Like-kind exchange of agricultural property runs into a problem

Gain from a couple’s disposition of agricultural property could not be deferred, even though the property was relinquished in a like-kind exchange that was properly executed, the Tax Court held. The case illustrates how Sec. 1031’s like-kind exchange rules operate when the property being disposed of is depreciated “Sec. 1245 property.”

Facts: Jack and Shelley Gerhardt exchanged an Iowa rental property consisting of hog buildings, equipment, and raw land for a rental property in Cape Coral, Fla. On their 2017 tax return they treated this transaction as a Sec. 1031 like-kind exchange. They reported deferred gain of $285,662 on the disposition of the Iowa agricultural site.

Upon examining their return, the IRS did not dispute that the transaction met the formalities of a like-kind exchange. Nonetheless, the Service determined that the hog buildings and equipment on the Iowa site were depreciated Sec. 1245 property, and, therefore, gain must be recognized currently as ordinary income. After making some other adjustments, the Service increased the Gerhardts’ income for 2017 by $284,746. The Gerhardts filed a petition with the Tax Court contending that they were entitled to defer the gain from the disposition of the Iowa site under Sec. 1031 on the grounds that they had engaged in a valid like-kind exchange.

Issue: The basic issue was, how do like-kind exchanges operate when the relinquished property is Sec. 1245 property? Under Sec. 1245, depreciation recapture is required on the disposition of certain trade or business property, including (as relevant here) personal property and a “single purpose agricultural or horticultural structure” (Sec. 1245(a)(3)(D)).

The Gerhardts argued that, while Sec. 1245 otherwise might have required them to recognize ordinary income on the sale of the Iowa agricultural site, they were entitled to defer the gain because they relinquished the property in a like-kind exchange. In other words, the Gerhardts “say that section 1031 trumps section 1245, at least as to the timing of gain recognition,” as the court put it.

Holding: The Tax Court rejected the Gerhardts’ position. The court began by acknowledging that, typically, no gain or loss is recognized on a like-kind exchange of property if all requirements of Sec. 1031 are met. But that does not mean there are no exceptions to this rule. The court explained that “if ‘section 1245 property’ is disposed of in a section 1031 like-kind exchange, then gain from the disposition of that property may be recognized as ordinary income.” While the Gerhardts wanted their transaction to be treated as a typical like-kind exchange, their contention “ignores that gain may still be recognized under section 1245,” the Tax Court said.

As support for the conclusion that Sec. 1245’s gain recognition rules apply even in the like-kind exchange context, the court cited Sec. 1245(a) (1), which states that gain from the disposition of Sec. 1245 property “shall be recognized notwithstanding any other provision of this subtitle” (see also Sec. 1245(b)(4) and Regs. Sec. 1.1245-6(b)).

The Tax Court noted that, so far as the Gerhardts were arguing that their gain from the Iowa agricultural site was allocable primarily to non–Sec. 1245 property (the raw land), “they have not set forth any facts supporting that view.” According to the revenue agent’s workpapers, when they purchased the Iowa site, they allocated 98% of the purchase price to buildings and equipment (the Sec. 1245 property) for depreciation purposes.

In short, the court held that the Gerhardts had not met their burden to demonstrate that the IRS’s determination was incorrect.

Although not applicable in this case involving 2017 taxes, the IRS provided further guidance on this general topic in Regs. Sec. 1.1031(a)-3(a)(7), issued in 2020:

[A] taxpayer transferring relinquished property that is section 1245 property in a section 1031 exchange is subject to the gain recognition rules under section 1245 and the regulations under section 1245, notwithstanding that the relinquished property or replacement property is real property under this section. In addition, the taxpayer must follow the rules of section 1245 and the regulations under section 1245, and section 1250 and the regulations under section 1250, based on the determination of the relinquished property and replacement property being, in whole or in part, section 1245 property or section 1250 property under those Code sections and not under this section.

It should be noted that the likekind exchange issue was not the only one before the court. The primary issue in this case (actually, several consolidated cases) was whether payments to the taxpayers from single premium immediate annuities (SPIAs) held by charitable remainder annuity trusts (CRATs) were taxable. The SPIAs had been purchased by the CRATs with proceeds from the sale of contributed high-value, low-basis Sec. 1245 properties the taxpayers had contributed to the CRATs. The Tax Court concluded that, under well-established law, the annuity payments were taxable to the CRATs’ noncharitable beneficiaries as ordinary income.

■ Gerhardt, 160 T.C. No. 9 (2023)

— Dave Strausfeld, J.D., is a JofA senior editor. To comment on this column, contact Paul Bonner, the JofA’s tax editor.