CCA 1325011: Debt pay-down does not create receipt of like-kind exchange proceeds

Plain-English summary

Chief Counsel Advice addresses whether a taxpayer had actual or constructive receipt of relinquished-property proceeds when a qualified intermediary used those proceeds to pay down credit lines secured by the property. The taxpayer used the credit lines to acquire replacement property and for general business operations. The advice concludes that the debt pay-down arrangement did not create actual or constructive receipt of the proceeds for section 1031 purposes. The exchanges could qualify for like-kind exchange treatment if the taxpayer met the other statutory and regulatory requirements.

Ruling snapshot

• Question: Did a qualified intermediary's use of relinquished-property proceeds to pay down secured credit lines cause actual or constructive receipt under section 1031?
• Outcome: Advice given. The arrangement did not, by itself, create actual or constructive receipt.
• Key authorities: IRC §§ 1031 and 6110; Treas. Reg. §§ 1.1031(k)-1 and 1.1031(b)-1(c); Rev. Proc. 2003-39; Barker v. Commissioner, 74 T.C. 555 (1980)

Full text (IRS public release)

Office of Chief Counsel
Internal Revenue Service
memorandum
Number: 201325011
Release Date: 6/21/2013
CC:ITA:B04: --------------------- Third Party Communication: None
POSTF-124290-12 Date of Communication: Not Applicable

UILC: 1031.07-00

date: September 10, 2012

 to:   Reid M. Huey
       Associate Area Counsel (St. Paul)
       (Large Business & International)

from: Michael J. Montemurro
Branch Chief, Branch 4
(Income Tax & Accounting)

subject: ----------------------------------------------
------------------------------

       This Chief Counsel Advice responds to your request for advice dated June 13, 2012.

       ISSUE

       Does a taxpayer have actual or constructive receipt of relinquished property (RQ) sales
       proceeds for purposes of § 1.1031(k)-1 of the Income Tax Regulations if the RQ is
       security for lines of credit used to purchase the RQ and for general business operations
       and the taxpayer’s qualified intermediary must use the proceeds to pay down amounts
       the taxpayer owes on the lines of credit?

       CONCLUSION

       The taxpayer does not have actual or constructive receipt of the RQ sales proceeds for
       purposes of § 1.1031(k)-1, by reason of the nature of the security burden and the debt
       pay-down arrangement.

       FACTS

       Taxpayer 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.

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. All property is separately listed as collateral for one or the other, but not both,
of the lines of credit. The full value of the rental property secures the entire outstanding
balances on the lines of credit.

The MEA provides that Taxpayer does not have the right to receive, pledge, borrow or
otherwise obtain the benefits of money or other property held by QI. The MEA also
provides that QI must use the proceeds from the sale of RQ to the pay down Taxpayer’s
outstanding balances on the lines of credit. Consequently, the proceeds from the
disposition of RQ as part of any exchange under the MEA are deposited directly into a
joint QI/Taxpayer account and then immediately disbursed by QI to satisfy Taxpayer's
obligation on one or the other line of credit. Under this arrangement, Taxpayer uses
borrowed funds to acquire RP and complete its exchanges.

APPLICABLE LAW

Section 1031(a)(1) of the Code provides that no gain or loss is recognized on the
exchange of property held for productive use in a trade or business or for investment if
such property is exchanged solely for property of like kind that is to be held either for
productive use in a trade or business or for investment.

Section 1.1031(k)-1(f)(1) of the regulations provides, in part, that in the case of a
transfer of relinquished property in a deferred exchange, gain or loss may be
recognized if the taxpayer actually or constructively receives money or other property
before the taxpayer actually receives like-kind replacement property. If the taxpayer
actually or constructively receives money or other property in the full amount of the
consideration for the relinquished property before the taxpayer actually receives the
like-kind replacement property, the transaction will constitute a sale and not a deferred

exchange even though the taxpayer may ultimately receive like-kind replacement
property.

Section 1.1031(k)-1(f)(2) explains that, except as provided in § 1.1031(k)-1(g) (relating
to safe harbors), for purposes of § 1031, the determination of whether (or the extent to
which) the taxpayer is in actual or constructive receipt of money or other property before
the taxpayer actually receives like-kind replacement property is made under the general
rules concerning actual or constructive receipt and without regard to the taxpayer's
method of accounting. The taxpayer is in actual receipt of money or property when the
taxpayer actually receives the money or property or receives the economic benefit of
the money or property. The taxpayer is in constructive receipt of money or property at
the time the money or property is credited to the taxpayer's account, set apart for the
taxpayer, or otherwise made available so that the taxpayer may draw upon it at any time
or so that the taxpayer can draw upon it if notice of intention to draw is given. Although
the taxpayer is not in constructive receipt of money or property if the taxpayer's control
of its receipt is subject to substantial limitations or restrictions, the taxpayer is in
constructive receipt of the money or property at the time the limitations or restrictions
lapse, expire, or are waived. In addition, actual or constructive receipt of money or
property by an agent of the taxpayer is actual or constructive receipt by the taxpayer.

Under § 1.1031(k)-1(g)(4)(i), a qualified intermediary is not considered the agent of the
taxpayer for purposes of section 1031(a). In such a case, the taxpayer's transfer of
relinquished property and subsequent receipt of like-kind replacement property is
treated as an exchange, and the determination of whether the taxpayer is in actual or
constructive receipt of money or other property before the taxpayer actually receives
like-kind replacement property is made as if the qualified intermediary is not the agent of
the taxpayer. Further, under § 1.1031(k)-1(g)(4)(ii), the agreement between the
taxpayer and the qualified intermediary must expressly limit the taxpayer's rights to
receive, pledge, borrow, or otherwise obtain the benefits of money or other property
held by the qualified intermediary.

Section 1.1031(k)-1(g)(4)(iii) provides that a qualified intermediary is a person who--
(A) Is not the taxpayer or a disqualified person, and
(B) Enters into a written agreement with the taxpayer (the “exchange agreement”)
and, as required by the exchange agreement, acquires the relinquished property from
the taxpayer, transfers the relinquished property, acquires the replacement property,
and transfers the replacement property to the taxpayer.

Section 1.1031(k)-1(g)(6) requires that the exchange agreement between the taxpayer
and the qualified intermediary provide that the taxpayer have no right to receive, pledge,
borrow, or otherwise obtain the benefits of money or other property held by the qualified
intermediary before the end of the exchange period, other than those provided in
§ 1.1031(k)-1(g)(6)(ii) and (iii).

Section 1031(b) of the Code provides, in part, that in an exchange that would be within
the provisions of § 1031(a) if not for the fact that the property received in the exchange
includes non like-kind property or money, the gain, if any, to the recipient must be
recognized but in an amount not in excess of the sum of the money and the fair market
value of the non like-kind property.

Section 1.1031(b)-1(c) of the regulations provides that consideration in the form of an
assumption of liabilities (or a transfer subject to a liability) is to be treated as “other
property or money” for the purposes of § 1031(b). If, in an exchange described in
§ 1031(b), each party either assumes a liability of the other party or acquires property
subject to a liability, then, in determining the amount of other property or money,
consideration given in the form of an assumption of liabilities (or the receipt of property
subject to a liability) is offset against consideration received in the form of an
assumption of liability (or transfer subject to a liability). Thus, when there are mortgages
on both sides of the transaction, the mortgages are netted and the difference becomes
recognized gain (boot) to the party transferring the property subject to the larger
mortgage.

In Example (5) of § 1.1031(k)-1(j)(3), B, the transferor of relinquished property in a
deferred exchange, transfers property that is encumbered with a $30,000 mortgage to C
on May 17, 1991. C assumes the mortgage on that date. On July 15, 1991, B receives
the replacement property and assumes a $20,000 mortgage encumbering the
replacement property. The consideration received by B in the form of the liability
assumed by C ($30,000) is offset by the consideration given by B in the form of the
liability assumed by B ($20,000). The excess of the liability assumed by C over the
liability assumed by B, $10,000, is treated as “money or other property.” Thus, as
provided in § 1031(b), B recognizes gain in the amount of $10,000.

Section 5.02 of Rev. Proc. 2003-39, 2003-1 C.B. 971, on Joint Accounts, provides that a
taxpayer engaged in an LKE Program will not be considered in actual or constructive
receipt of proceeds from the sale of relinquished property deposited into or held in a
joint bank, trust, escrow, or similar account in the name of the taxpayer and the qualified
intermediary, or in an account in the name of a third party (other than a disqualified
person as defined in § 1.1031(k)-1(k)) for the benefit of both the taxpayer and the
qualified intermediary, if:

(1) The account is used to collect, hold, and/or disburse proceeds arising from the sale
of relinquished property for the benefit of the qualified intermediary;

(2) The agreement setting forth the terms and conditions with respect to the account
requires authorization from the qualified intermediary to transfer proceeds from the sale
of relinquished properties out of the account; and

(3) The agreement setting forth the terms of the taxpayer's and qualified intermediary's
rights with respect to, or beneficial interest in, the account expressly limits the taxpayer's

rights to receive, pledge, borrow, or otherwise obtain the benefits of proceeds from the
sale of relinquished property held in the joint account as provided in § 1.1031(k)-1(g)(6).

Section 5.02 of the revenue procedure further provides that the account may also be
used by the parties for other purposes provided that the other use does not undermine
the qualified intermediary's right to control the proceeds from the sale of relinquished
property.

ANALYSIS

In the present case, proceeds from the disposition of the RQ are paid to the joint
account controlled by Taxpayer and QI. The QI then disburses the RQ proceeds to pay
down the debt on the Taxpayer’s lines of credit, as required by the agreements with
Taxpayer’s lenders. Taxpayer then acquires RP by financing the acquisition with new
debt in an amount that equals or exceeds the debt that encumbered the RQ.

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. Under this argument,
Taxpayer cannot defer the gain realized on its transfers of RQ under § 1031(a). We
disagree with the field attorney’s position.

The facts in the present case are similar to the situation described in Example 5 of
§ 1.1031(k)-1(j)(3). In the example, the taxpayer is relieved of debt on the transfer of
RQ and incurs debt on the acquisition of RP. The example concludes not that the
taxpayer has actually or constructively received all or a portion of the proceeds of the
RQ, but rather that the boot received in the form of debt relief is offset by the debt
assumed. Under the boot netting rules of § 1.1031(b)-1(c), the gain required to be
recognized by the taxpayer in Example 5 is the excess of the debt relieved on the
transfer of the RQ and the debt incurred on the acquisition of RP. While there are
differences between the facts in Example 5 and those in the present case, the
differences do not result in Taxpayer having actual or constructive receipt of the RQ
proceeds for purposes of § 1.1031(k)-1.

In the present case, the debt that is secured by the RQ is incurred not only to purchase
RQ but also for general business operations. In contrast, Example 5 provides only that
the RQ is “encumbered by a mortgage of $30,000” and does not discuss when or why
the property was encumbered. However, the result in Example 5 should not change if
the debt was incurred as a result of a refinancing of the RQ, the proceeds of which were
used for general business operations. That is, we not aware of any authority for making
a distinction along the lines of the purpose of the encumbrance or whether the taxpayer

used the proceeds for more than the purchase of RQ. Consequently, the fact that the
debt in the present case was incurred for more than the acquisition of the RQ should not
result in actual or constructive receipt of the RQ proceeds when QI pays off the RQ
debt.

Another difference between the facts of Example 5 and those of the present case is that
the transferee of the RQ in Example 5 assumed the RQ debt whereas, in the present
case, QI uses the RQ proceeds to pay down the RQ debt. That fact, however, should
not result in actual or constructive receipt of the RQ proceeds. In Barker v.
Commissioner, 74 T.C. 555 (1980), the Tax Court held that proceeds from the
disposition of RQ can be used to pay off debt on the RQ without triggering gain if the
taxpayer incurs or assumes a liability on the purchase of RP that equals or exceeds the
debt on the RQ. In Barker, which was decided before the issuance of deferred
exchange regulations of § 1.1031(k)-1, the taxpayer received cash in the exchange but
was contractually obligated by the transferee of the RQ to use the cash to pay off the
RQ debt. Thus, the Tax Court held that the boot netting principle in § 1.1031(b)-1(c)
covers not just assumptions of debt but also situations in which the proceeds of the RQ
are used to pay off RQ debt.

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.

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