Timberland and timber are sometimes traded or exchanged for other timberland, timber, or other property. This section deals with voluntary exchanges and should not be confused with the rules for postponing the recognition of gain or loss when property is involuntarily converted and qualified replacement property acquired. See IRS Publication 544 Sales and Other Dispositions of Assets Sales and Other Dispositions of Assets Sales and Other Dispositions of Assets for details.
Voluntary exchanges may be made because the parties do not want to make direct payments in cash, securities, notes, or other mediums of exchange. In many cases, however, exchanges are made to postpone the payment of income tax on the difference between the exchange value of the property and the owner's basis in the property. Unless specific nonrecognition requirements of the Internal Revenue Code are met the gain or loss on a sale or exchange of property is taxable and must be reported. In general, nonrecognition applies if business or investment property is exchanged solely for other like-kind business or investment property (IRC Section 1031).
Basis and Holding Period Carryover
Postponement of gain or loss is achieved by carrying over to the property received the basis of the property given in an exchange. Adjustments to basis are required if boot is paid or received to equate the values of the property given up and the property received. Likewise, the holding period of the property given up is tacked onto the holding period of the property received in exchange.
Non-recognition Mandatory for Qualified Transactions
Satisfaction of the like-kind exchange provisions results in mandatory application of nonrecognition treatment. Nonrecognition in such cases is not elective. Thus, you may not benefit from an exchange which results in a loss. This is because any available deduction for the loss would be postponed until the property received is disposed of by sale or other taxable transaction.
Qualifications for Nonrecognition
Nonrecognition of gain or loss depends on satisfying five conditions: (1) there must be an exchange of property, i.e. actual transfer of title; (2) the property transferred and property received must be of "like kind;" (3) the property given up and the property received must both be held for productive use in a trade or business or investment; (4) the property exchanged must be of a kind eligible for like-kind exchange treatment under the IRC; and (5) if the properties are not exchanged simultaneously, two timing requirements related to identification and receipt of replacement property must be met.
Sale and Exchange Distinguished – A sale occurs if the transfer of ownership occurs by recognition of prices for the properties and payment of this price in money or its equivalent. An exchange is the giving of one property for another without the intervention of money. If the values of the property given and received are not equal the adjustment for the difference may be made with cash or its equivalent. This adjustment payment is called boot. Boot does not necessarily make the exchange a sale. But, the use of boot does require the recognition of gain (but not loss) to the extent of the lesser of the gain realized on the transaction or the fair market value of the boot received.
The transactions involved in an exchange must be reciprocal and mutually dependent. They must be interdependent parts of an overall plan. A sale followed by a separate reinvestment of the sale proceeds in like-kind property does not qualify for non-recognition. It doesn''t matter that the sale and purchase of like-kind property occurred on the same day. For non-recognition treatment form matters as much as substance. The critical requirements are (1) transactions during the exchange period must be interdependent parts of an integrated plan resulting in the exchange of property; (2) exchange must occur without transferor's receipt of, or control over, cash or unlike property, and (3) transferor must retain rights in the property until the exchange takes place.
Like-Kind Property Defined – Like kind refers to the nature or character of property, not its grade or quality. Thus, an exchange of an item of property within one of the three classes of property for another item within the same class qualifies as like kind. In addition, the type of interest held in the property given up and received must be similar in character or nature. Real property located within the United States and real property located outside the United State are not like kind, however.
Three classes of property are used in defining like-kind property:
- depreciable tangible personal property such as equipment;
- other personal property including intangible personal property, nondepreciable personal property, and personal property held for investment; and
- real property.
Timberland and unsevered timber, also called standing timber or stumpage, are real property. The right to cut and remove standing timber under the provisions of a timber deed or cutting contract is classified as other personal property in most states. There is, however, some variation among states regarding the classification of timber contracts. Since, state, not federal, law determines the legal classification of items of property it is necessary to consult legal counsel for such determinations.
The exchange of virtually any parcel of real property for another parcel of real property should qualify as like kind as long as the interests in the property given up and the property received are of similar character or nature. The most common form of ownership interest is "fee simple." A fee simple interest is not limited to a certain period of time. A leasehold interest is not of the same character or nature as a fee simple interest because a leasehold interest is limited to a designated period of time. However, a lease with 30 years or more remaining is of like kind to a fee simple interest and non-recognition treatment is available to the person holding the lease (lessee). Nonrecognition may not be available to the person granting the lease (lessor) because receipt of the fee simple interest may be treated as advance rental payment that has to be reported as ordinary income.
Held for Productive Use in Trade or Business or Investment – At the time of the exchange the property given and the property received must be held for productive use in a trade or business, or investment. There is no precise definition of what constitutes a trade or business, or an investment. The key factor in both cases, however, is intention to make a profit.
The property given up may have been originally acquired for another purpose. Likewise, the use of the property received may be changed to a non-qualifying use some time after the exchange. However, such a change in use of the property received may indicate an intent not to hold it for a qualified use at the time of the transaction. The burden is on the taxpayer to prove the property given and received were held for productive use in a trade or business, or investment. Property held for use in a trade or business may be exchanged for investment property, and vice versa.
Kind of Property Eligible for Like-Kind Exchange Treatment – Property that is stock in trade or property held primarily for sale to customers in the ordinary course of a trade or business does not qualify for like-kind exchange treatment. Thus, timber considered to be held primarily for sale would not qualify if exchanged separately from the land. However, such timber would qualify if it is exchanged with the accompany land. In such cases the timber is classified as an unharvested crop exchanged with the land. Property acquired solely for exchange purposes is not held for productive use in a trade or business or investment. Partnership interests also do not qualify.
Timing Requirements – An exchange clearly occurs if the giving and receiving of qualified properties occurs simultaneously. This is not always possible, however. The regulations provide two specific timing requirements to distinguish a sale from an exchange. First, replacement property must be identified before the end of the "identification period." This period begins on the date that the property given up is transferred and ends at midnight on the 45th day thereafter. To qualify as identified the replacement property must be designated in either a written agreement signed by all parties, or a written document signed by the taxpayer and hand delivered, mailed, or otherwise sent to a person involved in the exchange such as escrow agent or title company. Second, replacement property must be received before the end of the "exchange period." This period begins on the date the property given up is transferred and ends at midnight on the earlier of (1) 180 days after that date, or (2) the due date for the taxpayer's return for the year in which the transfer occurs.
Multiple Party Exchanges
More than two parties may be necessary to complete an exchange. A frequent approach involves A (seller), B (buyer), and C (seller of replacement property acceptable to A). B purchases C's property, and then exchanges it for A's property. Assuming the other qualifications are met, A would qualify for nonrecognition treatment. In other cases more than three parties and escrow accounts or other forms of security are necessary. The critical factor in complex transactions is whether or not the taxpayer seeking nonrecognition treatment was in constructive receipt of cash or unlike property before title to the replacement property is finally received. If in constructive receipt the gain or loss would have to be reported in the year received. Four "safe harbor" rules are used to determine constructive receipt. These rules and other technical aspects of multiple-party exchanges should be discussed with qualified legal and tax counsel before carrying out exchanges.
Examples of timber related exchanges that qualify for nonrecognition as like-kind exchanges include: timberland containing all old growth timber exchanged for timberland containing second growth timber (Rev. Rul. 72-515); timberland for bare land (Rev. Rul. 78-163); timberland for real estate in a city; undeveloped ranch land for a commercial building; a tree farm in one state for timberlands in another state; timberland with reservation of cutting rights for state owned timberland of lesser value (Rev. Rul. 76-253); timber cutting rights on one tract for timber cutting rights on another tract, timberland and perpetual timber cutting rights (classified as real property under state law) for other timberland; and timberland held by a testamentary trusts for timberland held by an inter vivos trust.
Examples of timber related exchanges that did not qualify for nonrecognition as like kind exchanges include: timber held primarily for sale for timberland; right to cut timber on taxpayer's land for other timberland; and sale of timberland for cash and subsequent purchase of other timberland.
Exchanges Between Related Parties
If related parties exchange like-kind property, tax deferral ends and tax due must be paid if either party disposes of the property acquired in the exchange within two years after the exchange takes place.
Reporting of Like-Kind Exchanges
Like-kind exchanges must be reported in the year the exchange is made. Exchanges of investment property (capital assets) are reported on Schedule D of Form 1040. Exchanges of property held for use in a business are reported on Form 4797. Also, Form 8824, Like-Kind Exchanges, is filed to support the entries on Schedule D or Form 4797. If the exchange is between related parties Form 8824 must also be filed for the two years following the year of the exchange.