State Law Irrelevant to “Like Kind”: Deferral of Capital Gains Taxes

IRS building on Constitution Avenue in Washing...
IRS building on Constitution Avenue in Washington, D.C.. (Photo credit: Wikipedia)

IRS Chief Counsel: State Law Policies Are Generally Irrelevant to the Question of What is “Like Kind” for Deferral of Capital Gains Taxes

The Office of Chief Counsel for the Internal Revenue Service released a very important advisory opinion on September 21, 2012, concluding that state law characterizations of property as either real or personal are irrelevant to the determination of whether property acquired in a Section 1031 exchange is of a “like kind” to the property relinquished in the exchange (ILM No. 201238027). The advisory opinion appears to settle a long-standing debate and confusion among practitioners in this field, including qualified intermediaries, and even within the Service itself; that is, state law characterizations of property are not determinative of whether exchanged-for property is of a like kind. The Chief Counsel’s Office (finally) stated the obvious conclusion that federal tax law is not dependent on state laws and state policies. The determining factor under federal tax law is whether the property acquired in the exchange is of the same “nature and character” as that relinquished by the taxpayer.

The principal example in the advisory opinion concerns the exchange of identical natural gas pipelines in different states. In State A, a gas pipeline is classified as personal property. The taxpayer desires to exchange the pipeline for another one constructed within State B, but State B characterizes gas pipelines as real property. If state law controls the determination of whether these two pipelines are of a like kind, the taxpayer could not achieve a qualifying tax-deferred exchange, resulting in payment of capital gains taxes and depreciation recapture. As noted by the Chief Counsel, this result is simply absurd: the exchange of identical pipelines by their very nature are of the same character regardless of what various state legislatures think of their correct property classifications. As appropriately noted in the opinion,

…some states classify property as real for some purposes and personal for others. If state laws were determinative, this would raise the question of to which purpose federal tax law should look. Accordingly, state law property classifications are not determinative of whether property is of like kind. Rather, the Service should consider all facts and circumstances, including state law and federal tax law classifications as appropriate.

In short, a gas pipeline is a gas pipeline is a gas pipeline. You get the point.

While not mentioned in the advisory opinion, one might conclude that the IRS has rendered moot its Field Service Advice on gas pipelines issued in 2004, wherein the Service stated that examiners should rely on state law in reaching determinations as to the nature of property interests being exchanged under Section 1031 (Field Service Advisory No. 2004-4101F, considering whether a crude oil pipeline was real or personal property under state law). One must also wonder if the railroad company received an unjust result when the Service disallowed the exchange of used rail components (rails, ties, ballast, spikes) that were no longer assembled and affixed to the ground for new rail components in place. Noting that state law characterized the unaffixed rail components as personal property, the IRS found a taxable exchange, ruling that track components assembled and attached to the ground, considered real property under state law, are not like-kind to unassembled and unattached track components (Tech. Advice Memo. 2004-24001). The taxpayer unsuccessfully argued that, state law characterizations aside, the components are identical in nature and character and should therefore be considered like kind. Apparently, the taxpayer would win the case today.

This Chief Counsel advisory opinion is important and interesting on several grounds. First, it continues a trend that started in earnest about 6 years ago when the IRS showed a willingness to take positions on what property is of like kind. For years, the Service seemed to avoid the issue as one requiring too much factual interpretation. However, it began to issue rulings in 2006 and 2007 that challenged this assumption, and the rulings that followed were consistently favorable to taxpayers looking for tax-advantaged investments and sales (e.g., PLR 200805012, where the IRS held that a fee interest in real property is of a like kind to development rights with respect to other property that the taxpayer already owned). Second, this advice confirms the plain language of Reg. §1.103(a)-1(b) and black letter law that the Service itself is fond of relying upon; namely, that the question of what makes up like kind property is resolved by considering the nature and character of the properties exchanged, and that this standard is one of a like − not an identical – kind (Koch v. Comm’r, 71 T.C. 54, 65 (1978)(approving taxpayer’s exchange of (1) fee interests in unencumbered parcels of real estate for (2) fee interests in parcels of real estate subject to 99-year condominium leases)). Finally, this advice confirms what legal scholars know of the interplay between state and federal law; that is, federal law has primacy over state law and usually usurps it. The U.S. Supreme Court ruled more than 70 years ago that, while state law may choose an interest or right as one to be taxed, federal law prevails no matter what name is given to the interest or right by state law (Morgan v. Comm’r, 309 U.S. 78, 80-82 (1940)). We now have confirmation of the application of this general principle to the question of what is like kind property for Section 1031 purposes.