Personal Property Exchange Programs
By Gregory J. Rocca and Michael K. Phillips
Copyright 2005 Pacific Realty Exchange, Inc. All rights reserved.
In Rev. Proc. 2003-39, 2003-22 IRB 1, the IRS provided administrative
safe harbors for Like-Kind Exchange (LKE) Programs involving multiple
exchanges of 100 or more properties, such as exchange programs for fleets
of leased vehicles. The safe harbors are of immense benefit to corporations
engaged in large personal property exchange programs. Under the first
safe harbor, each exchange of a property is treated as a distinct exchange
under Section 1031, even if a relinquished property is part of a group
of properties. Consequently, the failure of one property exchange within
a group to qualify for Section 1031 treatment does not preclude Section
1031 from applying to other exchanges from within the group of properties.
The IRS also provided safe harbors in which taxpayers engaged in a LKE
Program will not be deemed to be in actual or constructive receipt of
money or other property upon processing a check, depositing proceeds into
a joint bank account, netting funds against sales prices, and lending
money to a buyer. Finally, the IRS provided safe harbors relating to the
definition of a qualified intermediary (QI) in a LKE Program. The safe
harbor allows the QI to receive assignments of rights and receive and
pay funds with respect to unmatched properties that fail to qualify under
Section 1031. The IRS also allowed the taxpayer’s assignment of
rights to an intermediary in a master exchange agreement to satisfy the
assignment safe harbor of Reg. Section 1.1031(k)-1(g)(4)(v) provided that
written notice of the assignment is given to each buyer and seller on
or before the date of transfer.
The revenue procedure provides safe harbors with respect to programs involving
ongoing exchanges of tangible personal property using a single intermediary.
The IRS determined that “it is in the best interest of sound tax administration
to provide taxpayers with guidance regarding the qualification of LKE Programs” under
Section 1031. The safe harbors only apply to certain exchanges of tangible
personal property pursuant to LKE Programs. The principles set forth in
sections 4 through 6 of the revenue procedure have no application to any
federal income tax determinations other than determinations that involve
LKE Programs qualifying for one or more of the safe harbors. For a transaction
to qualify under Section 1031, the transaction must also satisfy the requirements
of Section 1031 for which safe harbors are not provided in the revenue procedure
(e.g., whether property involved in an exchange is considered like-kind
property within the meaning of Section 1031).
Under the revenue procedure, an “LKE Program” is an ongoing
program involving multiple exchanges of 100 or more properties. Although
LKE Programs may differ in various ways, an LKE Program must have all of
the following characteristics:
(1) The taxpayer regularly and routinely enters into agreements to sell
tangible personal property as well as agreements to buy tangible personal
property;
(2) The taxpayer uses a single, unrelated intermediary to accomplish the
exchanges in the LKE Program;
(3) The taxpayer and the intermediary enter into a written agreement (“master
exchange agreement”);
(4) The master exchange agreement expressly limits the taxpayer’s
rights to receive, pledge, borrow, or otherwise obtain the benefits of money
or other property held by the intermediary as provided in Reg. Section 1.1031(k)-1(g)(6);
(5) In the master exchange agreement, the taxpayer assigns to the intermediary
the taxpayer’s rights (but not necessarily its obligations) in some
or all of its existing and future agreements to sell relinquished property
and/or to purchase replacement property;
(6) The taxpayer provides written notice of the assignment to the other
party to each existing and future agreement to sell relinquished property
and/or to purchase replacement property;
(7) The taxpayer
(a) implements a process that identifies potential replacement property
or properties before the end of the identification period for the relinquished
property or group of relinquished properties of which it is disposing in
each exchange,
(b) complies with the identification requirement by receiving replacement
property or properties before the end of the 45-day identification period,
or
(c) satisfies the identification requirements by a combination of the approaches
in (a) and (b);
(8) The taxpayer implements a process for collecting, holding and disbursing
funds (which may include the use of joint taxpayer and intermediary bank
accounts, or accounts in the name of a third party for the benefit of both
the taxpayer and the intermediary) that ensures that the intermediary controls
the receipt, holding, and disbursement of all funds to which the intermediary
is entitled (i.e., proceeds from the sale of relinquished properties);
(9) Relinquished property or properties that are transferred are matched
with replacement property or properties that are received in order to determine
the gain, if any, recognized on the disposition of the relinquished property
and to determine the basis of the replacement property; and
(10) The taxpayer recognizes gain or loss on the disposition of relinquished
properties that are not matched with replacement properties, and the taxpayer
takes a cost basis in replacement properties that are received but not matched
with relinquished properties.
A taxpayer may conduct more than one LKE Program simultaneously. In such
a case, each LKE Program is evaluated separately for purposes of determining
whether that LKE Program qualifies for the safe harbors of the revenue procedure.
The IRS also recognized that exchanges of property pursuant to LKE Programs
may qualify for nonrecognition treatment under Section 1031 although they
fall outside the safe harbors provided in the revenue procedure. The revenue
procedure provides that “no inference is intended with respect to
the federal income tax treatment of transfers of relinquished property and
acquisitions of replacement property that do not satisfy the terms of the
safe harbors provided in this revenue procedure.” Further, each of
the paragraphs under section 4 (separate exchange), section 5 (actual or
constructive receipt) and section 6 (definition of qualified intermediary)
of the revenue procedure is considered a distinct safe harbor. Therefore,
a taxpayer who fails to qualify for the benefits of one safe harbor may
nevertheless qualify for the benefits of another safe harbor.
Under Section 4 of the revenue procedure, in a LKE Program, the taxpayer’s
transfer of each relinquished property or group of relinquished properties
and the taxpayer’s corresponding receipt of each replacement property
or group of replacement properties with which the relinquished property
or group of relinquished properties has been matched by the taxpayer is
treated as a separate and distinct exchange for purposes of Section 1031.
The determination of whether a particular exchange qualifies under Section
1031 is made without regard to any other exchange. Replacement property
that is received within the 45-day identification period or that is otherwise
properly identified as provided in Reg. Section 1.1031(k)-1(c) is treated
as satisfying the requirement of Section 1031(a)(3) that replacement property
be identified, notwithstanding that it may not be matched with relinquished
property until after the end of the 45-day identification period. The replacement
property must, however, be matched no later than the due date (determined
with regard to extensions) of the taxpayer’s return for the year of
the transfer of the relinquished property.
Under Section 5 of the revenue procedure, any requirement that the taxpayer
transfer money or other property to the qualified intermediary will be deemed
to be satisfied if the amount of money held by the qualified intermediary
and the amount of money in any joint account equals or exceeds the amount
of proceeds from the sale of relinquished property (including the amount
that is required to be transferred by the taxpayer) that has not yet been
used to acquire replacement property. Further, a taxpayer engaged in an
LKE Program will not be considered to be in actual or constructive receipt
of proceeds from the sale of relinquished property deposited into or held
in a joint bank, trust, escrow, or similar account in the name of the taxpayer
and the qualified intermediary, or in an account in the name of a third
party (other than a disqualified person) for the benefit of both the taxpayer
and the qualified intermediary if certain requirements are met.
Under Section 5 of the revenue procedure, a safe harbor is also provided
for netting of funds. A taxpayer engaged in an LKE Program will not be considered
to be in actual or constructive receipt of money or other property as a
result of transferring relinquished property solely because an amount owed
by the taxpayer to the buyer (other than a lease security deposit) is netted
against the sales price of the relinquished property, provided that, as
required by the master exchange agreement, funds equal to the full amount
of sales proceeds from the relinquished property are transferred to or for
the benefit of the qualified intermediary by the opening of the next day’s
business. Likewise, a taxpayer acquiring replacement property in a like-kind
exchange will not be considered to be in actual or constructive receipt
of money or other property solely because an amount owed by the seller to
the taxpayer is netted against the purchase price of the property and the
qualified intermediary transfers to the taxpayer funds in an amount equal
to the amount owed by the seller to the taxpayer so that the qualified intermediary
expends the full amount of the purchase price obligation for the replacement
property.
The taxpayer may also act as a lender to the purchaser. If a taxpayer
that is engaged in an LKE Program lends money to the buyer for the purchase
of the taxpayer’s relinquished property, the taxpayer’s receipt
of the buyer’s promissory note or other evidence of indebtedness will
not be considered actual or constructive receipt of money or other property
if: (1) The taxpayer makes similar loans in the ordinary course of its business
operations; (2) The buyer is not obligated to obtain financing from the
taxpayer for the purchase of the relinquished property, but rather is free
to borrow the funds from another lender; (3) The taxpayer’s loan to
the buyer is an arm’s-length transaction at the prevailing market
terms; and (4) As required by the master exchange agreement, the taxpayer
promptly transfers funds equal to the loan proceeds (plus a market rate
of interest on such amount for the period between the date of the sale of
the relinquished property and the date of the transfer of the loan proceeds
to the qualified intermediary) to or for the benefit of the qualified intermediary.
Further, if the taxpayer is the lessor of the property being purchased by
the buyer-lessee, the buyer-lessee’s application of its lease security
deposit to the purchase price of the relinquished property will not be considered
actual or constructive receipt of money or other property. The taxpayer
must promptly transfer funds equal to the lease security deposit to the
qualified intermediary.
Under Section 6 of the revenue procedure, for purposes of determining
whether an intermediary is a disqualified person in the context of a LKE
Program, the intermediary will not fail to be a qualified intermediary merely
because the intermediary:
(1) is assigned the taxpayer’s rights in its agreements to sell relinquished
properties that ultimately are not matched with replacement properties under
the taxpayer’s LKE Program; (2) is assigned the taxpayer’s rights
in its agreements to buy replacement properties that ultimately are not
matched with relinquished properties under the taxpayer’s LKE Program;
(3) receives funds with respect to the transfer of relinquished property
that ultimately is not matched with replacement property under the taxpayer’s
LKE Program; or (4) pays funds with respect to the acquisition of replacement
property that ultimately is not matched with relinquished property under
the taxpayer’s LKE Program. Finally, the taxpayer’s assignment
in the master exchange agreement to the intermediary of the taxpayer’s
rights (but not necessarily its obligations) in existing and future agreements
to sell relinquished property and/or to purchase replacement property, and
the taxpayer’s written notice of the assignment to the other party
to each agreement on or before the date of the relevant transfer of property,
will be effective to satisfy the assignment safe harbor and notice requirement
under Reg. Section 1.1031(k)-1(g)(4)(v).
The issuance of Rev. Proc. 2003-39 for LKE Programs should obviate the
need for private letter ruling requests for such programs in the future.
However, taxpayers may continue to request such rulings as it relates to
the “like-kind” property issue. In PLR 200327039, the IRS ruled
that certain categories of depreciable personal property that a company
leases and then exchanges under a LKE program using a qualified intermediary
(QI) qualified for like-kind treatment. Under the exchange program, the
company proposed to classify exchange property in three categories as belonging
to one like-kind group and exchange property in three other categories as
belonging to a different like-kind group. The different groups of relinquished
and acquired property will be matched for exchange purposes.
In PLR 200327039, sales proceeds flowed through a LKE joint account structure
with a QI and were used to acquire replacement property (RP). Information
about relinquished property (RQ) and RP will be analyzed by a computer algorithm
to match RQ with RP. The matches will be made according to certain parameters
designed primarily to maximize the benefits of the LKE Program. For example,
RQ will be matched only with RP acquired within 45 days of the date RQ was
transferred to its purchaser and, to the extent possible, RQ will be matched
with RP costing at least as much as the RQ. In the LKE transactions that
will occur under this system, the taxpayer proposed to classify exchange
property consisting of Category A, Category B, and Category C as belonging
to Class 1 and exchange property consisting of Category B, and Category
C, and Category D as belonging to Class 2. RQ in Class 1 will be matched
only with RP in Class 1 and RQ in Class 2 will be matched only with RP in
Class 2.
The IRS found that, under the Product Class safe harbor, according to Subsector
xx of the NAICS Manual, property within Categories B, C and D are all of
the same Product Class. The IRS went on to state that the General Asset
Class and Product Class safe harbors are not the exclusive method for determining
if exchange properties are of like kind. For depreciable tangible personal
property to be considered of like kind, the property can be either like
kind or like class. Reg. Section 1.1031(a)-2(a) provides that an exchange
of properties of a like kind may qualify under Section 1031 regardless of
whether the properties are also of like class. The IRS found that, even
within the more restrictive parameters of the like-kind standard as applied
to personal property, the differences between the properties in Category
A, Category B and Category C did not rise to the level of a difference in
nature or character but were merely a difference in grade or quality. Therefore,
the IRS ruled that properties described as belonging to Categories, A, B
and C are of like kind even if they do not belong to the same General Asset
Class. Also, properties in Categories B, C and D are of like kind or like
class because they are within the same Product Class.
Second, the IRS ruled that the taxpayer’s transfer of each RQ, or
group of RQ, and the corresponding receipt of RP, or group of RP, in accordance
with the master exchange agreement will be treated as a separate and distinct
exchange for purposes of Section 1031. The IRS noted that taxpayers are
allowed “great latitude” in structuring transactions under Section
1031, citing Biggs v. Commissioner, 69 T.C. 905, 913 (1978). Moreover, the
regulations governing exchanges of multiple properties require such matching
when taxpayers exchange multiple properties. See Reg. Section 1.1031(j)-1(a)(2)(i).
The IRS concluded that “if an exchanger is complying with all requirements
under the Code and regulations for exchanging property under Section 1031,
any reasonable arrangement of like-kind properties into exchange groups
as relinquished or replacement property for separate transactions, consistent
with the regulations, should be respected.” [Underlying added.]
The IRS also ruled that the taxpayer did not have actual or constructive
receipt of money or other property from the disposition of RQ unless and
until such money or other property is actually transferred directly to the
taxpayer or to an account solely in the name of the taxpayer. Further, the
taxpayer’s participation in accordance with the master exchange agreement
in identifying sales proceeds from the disposition of RQ and in sorting
those proceeds from other funds (including processing, depositing, and other
handling of checks representing proceeds from the disposition of RQ) did
not result in actual or constructive receipt of money or other property.
The IRS also ruled in favor of the taxpayer’s financing of the purchases
of RQ. The IRS stated: “A taxpayer may advance money toward the purchase
of property to be acquired by exchange.” If the taxpayer promptly
transfers funds equal to the loan proceeds to the QI, the taxpayer’s
receipt of the borrower’s note does not constitute actual or constructive
receipt of money or other property from the disposition of RQ. Finally,
the IRS ruled that the application of the lessee’s lease security
deposit against the purchase price of RQ does not constitute actual or constructive
receipt of money or other property from the disposition of RQ. The IRS cited
Rev. Rul. 72-519, 1972-2 C.B. 32, which states that in cases involving rental
property, payments received by a lessor to secure the lessee’s performance
of covenants contained in a lease that are to be refunded at the expiration
of the lease are not taxable income even though the lessor has use of the
money.
Revenue Procedure 2003-39 indicates that “no inference” is
to be drawn from its safe harbors and that the safe harbors do not themselves
apply outside of the context of LKE Programs. But it is difficult to see
why the principles of these safe harbors would not apply outside of LKE
Programs (as defined in the revenue procedure). The authorities cited in
PLR 200327039 with respect to matching like-kind exchange properties, lending
funds to a purchaser, and the treatment of a lessee’s security deposit
should be equally applicable outside of LKE Programs. The private letter
rulings on LKE Programs may also be mined for other little gold nuggets
contained therein, such as creating separate and distinct exchanges by matching;
using anticipatory, blanket assignments in a master exchange agreement;
sending written notice of an assignment by email (at least where emails
are digitally stored on a secure data base); loaning funds to a purchaser
of relinquished property in a separate loan transaction without creating
boot; and converting receivables and payables held by a QI into cash at
face value (presumably including a buyer’s installment note) without
violating the safe harbors.
PLR 20010922 also involves a very interesting exchange program for equipment.
The taxpayer (T) acquires and disposes of large volumes of equipment and
entered into a master exchange agreement with a QI that is a third-party
financial institution. The parent of the QI and its affiliates provided
routine financial services to T and its affiliates, including funds processing,
lines of credit, lockbox services, counterparties in foreign exchange swaps
and purchases of taxpayer-issued debt obligations. These services were viewed
as routine and QI was not deemed to be a disqualified person. The ruling
illustrates a clever mass exchange program that was held to meet the requirements
of the safe harbors of the deferred exchange regulations. Within the 45-day
identification period, old and new equipment were matched (apparently by
computer program using certain parameters) to minimize boot and create a
separate and distinct like-kind exchange for each match.
Additional information relating to personal property exchanges is provided
in the separate link under Corporate Exchange Issues. That article discusses
replacement property options in connection with business and personal
property exchanges, and the tests for determining whether personal property
is of
like kind or like class. |