Financial Resource

assets that are used in large numbers in the United States, such as aircraft, automobiles, buses, light general-purpose trucks, heavy general purpose trucks, rail cars and locomotives, and tractor units, for example. If an asset does not fall within a General Asset Class an exchanger must look to the more restrictive Product Classes set forth in the Standard Industrial Classification Manual issued by the Executive Office of the President, Office of Management and Budget. Treas. Reg 1.1031(a)-2(b)(3). Although the “SIC manual,” as it is known, was replaced with the North American Industrial Classification System, also known as the NAICS manual, the Treasury Regulations have never been changed to reflect this update in the law. Exchangers must therefore continue to use the SIC manual to determine if properties are among a common Product Class.

Intangible assets such as franchise rights, patents and copyrights, do not fall into any class, although they can be exchanged for property of like kind. Treas. Reg. 1.1031(a)-2(c)(1). Due to the diverse nature of these types of assets exchangers must look to the nature and character of these rights to see if they are exchangeable. For example, an exchange of a restaurant franchise would undoubtedly not be like kind to an automotive service station franchise, but an exchange of one restaurant franchise for a different restaurant franchise would. [PLR 7824051] It is important to distinguish between the actual value of the franchise rights and the intrinsic value of the goodwill or going concern value.

An important distinction when considering an exchange of a business and all its various assets is the value of the business’ goodwill or going concern value. Treas. Reg. 1.1031(a)-2(c)(2) provides that “[t]he goodwill or going concern value of a business is not of a like kind to the goodwill or going concern value of another business.” The stated reason for this exclusion is that due to the inherent uniqueness of any single business, the goodwill or going concern value of two businesses could not possibly have the same nature or quality. Thus, an exchange of “Tony’s Pizza of N.Y.” for “Joe’s Pizza of Fla.” can only consist of real property and the equipment. The value of Tony’s goodwill, which, excluding the real property, represents the bulk of the business’ value, is excluded from like-kind exchange treatment.

Multiple Property

As previously stated, both real and personal property may be exchanged, but not for each other. Therefore, where transactions have elements of both real and personal property, care must be taken in the structure of the exchange to provide for the greatest tax benefit.

Let us return to the example we started where a proprietor is selling a chain restaurant. First, we have a building, which is clearly a straightforward real property exchange. Second, we have the cooking equipment, which is considered to be tangible personal property, and thus can be exchanged. Lastly, we have the franchise rights, which can be exchanged for like-kind franchise rights. Structuring this transaction as three separate exchanges works well if each interest is of similar value, but what if the values vary

Initially, the Internal Revenue Service issued Rev. Rul. 57-365 wherein it stated that an exchange of identical business assets, including real and personal property, of two telephone companies would be considered “property of like kind” within the meaning of 1031 of the Internal Revenue Code. In 1989, Rev. Rul. 89-121 sought to clarify the “identical business asset” rule set forth in Rev. Rul. 57-365 by stating that the mere fact that multiple assets comprise a business or an integrated economic investment does not mean that they may be treated as the disposition of a single property. The IRS stated that a review of the underlying assets pursuant to Rev. Rul. 55-79 was required to determine whether they were to be considered like kind.

The current system, which became effective for all transactions occurring on or after April 11, 1991, requires all exchangers contemplating a multi-asset exchange to group the properties, both real and personal, into like kind or like class groups. Treas. Reg. 1.1031(j)-1. The value to structuring an exchange as a multiple property exchange, as opposed to a separate exchange for each type of asset, is that a multiple property exchange provides an exception to the general rule that requires a property-by-property comparison when computing the gain and basis.

Thus, although the assets are segregated into exchange groups consisting of like-kind properties, the value and liabilities of the property are computed in aggregate with a gain being recognized only to the extent of a difference in these aggregate values. Treas. Reg. 1.1031(j)-1(b). This does not, however, change the computation of the resulting gain or basis, which is determined separately for each exchange group. Treas. Reg. 1.1031(j)- 1(c). The end result is an exchange of multiple properties wherein a greater proportion of the gain can be deferred than if the transaction were structured as several separate exchanges.

In conclusion, a careful review of most commercial real property transactions will often reveal a large amount of depreciated personal property being sold in addition to the real property. By taking the time to review the impact of these additional assets, and contemplating a multiple property exchange, an exchanger can defer much more of its gain than was originally thought possible or feasible.

Todd R. Pajonasis President of Legal 1031 Exchange Services, Inc., a national Qualified Intermediary for IRC §1031 tax deferred exchanges.

Legal 1031 Exchange Services, Inc. 877/701-1031 todd@legal1031.com

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