Like-Kind Exchanges

How would you like to sell your valuable performance horse and not owe any income tax? Most horse owners would think this could only happen if the horse has decreased in value from the time it was purchased. A special type of transaction is available, however, which allows performance horse owners to earn a substantial return on their equine investment without incurring any tax liability.

Taxpayers realize gain when they sell an asset at a profit. The profit equals the amount realized on the sale over the adjusted basis (generally cost less depreciation) of the asset sold. As a general rule, taxpayers recognize that gain at the same time. Upon recognition, the taxpayer reports the income on his or her Form 1040.

When a taxpayer sells a performance horse at a profit, generally that realized profit is recognized and subject to tax as either ordinary income or capital gain. The like-kind exchange rules provide a special exception that allows taxpayers to avoid recognition of gain. The most basic situation is as follows:

Clayton Jones breeds, raises, and trains horses for racing. Mr. Jones is profitable in this business.1 Sometimes, Mr. Jones purchases yearlings to add to his racing stock. In 1991, Mr. Jones purchases Expensive Gain, a yearling, for $20,000. He spends the next year training the horse for Thoroughbred racing.

As a 2-year-old, Expensive Gain quickly becomes well-known on the racing circuit, winning a number of races and earning substantial purses. In 1996, Hank Smith approaches Mr. Jones and offers $100,000 for Expensive Gain. Hasty to lock in his appreciation, Mr. Jones snaps up the offer and sells Expensive Gain outright at the proffered price.

As of the purchase date, Mr. Jones has claimed $10,000 in depreciation deductions on the horse.2 Total gain on the sale is $90,000. To replenish his stables, Mr. Jones then purchases four yearlings for $110,000.

On a pre-tax basis, Mr. Jones would likely consider himself as having earned a good return (400%) on his investment. Combined taxes will eat up more than 40% of this gain, however. At the top tax bracket, 39.6%, Mr. Jones would owe the federal government more than $26,000 in income taxes.3 The relevant state government would add an additional $3,000 to $6,000 in state income taxes.4 While making a good investment, Mr. Jones would find his net of tax proceeds from the sale reduced by up to $32,000 in income taxes. Further, the price the horses would fetch is lower because the purchaser must pay state sales tax on the purchase.5 His gain need not come at such great expense, however.

Mr. Jones has just made a tax "donation," because he has voluntarily (albeit unwittingly) inflated his income tax obligation on the transaction. By legislative grace, Congress and the states have provided a mechanism to avoid paying income tax on the transaction with relative ease. Mr. Jones should have availed himself of a like-kind exchange pursuant to section 1031 of the Federal Internal Revenue Code ("IRC" or "Code").

Under the like-kind exchange rules, taxpayers may exchange property, real or personal, held for investment or for use in a trade or business for property of "like-kind" without recognizing gain. Property is "like-kind" to the property exchanged if it in turn is acquired with the purpose of holding it either for investment or for use in a trade or business. Both Thoroughbred racing and Thoroughbred breeding qualify as investment or trade for business purposes.6

With proper planning, Mr. Jones could have qualified for the special exchange treatment. Mr. Jones held Expensive Gain for use in a trade or business, Thoroughbred racing. He acquired the four replacement horses for the same purpose. Under a properly structured like-kind exchange, Mr. Jones would have had the full $100,000 to reinvest in new horses. Federal and state income tax would not apply; and many states would not assess sales tax.7

There are two different types of exchanges. A simultaneous exchange is most common and constitutes the true "horse swap." Such an exchange involves the simultaneous sale and purchase of the exchange and replacement horses, respectively. At closing, the following events would occur:

1) Mr. Jones would transfer title to Expensive Gain to Mr. Smith.

2) A third party or parties would transfer title to the replacement horses to Mr. Jones.

3) Mr. Smith would transfer the $100,000 to the third party or parties.

4) Mr. Jones would transfer the remaining purchase price ($10,000 under our example) to the third party or parties.

5) Mr. Jones' basis in Expensive Gain will carry over to the replacement horses and be added to any additional amounts paid in their acquisition. Assuming all four replacement horses are equally valued, Mr. Jones would have a basis of $5,000 in each replacement horse.

While clearly offering a better result than outright sale, simultaneous exchanges fail to address a common problem. Horse owners often find buyers before they know which horses they wish to acquire as replacements. The solution most often relied upon is the "delayed exchange." Congress has provided taxpayers 45 days to shop around for replacement property through statutory delayed exchanges. In return, taxpayers must properly structure the exchange to comply with a number of additional restrictions. A properly structured delayed exchange, while more complicated, allows the taxpayer over six months to replace his horse.

To take advantage of the delayed exchange rules, horse owners must include certain exchange provisions in any contract to sell a horse. Planning is essential. You must arrange your horse's sale to ensure that the cash paid by the purchaser is safe, secure, and dedicated to the purchase of your replacement horse or horses. If you receive the cash direct and pay for the replacement horses yourself, you are taxed on the sale.

Assume Mr. Jones cannot refuse the offer he has received, but needs additional time in order to find replacement horses of suitable quality. To properly set up a deferred exchange, he first enters into a purchase and sale contract for Expensive Gain with Mr. Smith. Soon thereafter, Mr. Jones contracts with a third party, a qualified intermediary, to assist in the exchange. This contract must contain provisions that ensure Mr. Jones' funds to purchase his replacement horse will be safe. At closing, Mr. Jones transfers title to Expensive Gain to Mr. Smith, and Mr. Smith transfers the purchase funds to the intermediary. Mr. Jones then has 45 days from the date of closing (DOC) to "identify" his replacement horse or horses. Mr. Jones can list at least three possible replacements and more if certain rules are met.8 Provided he meets the 45-day deadline, Mr. Jones has a full 180 days from the DOC to close on his replacement horses.

A proper identification having been made, the qualified intermediary at the closing on the replacement horses would transfer the purchase funds to the seller and the seller would transfer title to the replacement horses directly to Mr. Jones. Any additional purchase price (in our example $10,000) would be transferred from Mr. Jones to the seller at this time. Any surplus funds in the qualified intermediary go to Mr. Jones. They would be treated as "boot" (property that is not like-kind) and any gain on the horse would be taxable to the extent of the boot. The basis analysis would be identical to that in a simultaneous exchange. Assuming there is boot, the net effect would be avoidance of any income tax on the sale of Expensive Gain. The taxpayer, Mr. Jones, would have succeeded in reinvesting the entire sale proceeds.

The use of a qualified intermediary to affect a simultaneous or delayed exchange enables the purchaser of a taxpayer's horse to avoid assisting in completing the exchange in any material way. The purchaser has no real economic incentive to reduce the tax ramifications of the other party's disposition and is unlikely to be willing to take on additional responsibilities or add complications to the transactions without a reduction in purchase price. Thus retaining the assistance of an intermediary assures that the exchange will take place smoothly without any obstructions from a recalcitrant purchaser.

To properly avoid gain recognition on the sale of Expensive Gain, certain general parameters must be kept in mind. The cost of the replacement horse or horses must be at least as much as the gain inherent in the property sold. As a general rule, the replacement horse or horses must be of equal or greater value than the taxpayer's horses to avoid gain; any cash payment or transfer of non-like-kind property (boot) received by the taxpayer in an exchange will trigger gain recognition. An exchange for a horse of lesser value will still qualify for a partial deferral of gain recognition, but will require partial recognition to the extent of boot received.

In our example, the horses purchased in the exchange must cost at least $100,000 to avoid recognizing any gain. Mr. Jones must recognize gain and pay taxes thereon to the extent the gain inherent in Expensive Gain exceeds the costs of the replacement horses because he will have received a partial cash payment.

Federal tax law also requires that gain be recognized to the extent of any net reduction in indebtedness. If Expensive Gain provided collateral for a $30,000 loan, there must be a loan or loans in at least that amount on the replacement horse or horses.

The full tax deferral benefits of a like-kind exchange might not be available if the taxpayer makes an exchange with a "related person." A disposition of a horse received in an exchange by a related party within two years of that exchange will trigger recognition of gain by both taxpayers. The original exchange will be treated as a sale and both parties might be subject to interest and penalties. If the exchange is structured to circumvent this two-year rule, gain deferral is disallowed on the original exchange; both taxpayers must recognize gain immediately and the two-year rule does not apply.

Finally, the IRS strictly interprets the provisions governing like-kind exchanges. Any like-kind exchange must be carefully analyzed to ensure that it is properly structured and that the intent of the parties is clearly captured in the supporting documentation. With proper tax planning assistance, taxpayers can avoid gain recognition, achieve significant tax deferral, and potentially avoid income tax permanently on the gain inherent in their horses.

About the Author

Timothy J. Eifler

Attorney Timothy J. Eifler is a member of the law firm of Stoll Keenon Ogden, PLLC in Louisville, Ky. His practice encompasses litigating tax issues in the federal and state courts as well as providing advice and planning assistance with tax-oriented transactions. Eifler graduated magna cum laude from the T.C. Williams School of Law at the University of Richmond.

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