The following article is adapted from reprinted from the M&A Tax Report, Vol. 7, No. 7, February 1999, Panel Publishers, New York, NY.


By Robert W. Wood, San Francisco

Section 1031 of the Code permits a tax-free exchange of property held for productive use in a trade or business or for investment, for property that is "like-kind." In the case of real estate, virtually any variety of realty is considered like-kind with other real estate. For example, unimproved real property is like-kind with respect to improved real property, and a leasehold interest with a 30-year or more term is considered like-kind to a fee interest in realty. In fact, about the only real property that doesn't qualify as like-kind is foreign property.

Still, problems have occasionally arisen with respect to Section 1031's "holding" requirement. Section 1031 only works if both the property exchanged out and the property exchanged in are held for use in a trade or business or for investment. If the property is received in exchange for property that is so held but is promptly disposed of, the IRS can be expected to challenge the applicability of Section 1031.

Basically, the IRS would say that the property received in the exchange was not "to be held" for the relevant purposes. Corporate taxpayers can have this problem to the same extent as other taxpayers. Unfortunately, there is no clear rule on how long after an exchange under Section 1031 the property that is received in the exchange must be held for investment or business use.

Mergers and Holding Period

In Letter Ruling 9850001 a corporation consummated a like-kind exchange and, as part of the plan, it liquidated into its parent. The parent promptly merged into a sister subsidiary. The question was whether the liquidation and the merger affected the requirement that the property be held by the taxpayer for investment or use in a trade or business. The ruling concluded that such transactions did not oust Section 1031 of jurisdiction. Each of the transactions (the liquidation and merger) was a transaction referred to in Section 381.

Section 381(c) contains a list of tax attributes that, in connection with a Section 381 transaction (subsidiary liquidations and certain acquisitive reorganizations), are inherited by the transferee. Although Section 381 does not expressly refer to Section 1031, the Service noted that the list contained in Section 381 was not intended to be the exclusive list of attributes available for carryover. For purposes of Section 1031, the ruling concludes, there is a carryover of attributes.

The Service noted that Section 1031 was included in the law to take account of transactions that (1) would be difficult to administer because of the inherent problems associated with valuing eclectic items of property and (2) are not the proper occasion for assessing a tax because the taxpayer has not yet "cashed out" of its investment. Section 1031 transactions involve taxpayers that are merely altering the form of a continuing investment, not disposing of it to trigger gain or loss recognition.

The IRS then went on to note, in defending its decision to extend Section 381(c) to encompass Section 1031 transactions, that these concerns remain equally applicable in cases where a "successor" obtains ownership of like-kind property previously received by a liquidated or acquired corporation. The Service found this situation present on the facts considered in Letter Ruling 9850001.

Plagued by Inconsistencies

Unfortunately, the Service has not been entirely consistent in applying the policy underlying Section 1031 with respect to other dispositions. In Revenue Ruling 75-292, the IRS concluded that Section 1031 was not applicable where the taxpayer, immediately after a like-kind exchange, transferred the property it received to a newly formed wholly-owned subsidiary in exchange for the latter's stock in a Section 351 transaction. This may seem innocuous enough. On the other hand, Section 351 is not one of the transactions described in Section 381.

Revenue Ruling 75-292 concluded that Section 1031 did not apply because the taxpayer did not exchange its property held for property to be held for investment or use in a trade or business. Instead, the property the taxpayer received was to be transferred (almost immediately) and was not to be held by the transferor in the underlying Section 1031 exchange.

A couple of important conclusions emerge from comparing these rulings. First, Section 1031 status is preserved in cases in which the property received in the exchange is transferred by the recipient to its 100% shareholder parent. However, Section 1031 does not apply where the property is conveyed downstream to a wholly owned subsidiary. From a policy viewpoint, it is hard to justify such a distinction.

Moreover, on the theory that a partnership is an entity separate from its partners (as opposed to an aggregate of the partners), the Service would be likely to challenge a downstream conveyance to a partnership of property that was received in a Section 1031 exchange. Again, it seems hard to figure just what the objection is here, since there is no true break in investment continuity.

Continuity of Business Enterprise Compared

The IRS' failure to recognize the innocuousness of downstream transfers in this Section 1031 context contrasts rather dramatically with the Service's forbearance in the area of continuity of business enterprise. In terms of importance, remember, continuity of business enterprise is one of the fundamental requirements that must be met for a transaction to qualify as a reorganization.

The continuity of business enterprise requirement necessitates that the issuing corporation in a reorganization continue the target's historic business, or use a significant portion of the target's historic business assets in a business. (This sounds an awful lot like the holding requirement under Section 1031 doesn't it?) In newly issued Reg. Section 1.368-1(d), the IRS has concluded that continuity of business enterprise is satisfied even though a target's business is continued not by the issuing corporation, but instead by: (1) a member of its "qualified group" (a designation that encompasses wholly owned and lower-tier subsidiaries); or (2) by a partnership in which the qualified group members own a "significant interest" or with respect to the degree to which such members have "active and substantial" management functions. (See Revenue Ruling 92-17.)

Nagging Question

This comparison to the Service's relative largesse when it comes to a far more pervasive doctrine (continuity of business enterprise) may leave one hankering for an answer. Why should a conveyance of assets to a wholly owned subsidiary (or an affiliated partnership) satisfy the continuity of business enterprise requirement, yet not be sufficient in the case of an attempted Section 1031 exchange? Go figure.

Section 1031: Not Just for Real Estate, Vol. 7, No. 7, M&A Tax Report (February 1999), p. 5.