Nonrecognition as a Structural Device

Three rationales recur in the regulations, the cases, and the literature: continuity of investment, the absence of wherewithal to pay, and the difficulty of valuation. Each explains part of section 1031 and none explains all of it. The chapter then shows how basis turns nonrecognition into deferral rather than exemption, sets the family of nonrecognition provisions side by side, and explains why section 1031 is the only general member whose condition is the kind of property received.

2.1 Continuity-of-investment rationale

The regulation's statement. The clearest official statement of the continuity rationale appears in the general regulation on sales and exchanges. It begins from the rule that realized gain or loss is recognized except where the Code provides otherwise. It then identifies exceptions, including sections 351(a), 354, 361(a), 721, 1031, 1035, and 1036, as describing exchanges in which the differences between the property given up and the property received are "more formal than substantial." And it states the assumption underlying all of them: that "the new property is substantially a continuation of the old investment still unliquidated."¹

The price of the rationale. The same regulation provides that exceptions to recognition are strictly construed and do not extend beyond either their words or their underlying assumptions and purposes. Nonrecognition is accorded only if the exchange satisfies both the Code's specific description and the purpose for which the exception exists. The exchange must be "germane to, and a necessary incident of, the investment or enterprise in hand," and the taxpayer claiming the exception must show that it applies.² Continuity was meant to limit nonrecognition as well as to justify it. Chapter 11 considers how much work that interpretive instruction still does.

Continuity in the cases. Courts invoke continuity most often when the question is whether the taxpayer's holding satisfies the statute. The Ninth Circuit, allowing an exchange followed by a contribution of the replacement property to a partnership, described the contribution as "a continuation of the Magnesons' investment unliquidated but in a modified form" (Chapter 20).³ Treasury's economists described the traditional argument the same way: taxpayers who exchange are continuing their investment in the same business activity rather than cashing it in.⁴

What continuity does not explain. As a justification, continuity has two weaknesses. The first is that it proves too much. A taxpayer who sells an apartment building for cash and buys another the next week has, economically, continued an investment in apartments, yet the sale is taxed unless it is structured as an exchange. The Code accepts continuity only when it appears in a particular legal form, and Chapters 23 through 32 examine the arrangements that the form requirement generated. The second is that section 1031's own standard stretches the concept. Whether real estate is improved or unimproved is immaterial to like kind, so an exchange of a city apartment building for rural land qualifies even though the character of the investment has changed completely.⁵ Continuity under section 1031 is continuity of legal category, not of economic activity. It also stops at the border. Congress has provided that real property inside and outside the United States are not of like kind, a line that treats continuity as meaningful only within the domestic tax base (15.4 and 65.1).⁶

Critics have pressed these points. Jensen found the traditional justifications for nonrecognition wanting, although he saw some plausibility in the provision as applied to traditional simultaneous exchanges, and Kornhauser concluded that whatever benefits the provision produces come at a high cost.⁷

2.2 Wherewithal-to-pay rationale

The argument. A tax that falls due when a taxpayer has received no cash may force a sale to pay it. Treasury's economists, describing the provision's origins, noted that the steep increase in rates during World War I produced strong lock-in, and that exchanges would be discouraged because not enough money would be left after paying the tax to buy replacement property of comparable value.⁸

The statute follows the argument closely. Section 1031 recognizes gain to the extent of money received and the fair market value of other property received.⁹ That is a wherewithal rule: tax follows cash and its equivalents out of the exchange, and only the portion that stays invested in like-kind property is sheltered. The involuntary conversion rules have the same structure. A taxpayer whose property is converted into money may elect to recognize gain only to the extent the amount realized exceeds the cost of qualifying replacement property bought within the replacement period.¹⁰

Where the argument fails. Wherewithal is not a general principle of the income tax, and it fits section 1031 poorly at three points.

The income tax regularly taxes gains that produce no cash. A lessor who repossessed land on which a departing tenant had built a building was taxed on the gain attributable to the building, though no cash changed hands (1.3).¹¹

Section 1031 also bars losses. A taxpayer who exchanges property worth less than its basis cannot recognize the loss, although a loss creates no liquidity problem.¹² If the provision rested on wherewithal alone, the loss rule would be inexplicable.

And the modern exchange is not cashless. In a deferred exchange the relinquished property is sold for cash, which a qualified intermediary holds and uses to buy the replacement (Chapter 24). The taxpayer has wherewithal in every economic sense, and the regulations treat the cash as not received only so long as the taxpayer's rights to it are restricted (Chapters 27 and 29). Treasury made a related observation when it proposed limiting the provision: complex three-party exchanges facilitated by intermediaries were not contemplated when the provision was enacted.

The Ninth Circuit reached the same conclusion about the rationale itself. In Starker, it read the legislative history as reflecting concern that taxpayers who do not cash in their investments would lack the cash to pay a tax, but it observed that a taxpayer who sells property for cash and reinvests in like-kind property a few days later receives no relief, so that the liquidity rationale must be limited.¹³

2.3 Valuation-difficulty rationale

The argument. Realization in an exchange requires a number. The amount realized is the money received plus the fair market value of the property other than money received, so an exchange of unique assets requires valuing what came back.¹⁴ If valuation is costly and contestable, the argument runs, it is better to postpone the tax until a sale for cash supplies a price. Treasury, in budget proposals to limit the provision, called the difficulty of valuing exchanged property a primary historical justification for deferral, and Johnson described nonrecognition as first adopted to avoid the difficulties of valuation.¹⁵

The argument's limits. Three features of the modern provision undercut it.

The provision itself requires valuation. Boot is measured by the fair market value of other property received. Basis must be allocated among multiple properties received by assigning other property its fair market value. And an exchange that is meant to avoid boot must balance the values on each side. Parties who negotiate an exchange have agreed on values, even if the tax law declines to use them for recognition. The Ninth Circuit made the same observation in Starker, adding that nonrecognition does not extend to other exchanges in which valuation is just as difficult, so that valuation cannot have been the controlling consideration.¹⁶

The Supreme Court has treated valuation at the moment of exchange as workable. In explaining its test for when an exchange realizes gain or loss, the Court emphasized that the test is easy to administer and permits values to be fixed against basis at the moment of exchange (1.3).¹⁷

The modern exchange supplies a cash price. When a qualified intermediary sells the relinquished property and buys the replacement, both legs are priced in cash. Treasury made this point in its budget proposals, and Johnson built his proposal for repeal on it, pairing repeal with an information return from the intermediary reporting the amount realized.¹⁸

What survives of the valuation rationale is largely historical, and Chapter 4 examines the text of the early statutes and what the legislative record does and does not show about their purpose.

2.4 Deferral distinguished from exemption: the role of substituted basis

The mechanism. A nonrecognition rule becomes a deferral rule only if something preserves the unrecognized gain for later, and that something is basis. Section 1031(d) gives replacement property the basis of the property exchanged, decreased by money received and increased by gain recognized, so that the unrecognized gain is embedded in the difference between the replacement property's value and its basis.¹⁹ The holding period follows the basis: property received in an exchange includes the holding period of the property exchanged when its basis is determined by reference to that property.²⁰

The vocabulary. The Code names the two ways basis can carry over. Exchanged basis property takes its basis by reference to other property held by the same person, as under section 1031. Transferred basis property takes its basis by reference to the basis in the hands of a donor, grantor, or other transferor, as in a gift or a transfer to a corporation or partnership. Both are substituted basis property.²¹ Substituted basis carries its history with it, because adjustments of the kind made to basis during the earlier holding period are made to the substituted basis as well.²²

Exemption compared. An exclusion works differently. When gain is excluded, basis is not reduced by the excluded amount, and the gain never returns. The exclusion of gain on the sale of a principal residence is the familiar example (Chapter 43).²³ A basis rule that erases gain has the same effect. Property acquired from a decedent generally takes a basis equal to its value at death, so a deferral that lasts until death becomes an exemption (3.5).²⁴

The cost of deferral inside the basis. Substituted basis preserves more than gain. Because the replacement property's basis is lower than its cost, its depreciation deductions are lower too, and deferred depreciation recapture travels with it (Chapters 36 and 37). Deferral is therefore not free even when the chain ends in a taxable sale. Its value is the time value of the postponed tax net of the depreciation given up, which is why present-value studies find the benefit of an exchange to be a fraction of the tax deferred (3.1).²⁵

2.5 The nonrecognition family: sections 351, 354, 361, 721, 1031, 1033, 1041

Section 1031 belongs to a family. Setting the members side by side shows what is common to nonrecognition and what is peculiar to section 1031.

Transfers to controlled corporations. No gain or loss is recognized when property is transferred to a corporation solely in exchange for its stock if the transferors are in control of the corporation immediately afterward, control meaning at least 80 percent of the combined voting power and of the shares of all other classes.²⁶ Money or other property received triggers recognition of gain up to its amount.²⁷ The transferor's stock takes an exchanged basis, and the corporation takes the transferor's basis in the property.²⁸

Reorganizations. No gain or loss is recognized when stock or securities of a corporation that is a party to a reorganization are exchanged, under the plan of reorganization, solely for stock or securities of such a corporation, or when a corporation that is a party exchanges property under the plan solely for stock or securities of another party.²⁹ On the shareholder side, boot triggers recognition of gain and the new stock takes an exchanged basis.³⁰

Contributions to partnerships. No gain or loss is recognized to a partnership or its partners on a contribution of property in exchange for a partnership interest, subject to an exception for certain contributions to partnerships that would be treated as investment companies.³¹ The partner's interest takes the basis of the contributed property, and the partnership takes the partner's basis in the property.³² Section 721 has no boot rule of its own. The disguised sale rules do that work, presuming a sale when a partner contributes property and receives money within two years (Chapter 50).³³

Involuntary conversions. When property that is destroyed, stolen, seized, or condemned is converted directly into property similar or related in service or use, no gain is recognized. When it is converted into money, the taxpayer may elect to limit recognized gain to the excess of the amount realized over the cost of qualifying replacement property bought within the replacement period.³⁴ For condemned real property held for business or investment, replacement property of like kind qualifies.³⁵ The replacement takes a basis that preserves the unrecognized gain.³⁶

Transfers between spouses. No gain or loss is recognized on a transfer of property to a spouse, or to a former spouse if the transfer is incident to divorce. The transfer is treated as a gift, and the transferee takes the transferor's adjusted basis.³⁷

Like-kind exchanges. No gain or loss is recognized on an exchange of real property held for productive use in a trade or business or for investment solely for real property of like kind to be held for either purpose. Gain is recognized to the extent of boot, loss is not recognized, and the replacement property takes an exchanged basis.³⁸

What the family shares. Four features recur. Each provision assumes a realized gain or loss that it declines to recognize. Each preserves the unrecognized gain through exchanged or transferred basis, and the holding period follows the basis. Most recognize gain to the extent the taxpayer takes something out of the continuing investment. And most apply of their own force. The involuntary conversion rule for money proceeds is the notable elective exception, and the involuntary conversion rules are also the only member of this group that defers gain but not loss. Section 1031, like sections 351, 721, and 1041, bars loss as well as gain when its conditions are met (9.6).

2.6 Why section 1031 alone conditions relief on the kind of property

What the other members condition on. Each member of the family requires something that supplies continuity. For transfers to corporations it is the transferors' control of the corporation. For reorganizations it is the plan and the status of the corporations as parties to it. For partnership contributions it is the partnership interest received. For involuntary conversions it is the involuntary character of the event and reinvestment in similar property. For spouses it is the marital relationship.³⁹ In each case the continuing investment is identified by an entity, a plan, an event, or a relationship.

Section 1031 has none of those. An exchange of real estate between unrelated parties involves no entity and no relationship through which continuity could be traced. The only thing that can connect the old investment to the new one is the property itself. The like-kind requirement supplies the connection by asking whether the two properties share the same nature or character, without regard to grade or quality.⁴⁰

Qualifications. Section 1031 is not the only provision that looks at the type of property. The narrow exchange rules for insurance contracts, for common or preferred stock exchanged for stock of the same kind in the same corporation, and for certain federal obligations are each defined by the instrument involved.⁴¹ Those rules are confined to particular instruments, while section 1031 is a general rule for business and investment real estate. The involuntary conversion rules borrow the like-kind standard for condemned real property, a borrowing that shows how closely the two provisions are related (Chapter 45).⁴² And other reinvestment provisions define eligible replacement property by statutory category, such as the qualified replacement property required after certain sales of qualified securities.⁴³ Among the general nonrecognition provisions, however, section 1031 is the one whose central condition is a relationship between two properties.

The consequences. Because the condition is a relationship between properties, the recurring disputes under section 1031 are disputes about property: what is held for investment, what is held for sale, what counts as real property, and which interests qualify (Chapters 12 through 16). Because the like-kind standard is broad among real properties, the condition does less work than its name suggests, and most of the practical limits on section 1031 come instead from the requirements of an exchange, of the same taxpayer, and of timing (Chapters 17 through 32). The 2017 narrowing of the eligible kind to real property made the condition stricter at its outer edge while leaving it as generous as ever within real estate (Chapter 7).