Hog Buildings are Like-Kind to Cape Property? Yes, But . . . The Strange Nexus of Section 1031 and Section 1245

Internal Revenue Code Sections 1031 and 1245 have an interesting relationship.  The recent Tax Court case of Gladys L. Gerhardt, et al. v. Commissioner[1] illustrated the interaction between these two sections.  In Gerhardt, the IRS agreed with the taxpayers that the transaction qualified for gain deferral as a like-kind exchange under Internal Revenue Code (IRC) Section 1031.  But the IRS argued that, nevertheless, IRC Section 1245 precluded the deferral of the gain under Section 1031. The Tax Court agreed with the IRS.

Under Section 1031, if real property used in a trade or business or held for investment (relinquished property) is sold, and the proceeds from the sale are used to purchase like-kind replacement property, and a myriad of other technical rules are complied with in executing the transaction, then the gain associated with the sale of the relinquished property is not recognized.

In Gerhardt, the taxpayers sold the “Armstrong Site” which consisted of “hog buildings and equipment, as well as raw land,” which was held as rental property by the taxpayers.  The taxpayers purchased real property called the “Cape Coral Property,” which is not described by the Tax Court, as its like-kind replacement property.

As set forth in the Gerhardt opinion: “The Commissioner does not dispute that the transaction at issue met the requirements of Section 1031. Instead, the Commissioner argues that, despite Section 1031, the gain must be recognized as ordinary income because the property was depreciated ‘Section 1245 property.’ For the reasons set out below, we decide this issue in the Commissioner’s favor.”

A couple of things to note here:

• The IRS agreed that the technical rules associated with Section 1031 were complied with. They were satisfied that real property held for investment had been exchanged for like-kind real property, and that the other requirements of Section 1031 had been met in a good exchange under Section 1031.
• In selling the Armstrong Site, the taxpayers allocated 1.6% of the purchase price to the “raw land,” and 98.4% of the purchase price to the “hog buildings and equipment.” Although “hog buildings” is somewhat descriptive, the Gerhardt opinion doesn’t give any description of the “equipment.”

Section 1245 is a “depreciation recapture” statute. The portion of the gain upon the disposition of “Section 1245 property” (defined below), which resulted from a reduction in basis from earlier depreciation, is “recaptured,” and is taxed as ordinary income.  Importantly, Section 1245(a)(1) makes it clear that Section 1245 trumps all other code sections (including Section 1031): “Such gain shall be recognized notwithstanding any other provision of this subtitle.”

Section 1245(a)(3) defines “Section 1245 property” by listing a number of categories of depreciable property under Section 167, the common feature of which is that each is benefitted by an accelerated depreciation schedule, under Section 168, which is shorter than the depreciation schedules for assets required to use “straight line depreciation,” such as commercial and residential real property (depreciated over 39 and 27.5 years, respectively).

Among the categories listed in Section 1245(a)(3) are “personal property” and “a single purpose agricultural or horticultural structure” (which includes, with reference to Section 168(i)(13), a “single purpose livestock structure” i.e., “any enclosure or structure specifically designed, constructed, and used for housing, raising, and feeding a particular type of livestock and their produce.”).

The court in Gerhardt pointed out the above-described two categories of Section 1245 property as being applicable to the hog buildings and the equipment sold by the taxpayers in their 1031 exchange.  Therefore, the gain resulting from the reduction in basis due to accelerated depreciation of those assets was recognized as “depreciation recapture” and taxed as ordinary income under Section 1245.

It’s seems pretty clear how the hog buildings qualified as Section 1245 property as “single purpose agricultural or horticultural structures.”  The equipment apparently qualified as Section 1245 property as “personal property.”  But wait a minute—the Tax Court found that the relinquished property complied with Section 1031, and Section 1031 is limited to real property.  How can property qualify as “real property” to be eligible for like-kind exchange treatment under Section 1031, and “personal property” to be subject to an accelerated depreciation schedule and depreciation recapture under Section 1245?

Treasury Regulation (Reg) Section 1.1031(a)-3 defines “real property” for purposes of Section 1031, and the definition is very broad and detailed, going well beyond just land and buildings.  Reg Section 1.1031(a)-3(a)(7) gives a clear answer to the question posed in the previous paragraph:

The rules provided in this section concerning the definition of real property apply only for purposes of section 1031. No inference is intended with respect to the classification or characterization of property for other purposes of the Code, such as depreciation and sections 1245 and 1250.[2] For example, a structure or a portion of a structure may be section 1245 property for depreciation purposes and for determining gain under section 1245, notwithstanding that the structure or the portion of the structure is real property under this section. Also, 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. ]emphasis added]

Section 1.1031(a)-3 gives examples of large pieces of equipment, such as 3-D printers, generators, and steam turbines, that would be deemed real property under Section 1031 since they are “designed to remain in place indefinitely once installed in the building, and [their] removal would be time-consuming and very costly, and would cause significant damage to the building.” (Examples 5 and 7).   Again, in the Gerhardt case, the “equipment” is not described by the Tax Court other than to list it as “personal property” under Section 1245, and apparently it also qualified as real property under Section 1031, similar to the examples of large pieces of equipment in Section 1.1031(a)-3 mentioned above.

So can gain resulting from depreciation recapture under Section 1245 ever be deferred in a Section 1031 exchange?  The multiple asset exchange regulations of Reg Section 1.1031(j)-1 provide rules for grouping property in the relinquished property and replacement property into exchange groups which offset each other. Although Section 1245 is not specifically addressed in Reg Section 1.1031(j)-1, the general rules regarding the grouping of assets has led to the general rule of thumb cited by practitioners that gain with respect to Section 1245 property in the relinquished property can be deferred by exchanging for an equal amount of Section 1245 property in the replacement property.  As described by one commentator:

The multiple asset exchange regulations do not address the application of §1245 to a multiple asset exchange, and the method of its application is not entirely clear. Section 1245(a)(1) states the general rule that ordinary income must be recognized in an exchange, notwithstanding any other provision . . . .  It seems logical, therefore, to calculate §1245 gain at the exchange group level, since that is the level at which the amount realized must be calculated under the multiple asset regulations.[3]

There is another special rule regarding Section 1245 and 1031 exchanges.  Under Section 1245(b)(4), Section 1245 gain in a 1031 exchange is limited to the sum of: (i) the amount of gain recognized in the transaction under provisions other than Section 1245, and (ii) the fair market value of property acquired in the exchange which is not Section 1245 property.  The example given in the Reg involves machine A exchanged for machine B  “Both machines are section 1245 property. No gain is recognized under section 1245(a)(1) because of the limitation contained in section 1245(b)(4).”  The limitation doesn’t work if the replacement property is made up of non-section 1245 property, as was apparently the situation in the Gerhardt case.

The Bottom Line:  As described in Gerhardt, when Section 1245 property is sold as part of the relinquished property in a 1031 exchange, the gain resulting from “depreciation recapture” must be recognized, and is taxed as ordinary income, despite Section 1031.  But this result may be alleviated by matching Section 1245 property in the relinquished property with Section 1245 property in the replacement property under the multiple asset exchange regulations.

[1]  160 TC No. 9 (4/20/2023)

[2] The relationship between Section 1031 and Section 1250 is, in some ways, even a little more strange, and will be the subject of a future Tax Blog post.

[3] BNA Portfolio 567-5th III(c)(3).  Section 1.1031(j)-1(a)(2)(i) describes the workings of the multiple asset regulations: “In general, the amount of gain recognized in an exchange of multiple properties is computed by first separating the properties transferred and the properties received by the taxpayer in the exchange into exchange groups in the manner described in paragraph (b)(2) of this section. The separation of the properties transferred and the properties received in the exchange into exchange groups involves matching up properties of a like kind of like class to the extent possible.  …. Then, the rules of section 1031 and the regulations thereunder are applied separately to each exchange group to determine the amount of gain recognized in the exchange.”