Originally published on Forbes.com July 15th, 2013
Every once in a while the IRS reacts to an issue in a surprisingly easy going manner . That is how CCA 201325011, which concerns debt pay-downs of property involved in like-kind exchanges (Code Section 1031) strikes me.
Nothing louses up a 1031 exchange like the receipt of boot. Boot is property not of like kind received in addition to your replacement property. I could make up silly examples for you like Farmer Jones throwing in some tractors and pigs when he swaps his farm in Nebraska for your strip mall in New Jersey, but usually the concern is money. It is really clear that you don’t want to touch that filthy lucre. That’s why there is an entire industry of exchange facilitators. The next biggest concern is probably debt. Getting your debt paid off is just like receiving money for income tax purposes, even though it doesn’t feel that way.
Since it is not that common to find somebody who has the property that you want, who wants the property that you have, most 1031 exchanges are done with facilitators. The facilitation arrangement is something of a black box. You put your relinquished property in and no more than 180 days later, out comes replacement property or money. To the extent it is money coming out you recognize gain. Debt complicates matter a bit. If the relinquished property has debt attached to it when it goes into the black box, then the replacement property coming out of the black box should have at least that much debt attached. To the extent there is less it is as if you received money.
The taxpayer involved in the ruling was not an entity with 1031 transactions that are isolated and infrequent. The corporation, let’s call it Rentalco, rents equipment to customers for use in farming, construction, manufacturing and warehousing.
In 2003, Taxpayer implemented a Like-Kind Exchange Program (LKE Program) through which it defers the recognition of gain from the sale of its rental equipment. Taxpayer entered into a Master Exchange Agreement (“MEA”) with a qualified intermediary (QI) to engage in these multiple exchanges in its LKE Program. The MEA is the written agreement between Taxpayer and QI for QI to acquire the RQ from Taxpayer, transfer the RQ, acquire the replacement property (RP) and transfer the RP to Taxpayer. In the MEA, Taxpayer makes a blanket assignment of its rights under sale and purchase contracts to QI and provides for written notification of the assignment to all parties.
The problem with the program was that the equipment was leveraged. Now if each piece of relinquished equipment had a separate note that it secured, then as replacement property(RP) popped out of the black box, you would want each piece of replacement property to be at least as encumbered. Presumably that would be feasible, since Rentalco will always be trading a used piece of equipment for a new one. On the other hand, that would make for an awful lot of paperwork and probably higher interest expense than the arrangement that Rentalco had with its lenders:
Taxpayer maintains lines of credit with two creditors. The proceeds from the lines of credit are used to purchase RP. However, Taxpayer also uses proceeds from these lines of credit for other business purposes, not just the acquisition of RP. Pursuant to its agreements with these creditors, all rental properties, including properties relinquished and acquired in its § 1031 exchanges as RQ and RP, secure the outstanding balances on the lines of credit from the time Taxpayer acquires the property until it is sold. The outstanding balances on the lines of credit are also secured by Taxpayer’s accounts receivable and new equipment held by Taxpayer for sale in the ordinary course of business.
The effect of this arrangement is that when relinquished property is sold by the qualified intermediary, proceeds pay down a line of credit that is not exclusively used to acquire replacement property. The IRS field attorney thought that the paydowns blew the exchanges:
Under its arrangements with QI and its lenders, QI must use the RQ proceeds, but not proceeds from its accounts receivable and new equipment sales, to pay down lines of credit. The field attorney argues that these arrangements taken together violate § 1.1031(k)-1(g)(6), which generally prohibits a taxpayer from obtaining the benefits of the RQ proceeds before the end of the exchange period. The field attorney argues that the debt pay-down arrangement results in Taxpayer actually or constructively receiving the RQ proceeds before the end of the exchange period.
Frankly that is what I would have thought also. The Chief Counsel is more easygoing:
We disagree with the field attorney’s position. In the present case, the fact that the RQ debt is used not only to purchase RQ but also for general business operations, and the fact that QI uses the RQ proceeds to pay down Taxpayer’s lines of credit, does not result in Taxpayer being in actual or constructive receipt of the RQ proceeds for purposes of § 1.1031(k)-1. Accordingly, Taxpayer’s exchanges will qualify as like-kind exchanges under § 1031 if Taxpayer meets the other requirements of § 1031 and the regulations thereunder.
I still would not bless an arrangement like this without a specific ruling for the affected taxpayer, but I could see that qualified intermediaries that are affiliated with banks might want to start asking for such rulings. It certainly might make life easier.
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Afternote
I have fallen way behind and will be playing catch-up for the next week or two. I was rather surprised that this ruling which was released over a week ago has not attracted more notice. The only mention I have found is on Prof. Brunetti’s Tax News.
I’ll avoid calling this an afterafternote, since that could get tedious. Carol Vieria pointed me to this discussion by the Association of Leaders in Equipment Distribution. They were pleased, but not surprised by the ruling.
“Although our firm and clients are very happy with the CCA, the conclusion is not surprising to any of us,” said Ron Hodgeman, a tax partner at WTP Exchange. “For over 10 years now, we have been comfortable structuring our clients’ LKE programs to include a debt pay-down arrangement.” WTP is AED’s preferred provider of LKE services.
“The CCA provides additional assurance to the AED members already running an LKE program that they are doing the right thing,” Hodgeman added. “And it allows the dealers that were skeptical in the past to now revisit the strategy. The timing of this IRS memorandum couldn’t be any better. After taking advantage of bonus depreciation the last few years, companies are now disposing of rental equipment with low-to-no tax basis. Equipment rental companies will pay substantially higher taxes this year and into the future unless an LKE program is in place.”