Calif.

For additional information about these items, contact Mr. Cook at 949-261-8600 or mcook@singerlewak.com.

Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.