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Section 1031 Exchanges: A Legitimate Tax Shelter for Business

Engaging in a "like-kind" exchange under IRC section 1031 is one of the few legitimate tax shelters available to corporations and other business entities engaging in disposition transactions. In a like-kind exchange, the taxpayer sells business property and acquires similar replacement property of equal or greater value within 180 days. By following the various requirements under section 1031, the taxpayer can defer gain on the sale of the "relinquished" property until the "replacement" property is sold at a future date.

Corporate tax managers should consider making it a priority to structure as many types of corporate transactions as possible to fit within section 1031. In general, there are two types of business asset dispositions that can be structured to qualify as a section 1031 exchange:

  • Isolated Assets, e.g., real estate, including raw land and buildings; personal property, including corporate aircraft, heavy machinery, telecommunications equipment, and artwork.

  • Lines of Business, e.g., newspapers, broadcast stations, distributorships, and franchises.

Section 1031 exchanges involving businesses are typically not simultaneous and include cash from buyers. Nonsimultaneous exchanges can be accomplished if the business uses a "qualified intermediary" - a third-party shell-entity that is retained as the taxpayer's agent.

A typical "forward" transaction is structured as follows:

Step 1. Corporation enters into a sale agreement with buyer to sell a business asset;

Step 2. Corporation enters into an agreement with a qualified intermediary and assigns its rights to the sale agreement to qualified intermediary;

Step 3. Buyer pays cash to qualified intermediary and corporation directly transfers the business asset to buyer;

Step 4. Corporation identifies a similar, "like-kind" business asset within forty-five days and enters into purchase agreement with its seller;

Step 5. Corporation assigns its rights to the purchase agreement to qualified intermediary; and

Step 6. Corporation directs qualified intermediary to pay cash to seller and seller transfers the purchased business asset directly to the corporation, all within 180 days of Step 1.

Isolated Business Asset Exchanges – Real Estate

The most common type of transaction designed to qualify under section 1031 remains the disposition of real estate. Corporate and other business tax managers should work closely with their company's real estate managers to ensure that real property dispositions are structured to qualify under section 1031 to the extent possible. The standard real estate acquisition or sales contract should contain a provision that permits the taxpayer to use a qualified intermediary structure to accomplish the section 1031 exchange, so long as the other party does not incur additional costs.

Real estate transactions remain the most common type of corporate transaction qualifying under section 1031 for several reasons. First, a broad category of real estate is "like-kind" property that can be exchanged tax-free. Raw land, parking lots, office buildings, warehouses, retail space, and manufacturing plants are "like-kind" with each other. A lease of thirty years or more of real estate is treated as real estate for section 1031 purposes. Second, because of the frequency of sales of real estate, it can be relatively easy to satisfy the requirement to complete the exchange within 180 days of the exchange's first leg.

There are a number of structuring issues that can arise in attempting to qualify under section 1031. Business tax managers should not become discouraged, as there is often flexibility to plan around potential roadblocks.

One issue that frequently arises is that the corporate affiliate disposing of real property is not the same corporate affiliate seeking replacement real property. If the corporate affiliate that disposes of the relinquished real property acquires the replacement property with a prearranged plan to transfer the real property title to the other corporate affiliate, that may not satisfy the "held for" requirement under section 1031. To resolve this issue, the corporate affiliate, instead of transferring the title to the replacement real property, can lease the property to the other affiliate. In this context, it is important that the lease be respected for income tax purposes as a true lease.

Another issue arises when a business locates replacement property before it can sell the relinquished property. The business can qualify for section 1031 treatment if it meets the complex requirements of a "reverse" exchange, where the replacement property is "parked" with a qualified intermediary until the relinquished property is sold.

The following is a "reverse exchange" transaction that we recently accomplished; it indicates how planning can be done to qualify a transaction under section 1031. Subsidiary A entered into an agreement to acquire a business, which included a valuable parcel of real estate that was needed in the business. Affiliate subsidiaries B and C planned to dispose of real estate in the near future. The transaction was structured as a "reverse" exchange qualifying under section 1031, with the parcel of real estate to be used by Subsidiary A serving as the replacement property. Subsidiaries B and C acquired undivided, tenancy-in-common interests in the parcel and leased them to Subsidiary A. Subsidiaries B and C, within 180 days of the acquisition, sold their real estate using a qualified intermediary structure.

One possible technique is a "build-to-suit" exchange. In this type of exchange, part or all of the replacement property received by the taxpayer consists of improvements that are constructed on the property while it is owned by the qualified intermediary. To fully utilize this technique, all of the cash proceeds from the sale of the relinquished property must be spent during the 180-day period, which can be a difficult task. The following transaction has been accomplished by taxpayers: (i) corporation leases its land to a qualified intermediary for a period of 30 years or more; (ii) the qualified intermediary constructs the improvements during the 180-day period; (iii) to complete the exchange, the qualified intermediary transfers the rights to the lease plus the improvements to the corporation.

Isolated Business Asset Exchanges – Personal Property

Corporate and other business tax managers may be surprised to realize the variety of personal property assets that they can attempt to dispose of under section 1031. Corporate aircraft is often disposed of and acquired in a section 1031 exchange. Other types of personal property that are sometimes exchanged under section 1031 include heavy machinery, telecommunications equipment (such as cable), restaurant equipment, fleets of cars and trucks, construction equipment, marine containers, rail cars, commercial aircraft, yachts and artwork. If a company leases such equipment as commercial aircraft, rail cars and marine containers, a section 1031 program can also provide significant tax benefits.

For an exchange of personal property to be like-kind, the relinquished property and the replacement property must be in a similar class - a service truck for a service truck, for example. To the extent that depreciation recapture would be triggered on the disposition of personal property under either sections 1245 or 1250, section 1031 would not defer such gain. Inventory also does not qualify as like-kind property. An asset cannot be like-kind property unless it is predominantly used in the United States.

In the case of corporate aircraft, care needs to be taken so that a "green" aircraft is fitted out and ready for delivery as replacement property within the 180-day exchange period. A "reverse" exchange is sometimes used in corporate aircraft exchanges in order to eliminate the risk that the corporation will not own any aircraft between transactions.

It is important to structure personal property exchanges to avoid or minimize state or local sales tax.

Lines of Business Exchanges

If a corporation or other business entity seeks to dispose of a line of business, doing so in a section 1031 exchange can result in significant tax savings. The types of businesses that have benefited from section 1031 exchanges often include businesses that operate in local markets, such as television stations, radio stations, newspapers, distributorships, and franchises. The business owner may want to dispose of one business in one metropolitan market in order to focus on another metropolitan market. Distributorships and franchises include sports teams, cable television franchises, beer distributorships, restaurant franchises, gas station franchises, automobile dealerships, and professional service practices.

Section 1031 exchanges are not limited to businesses that operate only in local markets. A national magazine could be exchanged for another national magazine. A software business could be exchanged for another software business.

Section 1031 exchanges are appropriate, of course, for businesses in which real estate is a significant element. These include businesses operating hotels, motels, warehouses, storage facilities, gas stations, power plants and paper mills.

A line of business exchange involves an exchange of multiple assets - real property, personal property, and intangible property. The exchange must be broken down into individual exchanges by category of "like-kind" assets. For example, the value of the office equipment relinquished must be matched against the value of the office equipment received.

Intangible assets are a key aspect of line-of-business exchanges. These include FCC licenses held by broadcast stations; subscriber lists held by newspapers, magazines, and cable television franchises; franchise and distributor agreements held by franchisees and distributors; and patents, copyrights, and technological know-how. To defer the maximum amount of gain, the value of a like-kind intangible asset received needs to be equal to or greater than the value of the like-kind intangible asset relinquished. Accordingly, it may be important to retain an appraiser to support the valuations.

IRS regulations provide that goodwill and going-concern value are never like-kind assets. However, case law supports the positions that the value of goodwill in a franchise should be included in the value of the franchise, and that broadcast stations do not have goodwill.

The following spreadsheet provides an example of a like-kind exchange of a television station for a television station. The spreadsheet shows the value of properties lumped in like-kind asset exchange categories, the realized gain in each category, the recognized gain, and the deferred gain. Note that the spreadsheet assumes no goodwill exists and that an exchange of going concern for going concern is taxable.

Television-for-Television Exchange

Company A and Company B agree to exchange television broadcast stations. Company A transfers its station to Company B and Company B transfers its station to Company A, plus $9,150,000 in cash. The parties agree that Company A's broadcast station is worth $118,700,000 and Company B's station is worth $109,550,000 (hence the need for Company B to make a cash payment). Each party intends for the exchange to qualify in part as tax-free under IRC Section 1031(a). The following spreadsheet is used by Company A to determine its taxable gain and deferred gain with respect to the station assets it surrendered, and the tax basis of the station assets it received. All amounts are in dollars. In general, realized gain is recognized to the extent of an "exchange group deficiency," which arises when the value of the assets in the like-kind exchange group that are received is less than the value of assets in the same exchange group that are surrendered.

Exchange Groups FMV Assets SurrenderedFMV Assets ReceivedExchange Group Surplus [Deficiency]Tax Basis of Surrendered AssetsRealized GainRecognized GainDeferred GainBasis of Assets Received
Tangible Assets
Real Property6,500,0006,000,000(500,000)4,000,0002,500,000500,0002,000,0004,000,000
Broadcast Equipment10,000,00012,000,0002,000,0001,000,0009,000,00009,000,0003,000,000
Office Equipment, F&F500,000600,000100,00050,000450,0000450,000150,000
Computer Equipment500,000400,000(100,000)200,000300,000100,000200,000200,000
Data Handling Equipment50,00050,000010,00040,000040,00010,000
Light Trucks400,000200,000(200,000)100,000300,000200,000100,000100,000
Heavy Trucks50,000100,00050,00010,00040,000040,00060,000
Tangible Assets Total18,000,00019,350,0001,350,0005,370,00012,630,000800,00011,830,0007,520,000
Intangible Assets
FCC Licenses100,000,00080,000,000(20,000,000)0100,000,00020,000,00080,000,0000
Favorable Programming Contracts05,000,0005,000,00000005,000,000
Favorable Tower Leases04,500,0004,500,00000004,500,000
Going Concern Value700,0000(700,000)0700,000700,00000
Going Concern Value0700,000700,0000000700,000
Intangible Assets Total100,700,00099,350,000(1,350,000)0100,700,00020,700,00080,000,00019,350,000

Nixon Peabody has considerable experience handling section 1031 transactions for businesses and guiding them through the complex steps that are often required. We work closely with our real estate and corporate attorneys to accomplish the transaction and can recommend trustworthy and competent qualified intermediaries. We represented the taxpayer in a recent case in which the IRS ruled that an FCC license for a radio station was like-kind with an FCC license for a television station. If you have any questions or require further information regarding these or any other matters, please call your regular Nixon Peabody contact, or feel free to contact Christian M. McBurney or one of Nixon Peabody's other Business tax attorneys.

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