Over the past few decades, I have had several debates about what constitutes “like kind” as part of Section 1031 tax deferred exchanges.  A new type of disagreement that I had never heard of in my 27+ years of consulting on 1031 exchanges came up a few weeks ago, as Sherry was working with an exchange client who wanted to dispose of a poultry farm and replace it with a different kind of farm property.  Their CPA had told them that such an exchange was not legal, which led to the following email exchange between me and that client’s CPA.   

From The Exchange Client:

Our accountant tells us that the 4 poultry houses (with a Tyson contract) will not fall under a 1031 because they are a single purpose agricultural unit and would be considered a personal business and "theoretically" could be moved.  We questioned this because we thought we could use them in the exchange also and further reduce the tax load.

My first email to the client’s CPA:

As you know, some kinds of real estate are allowed by IRS to be depreciated under Section 1245, while others are under Section 1250. The definition of like kind for 1031 exchanges does not distinguish between depreciation classes. 

The only description given in IRS rules, regulations and instructions has been "real property for real property" without regard to class.  In all of my years working in this area, I have never seen or heard anything from IRS requiring that the original and replacement properties be depreciable under the same code section (1245 or 1250).  What is more critical is how state law classifies the property.  If they treat it as real property and not personal property, then it falls under the same general classification for 1031 exchanging.

Over the years, I have actually prepared a number of returns where Section 1245 real property has been exchanged for 1250 real property and IRS has never had any problems.

I just pulled out one of my main reference sources regarding 1031 exchanges, the Thomson-West book "Tax Free Exchanges Under Section 1031."  I couldn't find any distinction regarding exchanging between Section 1245 and 1250 properties.  They have a short list of some examples where different kinds of real property have been treated as qualifying like kind under Section 1031.  Some of these aren't even under Section 1245 or 1250; so the definition of like kind for real property is very very wide.

I will copy these pages and fax them to you later this afternoon.

I hope this clears up any confusion you may have.

Kerry Kerstetter

His Reply:

Kerry, I got your fax.  I agree that there are no class distinctions regarding section 1250 property and that the the choices here are very broad.  However, the exchange of 1245 property for real estate is denied by the regs.  How do you get around the IRS definition of poultry houses? 

 

The fact that your exchanges have never been challenged doesn't mean the IRS agrees with them.  I'm wondering if your contracts are being attached to returns, and whether they separately identify all the section 1245 property involved. If not, maybe we should try one and see if it flies. If you have no objections, we could do the client’s contract in that manner, and I'll submit a copy with their return. 

 

Let me know.  Thanks. 

My Answer:

As I've said, we've never had any problems with IRS accepting the classification of poultry houses as business real property as long as they were assessed by the local counties as such.

This is very similar to a situation I have frequently encountered over the past 20+ years when discussing 1031 exchanges with various people.  A common misconception is that only the exact same kinds of real estate must be involved in an exchange.  For example, a single family rental house can only be replaced with another single family rental house.  Or an office building can only be replaced with an office building; and so on.  I have heard this from many tax pros, as well as from IRS auditors.  When I explain that the definition of "like kind" is any type of business or investment real property for any type of business or investment property, they ask me when the rules were changed to allow this kind of cross-over between different kinds of real estate.  I then explain that those were always the rule and it was never restricted to the same exact kinds of real estate.  IRS's own instructions for valid like kind exchanges include examples of different types and classes of real estate being involved. 

However, as you know, with personal property, the definition of valid "like kind" is much more narrow and is where the depreciation classes used are extremely important in deciding whether the original and replacement property qualify for Section 1031 treatment.

The 8824s reporting the exchanges have always included complete descriptions of the properties involved; so IRS has had plenty of chances to see where special use properties such as poultry houses and self storage units have been exchanged for completely different kinds of real properties.  IRS has never had any problems with the returns I prepared and we have never heard of any problems with tax returns that were prepared by other accountants for these same kinds of exchanges.  

I've never attached an actual exchange agreement to the tax returns that I have prepared, and I have no way of knowing if any other tax preparers attached any to the returns they prepared.  However, I have always been a big believer in attaching a ton of explanatory info to tax returns when there are things that may be considered out of the ordinary. That is the main reason I have never believed in the IRS's electronic filing program.  If you feel such a need to attach a copy of the exchange agreement to the clients' 1040, by all means do that.  I am completely confident that there will be no problem from IRS in regard to this.

Kerry Kerstetter

What I didn’t include in any of emails was the fact that I also went through the TaxTools questionnaire / flowchart regarding qualification for a 1031 exchange with this client's info and it qualified with no problem.  In fact, it never asks for the type of depreciation that was claimed on either the original or replacement property.  As I mentioned earlier, I had never seen or heard of that being a factor in determining like kind status of property.  As long as the county assessed the poultry houses as real property (which it did) and not personal property, IRS would honor that as like kind for an exchange into other types of business or investment real property.  

Labels: 1031

- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 8/07/2005 11:00:00 AM Send this post: