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PLR addresses the “held for” requirement in a like-kind exchange transaction for a property held by a trust that was distributed to its beneficiaries
May 2024
In brief
What happened?
In Private Letter Ruling 202416012 (PLR), the IRS issued a ruling to an individual taxpayer (taxpayer) that intended to effectuate a like-kind exchange. The PLR addressed the “held for productive use in a trade or business or for investment” requirement under Section 1031 holding that:
- The distribution of a tenancy-in-common (TIC) interest in real property, that was subject to a sale contract, as a result of the trust's involuntary termination, did not preclude the interests from being “held for the productive use in a trade or business or for investment.
Why is it relevant?
This is the most recent PLR where the IRS has ruled that involuntary transfers of real property to beneficiaries of a trust will not preclude the real property interest from being viewed as “held for the productive use in a trade or business or held for investment” in the hands of the beneficiaries. This ruling may provide some indication of the IRS’s position to other entities, such as partnerships or limited liability companies (LLCs), that may be considering similar like-kind exchange transactions.
Action items to consider
Although the PLR applies only to the taxpayer to which it was issued, taxpayers contemplating like-kind exchange transactions may want to consider this ruling, particularly with respect to whether voluntary or involuntary distributions of TIC interests from entities including trusts, LLCs, or partnerships might satisfy the “held for productive use in a trade or business or held for investment” requirement.
In detail
Section 1031 allows taxpayers to enter into like-kind exchange transactions for real property assets. A taxpayer can dispose of real property (relinquished property) and acquire other like-kind real property (replacement property) and defer gain on the relinquished property provided that the specific requirements under Section 1031 are satisfied.
The PLR addressed the requirement under Section 1031(a) that both the relinquished property and the replacement property, in the hands of the taxpayer, be “held for productive use in a trade or business or for investment.” This is commonly referred to as the "held for" or “qualified use" rule.
Taxpayer facts and representations
The ruling involved a testamentary trust that held real property (property) in which the taxpayer was a beneficiary. The trust’s terms were established by the decedent’s will and the trust was set to terminate upon the death of the last surviving child (i.e., alive at the time of decedent's death) of certain beneficiaries of the trust (terminating event). Upon the terminating event, the trustees were to distribute the assets of the trust to the beneficiaries.
Prior to the terminating event, the trustees intended for the trust to engage in a like-kind exchange transaction for the property that was held for investment purposes throughout the trust’s existence. During negotiations with a potential buyer of the property, the terminating event occurred, and the trustees were unable to effectuate the like-kind exchange. The trustees did, however, finalize the sales contract with the potential buyer of the property. Because of the terminating event, the trustees determined that it was no longer feasible for the trust to consummate the like-kind exchange transaction. The trustees informed the beneficiaries of their intention to request the probate court (court) to approve of the disposition of the property as part of the overall approval of the termination plan for the trust (termination plan). Under the termination plan, the trustees finalized the sales contract to dispose of the property and agreed to accommodate any beneficiaries interested in completing exchanges like what was initially contemplated for the trust prior to the termination event.
Disregarded entities were formed and owned separately by each of the beneficiaries that intended to effectuate the like-kind exchanges (exchanging beneficiaries), which included the taxpayer. Following the creation of the disregarded entities, the trustees planned to distribute undivided TIC interests in the property subject to the sales contract to the exchanging beneficiaries’ disregarded entities. Then the trustees planned to dispose of the TIC interests and each exchanging beneficiary planned to engage in a separate like-kind exchange transaction.
The taxpayer made certain representations in the PLR including, among others, the following:
- The property had been held by the trust for investment purposes throughout the trust’s existence.
- Any replacement properties acquired by the taxpayer would be held for investment purposes.
- The disposition of taxpayer’s TIC interest and the acquisition of replacement properties by the taxpayer would be accomplished in a manner that in all respects, aside from the “held for” issue raised in the ruling, would qualify as a like-kind exchange transaction eligible for nonrecognition treatment under Section 1031.
- The trust’s winding-up period, within the meaning of Reg. 1.641(b)-3(b) had not been unduly postponed.
IRS analysis
The IRS compared the facts in the PLR to older revenue rulings where the exchanges did not qualify for nonrecognition treatment.
In Revenue Ruling 75-292, an individual taxpayer, as part of a prearranged plan, exchanged real property used in the taxpayer’s trade or business with real property held by an unrelated corporation. The replacement real property was received and immediately thereafter contributed to a new corporation in a Section 351 transaction. The IRS concluded that nonrecognition treatment was not allowed because the taxpayer did not hold the replacement real property for use in a trade or business or for investment; rather, the taxpayer acquired the replacement property for the purpose of transferring it to a new corporation.
Using a similar attribution analysis, in Revenue Ruling 77-337, an individual taxpayer, as part of a prearranged plan, liquidated all of the stock of a corporation, resulting in the taxpayer’s acquisition of the property held by corporation, followed by an immediate transfer of the corporation’s real property asset to a third party in exchange for like-kind property. The IRS concluded that the corporation’s previous trade or business could not be attributed to its sole shareholder and therefore the relinquished property was not “held for productive use in a trade or business or for investment” by the individual taxpayer and thus ineligible for like-kind exchange.
The IRS noted in its analysis that the “held for” requirement was designed, in part, to postpone the recognition of gain or loss when property used in a trade or business or held for investment is exchanged for other property in the course of the continuing operation of that trade or business, or in the course of investment.
The IRS noted that the termination event occurred after the trust had held the property for many years, and the termination event was fixed and could not be modified or changed. The IRS further noted that the termination plan was anticipated to be approved by the court without regard to whether the taxpayer’s exchange of the TIC interest for replacement property would be completed. The IRS distinguished the facts of the PLR from the revenue rulings because those rulings involved prearranged plans that were voluntary transfers of property. Whereas, in this PLR, the distribution of the TIC interest was involuntary, it was the result of the termination event, and it was wholly independent of the taxpayer’s proposed like-kind exchange.
Therefore, the IRS held that the distribution of the TIC interests in the property, subject to a sale contract, as a result of the trust's involuntary termination, would not preclude the interests from being “held for the productive use in a trade or business or held for investment.” In other words, the IRS viewed the property as satisfying the “held for the productive use in a trade or business or held for investment” requirement in the hands of the taxpayer as it was in the hands of the trust.
Observation: The IRS’s analysis in this PLR is consistent with the IRS’s holdings in two earlier PLRs that involved involuntary transfers of property in trusts, where the IRS ruled that the “held for productive use in a trade or business or held for investment” requirement was not violated.
Observation: The holding in the PLR is noteworthy because the IRS distinguished the facts of the PLR from those in the revenue rulings, which involved voluntary transfers of properties under prearranged plans. The PLR suggests that involuntary transfers of property, from a trust to its beneficiaries, might not preclude those taxpayers from being viewed as holding the property for the productive use in a trade or business or for investment purposes. The IRS’s analysis in the PLR appears to have placed a significant emphasis on the involuntary termination of the trust, suggesting that a voluntary termination could have had a different tax result. Although this PLR related specifically to a trust, the analysis as it relates to the “held for the productive use in a trade or business or held for investment” requirement potentially could be relevant to other entities (e.g., partnerships, LLCs) that may engage in similar like-kind exchange transactions.
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