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Mere Change in Form

It is a basic principle of the income tax that the gain or loss realized by a taxpayer from the conversion of property into cash, or from the exchange of property for other property that differs materially in kind from the exchanged property, is treated as realized income or loss.

Moreover, the general rule with respect to such realized gain or loss is that the entire amount thereof is recognized for purposes of determining the taxpayer’s income tax liability,[i] except in cases where the Code specifically provides otherwise.[ii]


The converse of the above-stated principle is equally fundamental to the tax law. Thus, a taxpayer’s exchange of property for other property that does not differ materially in kind from the exchanged property is generally not treated as a taxable event,[iii] provided the taxpayer’s relationship to the property received is not materially different from their former relationship to the exchanged property.

The underlying assumption of the exceptions to the recognition of gain or loss on the exchange of property is that the new property acquired by the taxpayer in the exchange represents a continuation of their investment in the old property.


Thus, a taxpayer’s exchange of one real property for another real property[iv] will generally not be treated as a taxable event provided the relinquished property was held,[v] and the replacement property will be held, by the taxpayer for investment or for productive use in a trade or business (the “holding requirement”).[vi]

Likewise, in certain corporate reorganizations, a taxpayer’s exchange of equity in one corporation for equity in a second corporation[vii] following the first corporation’s transfer of its assets to the second, will not result in the recognition of gain by either the shareholder or the transferor corporation provided certain requirements are satisfied,[viii] including the following: the shareholder’s equity interest in the second corporation represents a sufficient continuity of their interest in the first corporation’s business and assets, and the second corporation continues the business of the first corporation. In that case, the taxpayer’s interest in the second corporation is generally treated as a continuation of their investment in the business of the first.[ix]

There are other instances in which these principles apply to treat a new enterprise or a new business structure as a substantial continuation of the old; for example, a taxpayer’s contribution of property to a partnership in exchange for a partnership interest,[x] and the contribution of property to a controlled corporation in exchange for stock of such corporation.[xi]

The Same Taxpayer

Because the ability to defer the recognition of gain from an exchange of property is premised, in part, upon the continuation of the exchanging taxpayer’s interest or investment in such property, it generally follows that this gain deferral benefit is available only to the taxpayer that owned the exchanged property, had the requisite connection to such property until the time of the exchange, and acquired “new” property in the exchange with respect to which the taxpayer maintained the same connection they had with the exchanged property. 

Stated differently, the exchanging taxpayer generally cannot preserve their right to defer the recognition of gain with respect to the relinquished property by assigning the right to acquire the replacement property to another person; the latter cannot be said to have had the same relationship to the relinquished property as the exchanging taxpayer had, nor can the taxpayer transfer this attribute to another person.

Thus, in the case of a like kind exchange of real property, the Code provides that “any property received by the taxpayer” will not be treated as like kind to the exchanged property if such property is not identified within “45 days after the date on which the taxpayer transfers the property relinquished in the exchange,”[xii] or if the properly and timely identified property is not received within “180 days after the date on which the taxpayer transfers the property relinquished in the exchange.”[xiii] In other words, to satisfy the continuity requirement and qualify for the deferral of gain, the taxpayer who disposes of property must also acquire the replacement property.


Over the years, this “same taxpayer” requirement has raised a number of issues for taxpayers, and especially for those who held an indirect interest in the relinquished property.

An often encountered scenario involves a partnership disposing of real property that it has held for investment or for use in a trade or business for several years. Assume only one of its partners wants to engage in a like kind exchange with respect to “their share” of the property, while the other partners prefer to take the sale proceeds and pay the resulting tax. The partnership may distribute a tenancy-in-common (“TIC”) interest in the real property to such partner in liquidation of their partnership interest.[xiv] The partnership, with its remaining partners, would hold the other TIC interest, which it would sell for money, while the former partner would dispose of their recently received TIC interest in exchange for a like kind replacement property.[xv]

However, did the exchanging former partner hold their newly acquired TIC interest for the requisite investment or business purpose? Is the partnership’s purpose for holding the real property, or its use of the property in a partnership business, attributable to the former partner such that the latter may engage ? According to the IRS, no.[xvi]

A similar attribution issue arises with respect to the beneficiaries of a trust, as illustrated by a recently issued private letter ruling[xvii] in which the IRS considered whether a trust’s relationship to a real property that the trust held for investment may be attributed, or carried over, to a beneficiary of the trust to whom an interest in the property was distributed.

The Trust

Trust was created under Decedent’s Will, which also directed the transfer of Real Property from Decedent’s estate to Trust.[xviii] Taxpayer was identified under the Will as a beneficiary of Trust.

According to Decedent’s Will, Trust would terminate upon the death of the last surviving child of Decedent’s Daughters who was living upon the death of Decedent (“Terminating Event”).  Following the Terminating Event, the Trustees of Trust were directed to distribute the Trust corpus, including Real Property, to the beneficiaries, including Taxpayer.[xix]

During the period between Date 3 and Date 4, Trustees took no significant actions to dispose of Real Property. After Date 4, Trustees determined that it would be in the best interests of the beneficiaries to engage in a like-kind exchange of Real Property for other real properties[xx] and began negotiations with a potential buyer for its disposition.

Termination of Trust

On Date 5, during negotiations with Buyer, the Terminating Event occurred upon the death of Individual. After Date 5, Trustees completed negotiations and entered into a contract for the sale of Real Property, subject to a due diligence clause (“Sales Contract”). At that time, Trustees also determined that it was no longer feasible for Trust itself to consummate a like-kind exchange of Real Property because of the Terminating Event.

Trustees informed Trust’s beneficiaries of their intention to request the Probate Court to approve the disposition of Real Property as part of the overall plan to terminate Trust (“Termination Plan”).

Upon the Court’s approval of the Termination Plan, Trustees would finalize the Sales Contract to dispose of Real Property with Buyer.

Distribution to Beneficiary

As part of the Termination Plan, Trustees agreed to accommodate any beneficiaries interested in completing like kind exchanges with respect to their “share” of Real Property in a manner similar to that which Trustees initially contemplated prior to the Terminating Event.

Certain beneficiaries, including Taxpayer, informed Trustees of their desire to complete such an exchange (“Exchanging Beneficiary”).

Pursuant to the Termination Plan, limited liability companies (“LLCs”) would be formed and owned separately by each Exchanging Beneficiary, including Taxpayer. Each LLC would be disregarded as an entity separate from its sole member,[xxi] and would be managed initially by Trustees.

Following the creation of the LLCs, Trustees would distribute the appropriate undivided TIC interests in Real Property, subject to the Sales Contract, to each Exchanging Beneficiary’s LLC. Shortly after the distributions, Trustees would cause the disposition of the TIC Interests (i.e., 100 percent of Real Property, as the relinquished property). Each Exchanging Beneficiary, through their respective LLC, would engage in a separate exchange transaction.[xxii]

The Exchange

Taxpayer represented[xxiii] to the IRS that:

  1. Real Property had been held by Trust for investment purposes throughout Trust’s existence.
  2. Any replacement properties to be acquired by Taxpayer through their LLC would be held for investment purposes.
  3. The disposition of Taxpayer’s TIC Interest and the acquisition of replacement real properties by Taxpayer through the LLC would be accomplished in a manner that in all respects would qualify the transaction as a like-kind exchange eligible for nonrecognition treatment under the Code’s like kind exchange rules.[xxiv]

IRS’s Analysis

The IRS began by reviewing the statutory and regulatory requirements for “tax-free” like kind exchange treatment under the Code and the applicable regulations.

It then determined that Trust terminated in accordance with the terms of the Trust agreement when it distributed TIC interests in Real Property to the beneficiaries, including Taxpayer, subject to the sale contract.[xxv]

The agency next considered the effect of the distribution on Taxpayer’s ability to engage in a like kind exchange with respect to their TIC interest.

With that issue in mind, the IRS discussed an earlier published ruling[xxvi] in which an individual taxpayer, in a prearranged transaction, transferred land and buildings used in the taxpayer’s trade or business to an unrelated corporation in exchange for land and an office building. Immediately following the exchange, the taxpayer transferred the newly acquired land and office building to the individual’s newly created corporation in exchange for stock in such corporation in a transaction that qualified for nonrecognition of gain as a contribution to a controlled corporation.[xxvii]  Under these circumstances, the IRS concluded, the taxpayer did not exchange its property for other property of like kind to be held either for productive use in a trade or business or for investment by the taxpayer; rather, the taxpayer acquired the replacement property for the purpose of transferring it to the new corporation.[xxviii] As a result, the exchange did not qualify for nonrecognition treatment under the like kind exchange rules.

The IRS then referred to another published ruling[xxix] involving an individual taxpayer who, in a prearranged plan, liquidated all the stock of a corporation and transferred the corporation’s sole asset, a shopping center, to a third party in exchange for like-kind property. The IRS noted that a corporation’s use of property in its trade or business was not attributable to its sole shareholder. Consequently, the individual distributee-taxpayer did not hold the shopping center for use in a trade or business or for investment, because the corporation’s previous trade or business use of the property could not be attributed to its sole shareholder. Thus, the exchange did not qualify for nonrecognition of gain under the like kind exchange rules.

Underlying Policy

According to the IRS, the like kind exchange rules were designed, in part, to postpone the recognition of gain or loss when property held for productive use 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 continuing to hold that investment. Under these circumstances, the IRS continued, a taxpayer is not considered to have “received” a gain in an economic sense, nor has the exchange of property resulted in the termination of one venture or investment, and an assumption of a new venture or investment. The business venture operated, or the investment held, before the exchange continues after the exchange without any real economic change, and without liquidating or converting the exchange property.

The Ruling

In this case, the IRS explained, the Terminating Event occurred after many years of Trust’s existence; i.e., Trust itself satisfied the holding requirement. Because Trust was a testamentary trust, the Terminating Event was fixed by the Decedent and could not be modified or changed by any beneficiary.

Based on the representation that Taxpayer’s LLC would be disregarded as an entity separate from Taxpayer, the distribution of the TIC Interest by Trust to the LLC would be considered, for federal income tax purposes, as a distribution of the TIC interest to Taxpayer. The Termination Plan was anticipated to be approved by the Probate Court and implemented as described above without regard to whether the exchange of Taxpayer’s TIC Interest for eligible like-kind replacement property was consummated (“Proposed Exchange”).

Accordingly, Trust’s distribution of Taxpayer’s TIC Interest pursuant to the Termination Plan would be wholly independent of Taxpayer’s Proposed Exchange. In other words, it did not involve the voluntary transfers of properties pursuant to a prearranged plan to achieve q desired tax result.[xxx]

With that, the IRS ruled that the distribution from Trust to Taxpayer of the TIC Interest subject to the Sales Contract, as a result of Trust’s involuntary termination, would not preclude the TIC Interest from being held for investment or for productive use in a trade or business within the meaning of the like kind exchange rules.[xxxi]

Proper Outcome?

At first glance, it may seem incongruous for the IRS to have ruled that Taxpayer, as a beneficiary of Trust, was permitted to engage in a like kind exchange using recently acquired Trust property (Real Property), especially because the property was distributed by Trust to its beneficiaries subject to sale contract.[xxxii]

Why should Taxpayer have enjoyed a positive outcome while a former partner of a partnership, to whom the partnership made a liquidating distribution of a TIC interest in partnership property to enable the former partner to engage in an exchange, may expect the IRS to challenge the former partner’s treatment of such exchange as one described in the like kind exchange rules of the Code?

The IRS based its ruling upon its determination that the termination of Trust and, thus, the “compelled” distribution of the TIC interest to Taxpayer were independent of the subsequent exchange – Trust did not distribute the TIC interest in the relinquished property to Taxpayer in order for Taxpayer to dispose of it, notwithstanding the TIC interest was distributed subject to a contract that required Taxpayer to sell the interest.

That sounds like a pretty weak argument. For one thing, as mentioned above, the TIC interest was distributed subject to a contract with an unrelated third party that compelled the sale of the distributed property by Taxpayer – Taxpayer exercised no dominion or control over the TIC interest and could not have held it for investment or for use in a trade or business. When Taxpayer received the TIC interest, they received for the purpose of selling it.

Perhaps more importantly, the only way to accept the IRS’s ruling is by reading into it the conclusion that Trust’s purpose for holding Real Property, as well as the period during which it was so held, were attributed to Taxpayer. If we accept that premise, then Taxpayer’s receipt of the property subject to a sale contract should not jeopardize the subsequent like kind exchange because Taxpayer merely stepped into the shoes of Trust.

Let’s assume for the moment that there is legal authority for attributing a trust’s activities to its beneficiaries for tax purposes. Why should the outcome be different for a partner who receives an in-kind distribution of real property (or of a TIC interest therein) from a partnership that satisfied the holding requirement with respect to such property for like kind exchange treatment?[xxxiii]

According to the Code, the character of any item of income, gain, loss, deduction, or credit included in a partner’s distributive share is determined as if such item were realized directly from the source from which realized by the partnership, or incurred in the same manner as incurred by the partnership.[xxxiv] Stated differently, the partner is treated as being engaged in the same activity as the partnership.[xxxv]

In contrast, the Code provides that the character of any amount included in the gross income of a beneficiary to whom a trust distribution was made or was required to be made shall have the same character in the hands of the beneficiary as in the hands of the trust.[xxxvi] It says nothing about having been realized directly from the same source from which realized by the trust.

What’s more, the partners of a partnership must include their distributive share of the partnership’s items of income, deduction, etc., without regard to whether the partnership has made any distribution to the partners.

The beneficiaries of a trust must include in gross income only so much of the trust’s income as the trust has distributed, or is deemed to have distributed, to them. In the absence of such distributions, the trust itself may be subject to income tax.

Crystal Ball

Query whether the ruling signals any sort of change in the IRS’s thinking with regard to in-kind distributions by a partnership to partners for the purpose of the latter’s participating in a like kind exchange.

As interesting as it may be to ponder this question, at least for some of us, it may become moot if the Dems remain in the White House,[xxxvii] retain control of the Senate, and recapture the House of Representatives this November.

You may recall that the current Administration has proposed to eliminate, by and large, the tax deferred treatment for otherwise qualifying like kind exchanges of real property. [xxxviii] Among the rationales provided for this change[xxxix] is that it would align the treatment of real property exchanges with exchanges of other types of property.


As we saw at the beginning of this post, the like kind exchange of real properties is only one example of an exchange with respect to which the taxpayer is not required to recognize gain because the exchange does not materially alter the nature of the taxpayer’s investment. There are many other instances in which the transfer of business assets in exchange for equity in a business entity (such as a partnership, LLC, or corporation) is granted nonrecognition treatment for the very same reason – the equity interest received represents a continuing interest in the property transferred to the business entity in exchange therefor.

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The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.

[i] Reg. Sec. 1.1001-1(a).

[ii] Reg. Sec. 1.1002-1(a).

[iii] It may be more appropriate to describe such an exchange as a tax deferral event instead of as a non-taxable event. That’s because the gain realized on the exchange is not eliminated but is preserved in the property received, such that it will be recognized in a subsequent exchange or sale that does not qualify for deferral treatment. See, for example, the basis rules of IRC Sec. 358, 362, 705, and 1031(d). Consistent with the basis rules are the holding period rules under IRC Sec. 1223, pursuant to which the taxpayer’s holding period for the exchanged property attaches to the property received in the non-taxable exchange.

[iv] It is not enough for the exchanging taxpayer to receive money in the exchange, which they then use to acquire replacement property. The receipt of money breaks the requisite continuity – it constitutes a liquidation of one’s investment – and the use of such money to purchase a new property is treated as a separate event from the sale of the first. Thus, in order to qualify an exchange as a deferred like kind exchange, the consideration paid by the buyer of the relinquished property must be paid to and held by a qualified intermediary, for example, and the exchanging taxpayer generally must be prohibited from accessing such consideration. See Reg. Sec. 1.1031(k)-1(f).

[v] There is no statutorily or administratively prescribed period for which a taxpayer must hold a property for a qualifying purpose in order to satisfy the pre- and post-exchange holding requirements.  

[vi] IRC Sec. 1031.

[vii] Very broadly, this may occur in the context of a stock-for-stock exchange, or in a transfer of assets from one corporation to another in exchange for equity in the acquiring corporation.

[viii] IRC Sec. 368, Sec. 354, and Sec. 361.

[ix] According to IRS Regulations, these provisions describe certain specific exchanges of property in which at the time of the exchange particular differences exist between the property parted with and the property acquired, but such differences are more formal than substantial. As to these, the Code provides that such differences shall not be deemed controlling, and that gain or loss shall not be recognized at the time of the exchange. Reg. Sec. 1.1002-1(c).

[x] IRC Sec. 721.

[xi] IRC Sec. 351.

[xii] IRC Sec. 1031(a)(3)(A).

[xiii]  IRC Sec. 1031(a)(3)(B).

[xiv] Under IRC Sec. 732(b), the basis of property (other than money) distributed by a partnership to a partner in liquidation of the partner’s interest is equal to the adjusted basis of such partner’s interest in the partnership, reduced by any money distributed in the same transaction.

The former partner would tack the holding period for their former partnership interest to their holding period for the distributed TIC interest in the real property. IRC Sec. 1223(1).

[xv] A so-called “drop and swap.”

[xvi] That said, taxpayers and their advisers continue to engage in drop-and-swaps or in variations thereof. The most frequently encountered issue in these transactions: has the distributee-former partner “held” the property long enough following the distribution so as to satisfy the “held for” requirement?

[xvii] PLR 202416012.

[xviii] Query whether a decedent’s estate steps into their shoes for purposes of satisfying the holding requirement? Alternatively, would the estate be permitted to close out an exchange begun by the decedent prior to their demise?

[xix] Decedent’s Will granted Trustees broad powers to determine the nature of property and cash proceeds includible in any distributions and made those determinations binding on the beneficiaries. In addition, it did not provide the beneficiaries with the right to alienate their interest in the Trust.

[xx] Taxpayers will sometimes exchange a single real property for a number of replacement properties, thereby diversifying their holdings. Conversely, a taxpayer may use multiple exchanges into a lesser number of replacement properties to consolidate their holdings. But timing . . .

[xxi] Within the meaning of Reg. Sec. 301.7701-2(c)(2) and § 301.7701-3(b)(1)(ii).

Under Reg. Sec. 301.7701-3(b)(1)(ii), a domestic eligible entity is generally disregarded as an entity separate from its owner if it has a single owner.

Reg. Sec. 301.7701-2(c)(2) provides that, in general, a business entity that has a single owner and is not a corporation is disregarded as an entity separate from its owner for federal tax purposes.

[xxii] These would be deferred exchanges under IRC Sec. 1031(a)(3) and Reg. Sec. 1.1031(k)-1.

[xxiii] It is important to appreciate that the IRS did not verify any of the material submitted in support of the ruling request. Indeed, the IRS noted that, as part of an examination process, the agency may verify the factual information, representations, and other data submitted.

[xxiv] I.e., IRC Sec. 1031.

[xxv] The IRS explained that, according to regulations, the determination of whether a trust has terminated for tax purposes depends upon whether the property held in trust has been distributed to the persons entitled to succeed to the property upon termination of the trust. Reg. Sec. 1.641(b)-3(b).

[xxvi] Rev. Rul. 75-292.

[xxvii] IRC Sec. 351.

[xxviii] Query how long Taxpayer should have held Real Property to demonstrate the required intent for like kind exchange treatment prior to contributing the property to a corporation.

[xxix] Rev. Rul. 77-337.

[xxx] There was an independent non-tax reason.

[xxxi] No determination was made as to whether the transaction otherwise qualified for deferral of gain realized under IRC Sec. 1031.

[xxxii] Taxpayer was obligated to sell.

[xxxiii] The distributee-partner takes the property with the partnership’s holding period, though their basis for the property is equal to the distributee’s basis in their partnership interest. IRC Sec. 732.

We assume for purposes of this post that none of IRC Sec. 704(c), 707, 737, or 752 are applicable. We should always be so lucky.

[xxxiv] IRC Sec. 702(b).

[xxxv] See also IRC Sec. 875.

[xxxvi] IRC Sec. 662(b).

[xxxvii] Query who that individual may be.

[xxxviii] The proposal would allow the deferral of gain up to an aggregate amount of $500,000 for each taxpayer ($1 million in the case of married individuals filing a joint return) each year for real property exchanges that are like-kind. Any gains from like-kind exchanges in excess of $500,000 (or $1 million in the case of married individuals filing a joint return) in a year would be recognized by the taxpayer in the year the taxpayer transfers the real property subject to the exchange. 

[xxxix] That is, in addition to raising revenue and “increasing the progressivity of the tax system.”