Vanishing Holding Requirements: Like-Kind Exchanges After Magneson, Bolker and The Tax Reform Act of 1984

A random glance at the real estate advertisements in any major newspaper indicates the extent to which exchanges of properties have become a major component of the investment market. Like-kind exchanges, although always present, have blossomed in number in recent years, due in large part to the Ninth Circuit's decisions in Starkerv. U.S., 602 F.2d 1341 (9th Cir. 1979), and related cases, which allowed taxpayers a wide range of timing and property selection in such exchanges, and to liberal Tax Court decisions permitting like-kind exchanges of partnership interests. Estate of Meyer v. Commissioner, 58 T.C. 311 (1972), non-acq. 1975-1 C.B. 3, aff'd 503 F.2d 556 (9th Cir. 1974); Gulfstrearn Land & Development Corp. v. Commissioner, 71 T.C. 587 (1979); Long v. Commissioner, 77 T.C. 1045 (1981); Pappas v. Commissioner, 78 T.C. 1078 (1982).

At the request of Administration officials, Congress acted to restrict deferred exchanges under Starker and exchanges of partnership interests, viewing them as abuses worthy of legislative correction. Section 77 Tax Reform Act of 1984; H.R. Rep. No. 98-432, Pt 2, at 12311234; S. Rep. No. 98-169 at 241-244. Left unchecked, however, was the recent trend of Tax Court decisions represented by the cases of Magneson v. Commissioner, 81 T.C. 767 (1983) and Bolker v. Commissioner, 81 T.C. 782 (1983), both suggesting that considerable leverage continues to exist in the exchange of assets similar to partnership property. Since the enactment of the Tax Reform Act of 1984, the Tax Court's decision in Magneson has been affirmed by the United States Court of Appeal for the Ninth Circuit. While both cases arose from disputes between the Commissioner and taxpayers over whether property exchanged or received was "held" for investment, their language indicates that the Tax Court will soon be required to re-decide whether corporate and/or partnership-like property will continue to be exchanged without recognition of gain after the Tax Reform Act of 1984.

The general rule regarding recognition of gain on sales or exchanges of property is set forth in Internal Revenue (hereinafter "IRC") Code Section 1001(c), which provides:

"Except as otherwise provided in this subtitIe, the entire amount of the gain or loss, determined under this Section, on the sale or exchange of property shall be recognized."

One of the most significant exceptions to the recognition rules of the Code is IRC Section 1031, which provides that no gain or loss is recognized if property held for productive use in trade or business or for investment is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment. Like other non-taxable exchange provisions, Section 1031 only provides an exception from current recognition of gain or loss realized, with recognition of gain or loss deferred until the exchanged property is disposed of in a subsequent taxable transaction. Further, the deferral of gain may not be complete, since the receipt of "boot" or the existence of recapturable depreciation under IRC Sections 1245 and 1250 may result in some income being currently recognized.

The rationale for non-recognition of gain or loss on like kind exchanges is twofold. First, it was understood to be a hardship for tax to be imposed upon a theoretical gain where a taxpayer was continuing his investment in illiquid property of a like-kind. H.R. Rep. No. 704 73rd Cong., 2nd Sess. 1939-2 C.B. 564; Koch v. Commissioner, 71 T.C. 54 (1978), acq. 1979-1 C.B. 1. Second, it was felt to be an administrative burden to detect and evaluate the innumerable (and usually minor) barters which take place on an annual basis. For these reasons, the non-recognition treatment of like-kind exchanges has existed in the Internal Revenue Code almost from its inception.

Under the parenthetical exclusion of Section 1031 (a) prior to its amendment under the Tax Reform Act of 1984, stock-in-trade or other property held primarily for sale, stocks, bonds, notes, choses in action, certificates of trust, securities or evidences of indebtedness were unqualified for non-recognition exchange treatment. Effective for transfers after March 31, 1984, the Tax Reform Act adds partnership interests as non-qualified property for deferred treatment under IRC Section 1031.

What, then, would be the result if a partnership were terminated and the underlying property transferred in exchange for like-kind property, which was subsequently recontributed to a new partnership? For many real estate partnerships with a small number of partners, this may well be a viable alternative to an actual exchange of the partnership interest itself. Under IRC Section 731(a) and (b), distribution in liquidation of a partner's interest is generally tax-free to both the distributee and the distributing partnership, except to the extent that cash is distributed in excess of the partner's adjusted basis, or to the extent of distributions of cash, unrealized receivables and inventory. Contributions of property to a partnership are similarly tax-free to the contributing partner under IRC Section 721 (a) except to the extent that liabilities in excess of adjusted basis are assumed. If an intervening transfer of property can be conducted without the recognition of gain or loss, then an effective exchange of partnership interests will have been accomplished by reducing the exchange to its component parts. Certainly, the properties would have to be of like kind, but such was the requirement for underlying partnership property prior to the amendment of IRC Section 1031 by the Tax Reform Act of 1984.

Until the recent trend in Tax Court decisions, the principal impediment in obtaining non-recognition treatment was the requirement in IRC Section 1031 that both the exchanged and received properties be "held for productive use in trade or business or for investment." With the proposed exchange being one of recently distributed partnership property, there are two troublesome aspects of this requirement: (i) both properties must be "held" by the partner at the time of the transfer and exchange rather than by an entity owned by the transferor and (ii) the requisite investment purpose must be present.

Whether property is held by a taxpayer or by a related entity is a question of fact. Waltham Netoco Theaters, Inc., v. Commissioner, 49 T.C. 399 (1968), aff'd 401 F.2d 333 (1st Cir. 1968). The principal cases in this area are those of Commissioner v. Court Holding Co., 324 U.S. 331, 65 S.Ct. 707 (1954) and United States v. Cumberland Public Service Co., 338 U.S. 451, 70 S.Ct. 280 (1950). In Court Holding, a corporation agreed to sell a commercial building and contracts were drafted setting forth the terms of sale. When it was discovered that the sale would result in the imposition of a substantial income tax at the corporate level, the contracts were redrafted to show the shareholders as sellers, and the building was distributed to them in complete liquidation prior to execution of the new contract of sale by the shareholders. The Supreme Court held that the transaction was a corporate sale and income tax was imposed on the corporation. While the Court Holding problem has been largely legislated out of existence by IRC Section 337, it still stands for the rule that an entity will be subject to tax in the event it negotiates a sale, notwithstanding that shareholders are later substituted in as parties following liquidation. In Cumberland Public Service Co., the Supreme Court modified the Court Holding rule in a situation where the facts indicated that the shareholders were dealing on their own account rather than as agents or officers of the corporation, even where the property was held by the corporation at the time of negotiations. The Court in Cumberland noted that the distinction may be Aparticularly shadowy and artificial."

The danger that a transaction may be deemed to have been consummated by a related entity rather than by the taxpayer seeking to make the exchange is equally applicable to exchanges under IRC Section 1031. In Bolker v. Commissioner, the Tax Court held that, where property received in a Section 333 one-month liquidation was exchanged in a pre-arranged transaction for other like-kind property, the exchange qualified under Section 1031. The Court examined all of the facts and circumstances of the negotiations and determined that the transaction was negotiated and consummated by the individual shareholder rather than the corporation, even though the time period of negotiation preceded distribution and liquidation of the corporation.

It is reasonable to assume that these cases are equally applicable to transactions involving partnerships and partners, since for many purposes the Internal Revenue Code recognizes partnerships as taxable entities. See, for example, IRC Section 1033, where non-recognition treatment is available for involuntary condemnations of property only where this election and replacement of property is made by the partnership itself and not the individual partners. Demiriian v. Commissioner, 54 T.C. 1691, aff'd 457 F.2d 1 (3rd Cir. 1972); Rev. Rul. 66-191.

If, under these authorities, a partnership will be recognized as a separate entity for purposes of tax-free exchanges under IRC Section 1031, in order to avoid the partnership being treated as the transferor all negotiations and transactions must be carefully orchestrated to make clear that they are being conducted by a partner in his individual capacity. Under the language of Bolker, it would appear that a partner could negotiate an eventual transaction of property received in distribution prior to its actual receipt without violating the entity concept of Court Holding.

It the exchanged property has been recently received in liquidation of a partnership, or if the received property is immediately transferred to a partnership, the question is whether either property will be deemed to have been held for investment" as required under IRC Section 1031 (a), particularly if the taxpayer receiving the properties negotiates for the exchange of the properties prior to their receipt.

Neither the Code nor the regulations defines "held for investment" as set forth in IRC Section 1031, although Regulation Section 1.1031(a)-l(b) provides the following definitions of "investment":

"Unproductive real estate held by one other than a dealer for future use or future realization of the increment in value is held for investment..."It seems certain, nonetheless, that some intent to hold property for investment must be present at the time the property is acquired. If property is acquired with an intention to later sell the property to customers, Section 1031 treatment will be denied. Land Dynamics 37 T.C.M. 1119 (1978). In S.H. Klarkowski, 24 T.C.M. 1827 (1965), aff'd on other grounds, 385 F.2d 398 (7th Cir., 1967), real property received in an exchange was held for six years before being sold as a single parcel, yet the Tax Court determined that the property was held not for investment but for sale, since the intent at the time of acquisition determines the future tax treatment under IRC Section 1031. Property received in an exchange which is held with intent to make a gift of the property will similarly be denied non-recognition treatment. (Compare Click v. Commissioner, 78 T.C. 225 (1980) where non-recognition treatment was allowed in a case in which the taxpayer's intent to make a gift did not arise until shortly after acquisition of the property.)

In a pair of 1983 decisions, however, the Tax Court has signaled a more liberal attitude toward the investment requirement for like-kind exchanges. In Magneson v. Commissioner, 81 T.C. 767 (1983), aff'd 753 F.2d 1490 (9th Cir., 1985), the Tax Court ruled that the prearranged transfer of an interest in real property to a partnership following a tax-free exchange satisfied the holding requirement of IRC Section 1031(a). The majority reasoned that the contribution represented a continuation of the old investment and not a liquidation of that investment since the transfer to the partnership was not taxable under IRC Section 721. Writing for the majority, Judge Goffe examined the legislative history and intent behind IRC Section 721, which allows a tax-free contribution of property to a partnership, and concluded that inasmuch as the partnership interest was simply the continued holding of the property received in different form, the "holding for investment" requirement of IRC Section 1031 was satisfied. The Tax Court stated:

"The contribution of Plaza Property to U.S. Trust admittedly is a nontaxable transaction under Section 721 which, together with Section 1031, is unequivocally described above in Section 1.1002-1, Income Tax Regs., as representing a continuation of the old investment, not a liquidation."

While the authorities cited are far from overwhelming, the clear statement of the majority opinion in Magneson is that the "holding" issue will be resolved in favor of the taxpayer where acquisition is followed by a tax-free transfer of property to a partnership which continues to hold for investment. However, a five judge dissent viewed the result in Magneson as contrary to established authority, especially Rev. Rul. 75-292, 1975-1 C.B. 333, discussed below. Writing for four of the dissenting judges, Judge Tannenwald differentiated the rights of a fee owner of property from those of a partner under the applicable local law (California) and went on to state:

"Whatever the reach of that requirement may be where the taxpayer immediately exchanges the property received in the transaction for which the benefits of Section 1031(a) is claimed in a tax-free transaction for an interest in the property of a like-kind and the rights of the taxpayer are substantially the same as those which it had in the property previously received, that requirement is clearly not satisfied where those rights are not substantially the same."

The Ninth Circuit's affirmance in Magneson undoubtedly lends support to the Tax Court majority opinion, but the decision leaves many questions unanswered. The Ninth Circuit viewed the Magneson exchange as two separate transactions: a transfer of a 100% fee interest in property for a 1/10 undivided interest in a partnership property, followed by a transfer of the undivided interest for a general partnership interest in property holding similar underlying property. In the court's view, the first exchange constituted the only relevant transaction under IRC Section 1031, with the subsequent tax-free contribution to a partnership under IRC Section 721 not being a true exchange. The court stated:

"The Magneson's transactions therefore fit squarely within the central purpose of Section 1031. They exchanged their investment property for like-kind investment property which they continue to hold for investment, albeit in a different form of ownership."

To reach this conclusion, the court engaged in a confusing examination of the taxpayer's intent upon receipt of the like-kind property, in this case the 1/10 undivided interest. The court recognized that the taxpayer must intend to hold the property for investment, and it was stipulated that the Magnesons intended at the time of the exchange to hold the property for contribution to the partnership. In allowing this transaction to qualify for like-kind exchange under Section 1031, the court implicitly held that intent to transfer to a partnership is equivalent to intent to hold for investment, a difficult conclusion to justify. Yet in an inexplicable shift of gears, the court stated in its conclusion that such a transaction would only be permitted if the partnership intended to hold the acquired property for investment. The court stated:

"Further, the taxpayer must show, as the Magnesons have here, that the purpose of the partnership is to hold the property for investment..."

In bolstering its opinion, the Ninth Circuit Court of Appeals, in an elaborate piece of dictum designed to distinguish Revenue Ruling 75292, held that a similar transaction followed by a tax-free transfer to a corporation under IRC Section 351 would not qualify under IRC Section 1031 as a like-kind exchange. In reaching this conclusion, the court stated that a corporate shareholder's interest in a corporation's property is significantly different from a partner's interest in partnership property under California law, and that a partner's interest in property was the practical equivalent of a fee ownership. As the minority pointed out in the Tax Court's decision, this rationale is certainly not above argument. Secondly, the Ninth Circuit Court of Appeals stated that stock was specifically ineligible as like-kind property while partnership interests were eligible. While this may have been true at the time of the Magneson transaction, after the Tax Reform Act of 1984 partnership interests are no longer eligible for like-kind exchange treatment under IRC Section 1031. Further, in indulging in this argument, the court tacitly reduced the transaction to a single exchange of a fee interest in property for a partnership interest, an argument which is fatal under the Tax Reform Act of 1984.

In Bolker v. Commissioner, 81 T.C. 782 (1983), the Tax Court held that, where property received in an IRC Section 333 liquidation was exchanged in a pre-arranged trans action for other like-kind property, the subsequent like-kind exchange qualified under Section 1031(a). The Court relied on its decision in Magneson and determined that the fact that the tax-free transaction preceded rather than followed the like-kind exchange was not significant enough to warrant a different result. The Court in Bolker stated:

"We believe Magneson entities petitioner to relief herein. In both Magneson and the instant case, property A was exchanged for property B in a like-kind exchange, both properties being held for business or investment as opposed to personal purposes. In Magneson, the exchange of A for B was immediately followed by a tax-free section 721 transfer; in the instant case the exchange of A for B was immediately preceded by a tax-free acquisition under Section 333. That the tax-free transaction preceded rather than followed the exchange is insufficient to produce opposite results. For as noted, Section 1031's holding for business or investment requirement is reciprocal, equally applicable to properties at both ends of an exchange. Nothing in the policy underlying Section 1031 suggests that this minor variation in sequence warrants treating taxpayers dramatically different."

Although IRC Section 1031 requires that both the property transferred and the property received be held for use in a trade or business or for investment, the majority of cases which litigate this issue concern the holding period of the property received in the exchange, rather than the property transferred. Presumably, this is so because there is little or no gain inherent in property acquired immediately before an exchange or disposition. The decisions prior to Magneson and Bolker reach results which tend to be adverse to the exchanging taxpayer, and require clear evidence of holding period and intent. In Regals Realty Co. v. Commissioner, 43 B.T.A. 194 (1940), acq. 1941-1 C.B. 9, aff'd 127 F.2d 931 (2nd Cir. 1942), the property received in the like-kind exchange was immediately transferred to a new corporation, and thus was held to have failed the holding period requirement for the property received. In Black v. Commissioner, 35 T.C. 90 (1960), a taxpayer received property which she then repaired, improved and sold nine months later, and the Tax Court held that this did not constitute property held for investment. In Griffin v. Commissioner, 49 T.C. 253 (1967), the taxpayer had previously obligated himself to sell the property received in the exchange to a new purchaser and the Tax Court determined that the property received was clearly not held for investment. In Rev. Rul. 75-292, supra, the Service examined a situation in which a taxpayer made a like-kind exchange and then, in a prearranged transaction, transferred the property tax-free to a corporation in exchange for stock under IRC Section 351. The Service ruled that the property received was not to be held for investment in that it was to be transferred to the new corporation, and therefore the like-kind exchange did not qualify under IRC Section 1031. In Rev. Rul. 57244, an older and somewhat unusual ruling favoring the taxpayer, the Service reviewed a situation where three individuals owning contiguous parcels of undeveloped real property exchanged lots, and one of the individuals then sold his newly acquired lot to an unrelated individual. Although the ruling does not specify the time or circumstances of the taxpayer's later sale, the Service ruled that the like-kind exchanges constituted tax-free transfers under Section 1031, notwithstanding the later transfer.

The decisions in Magneson and Bolker have given practitioners pause to reconsider the appropriateness of non-recognition treatment on like-kind exchanges of partnership property, especially in light of the prohibition against such transfers added to IRC Section 1031 by the Tax Reform Act of 1984. If the Tax Court does not revise its trend in this area, or if the trend is not reversed by appeal or legislation, the impact of the amendment to IRC Section 1031 may well be emasculated.

While there is no specific time requirement set forth in the statute, and despite the lack of clarity of the published decisions, it seems reasonable to assume that like-kind property must be held with the intent of investment for some period of time. Property acquired simply for the purposes of an exchange would not be "held for" the prescribed purpose, no matter how long the property is actually held, if the intent to hold is not present. Compare the recently issued Private Letter Ruling 8429039, where the Internal Revenue Service stated that even where the requisite intent is present it looks to the taxpayer to hold property for a minimum of two (2) years, with Klarkowski, cited supra, which held that actual time held for investment is not material if intent to hold is not present, and Click, cited supra, which allowed an exchange under Section 1031 even though the intent to hold for investment changed shortly after acquisition.

Discretion may be the better part of valor in this area, at least until further guidance is forthcoming.