Tax-Free Exchanges of Aircraft Under Section 1031

Statutory Requirements
Under Section 1031

There are three general requirements imposed by statute in order for a transaction to qualify as a tax-free Section 1031 exchange.

1. The relinquished property and the replacement property must be held either for productive use in a trade or business, or for investment.

2. The exchange must be reciprocal, i.e., a transfer of property in exchange for other property (as opposed to a sale and purchase).

3. The relinquished property and the replacement property must be of "like-kind."


A. Held For Productive Use In a Trade or Business, or For Investment

1. Business Use vs. Personal Use

For a transaction to qualify for tax-free treatment under Section 1031, the relinquished property and the replacement property must be held for investment or used in a trade or business in which the taxpayer is engaged. An exchange of non-business property or property used for personal reasons would not satisfy this requirement. According to the IRS, an exchange in which both parties swap both business property and personal property would be viewed as two simultaneous transactions, a tax-free exchange with respect to the business property and a taxable one with respect to the non-business property. P.L.R. 8221054 (February 24, 1982).(1) The IRS has also ruled that property that is used solely for business purposes except for some minimal amount of time (e.g., ten days per year) should qualify as trade or business property for purposes of the statute. P.L.R. 8103117 (October 27, 1980).

2. Holding Requirement

Section 1031 states that a like-kind exchange will be tax-free only if the relinquished property has been "held for productive use . . . or for investment" and the replacement property "is to be held either for productive use . . . or for investment." This requirement reflects the notion that the replacement property represents a kind of continuation of the owner's investment in the relinquished property. While the statute clearly requires that relinquished property be held before the exchange, it does not specify how long the relinquished property must be held before the exchange. Similarly, while the statute clearly requires that the replacement property be "held" after the exchange, it does not specify how long the replacement property must be held after the exchange before it can be disposed of.

The IRS has historically taken the position that property that is the subject of a tax-free exchange under Section 1031 may not be transferred immediately before or after that exchange. Rev. Rul. 84-21, 1984-2 C.B.168 ; Rev. Rul. 77-337, 1977-2 C.B. 305; Rev. Rul. 75-292, 1975-2 C.B. 333; P.L.R. 8221054 (February 24, 1982).(2) Recent decisions, however, have suggested that the courts will allow a tax-free transfer of the exchange property immediately before or after the exchange when that transfer merely alters the form of ownership, without altering the beneficial economic ownership of the property in question. The Tax Court and Ninth Circuit Court of Appeals have both concluded that a taxpayer who receives business property tax-free (e.g., in a corporate liquidation, reorganization or a §351 contribution) may immediately exchange that property tax-free for property of like kind. Mason v. Commissioner, 55 T.C.M. 1134 (1988); Bolker v. Commissioner, 81 T.C. 782 (1983), aff'd, 760 F.2d 1039 (9th Cir. 1985). The Ninth Circuit has gone further still, suggesting that any newly acquired business property may be exchanged immediately in a like-kind exchange. The appeals court reasons that the intent to exchange property for like-kind property constitutes an intent to continue to hold the original investment in property, albeit in different form. Id. at 1045. See also, 124 Front Street v. Commissioner, 65 TC 6 (1975).

With respect to how long before or after an exchange one must hold the replacement property, the IRS has indicated that two years of business use is sufficient. P.L.R. 8429039 (April 17, 1984). Where the disposition of the replacement property is required by circumstances unrelated to the exchange, the IRS has approved a holding period of less than six months. P.L.R. 8126070 (March 31, 1981).

Moreover, the Tax Court and Ninth Circuit have held that replacement property may immediately be contributed to a partnership, because such a contribution changes only the form of ownership, without affecting the substance of the investment. Magneson v. Commissioner, 81 T.C. 767 (1983), aff'd, 753 F.2d 1490 (9th Cir. 1985). Similarly, the Tax Court has ruled that a corporation may acquire property in a like-kind exchange, then immediately transfer the replacement property received to its shareholder(s) by liquidating. Maloney v. Commissioner, 93 T.C. 89 (1989). But see, Barker v. Commissioner, 668 F.Supp. 1199 (C.D. Ill. 1987); Regals Realty, 127 F.2d 931 (2d Cir. 1942).

Notwithstanding these judicial rulings in favor of pre-exchange and post-exchange transfers, the IRS has so far refused to completely concede the issue. The IRS may be expected to view such transfers as a failure to satisfy the "held for productive use" requirement, rendering the like-kind exchange a taxable transaction. Certainly, where such transfers are required by unforeseen circumstances, the IRS is more likely to recognize the existence of the requisite intent. Moreover, the IRS has recently shown more leniency in their original position when the taxpayer has not cashed out its investment in the relinquished property in any significant way. See, P.L.R. 9751012 (September 15, 1997); P.L.R. 9152010 (September 13, 1991). In P.L.R. 9751012 the Service ruled that the acquisition of replacement property by a taxpayer corporation, through the use of two wholly owned LLCs (see discussion below), was allowed to be accomplished tax free under IRC § 1031 despite the fact that the relinquished properties had been held by predecessor corporations which were related to, and liquidated and merged into, the taxpayer corporation.

3. Use of Single Member LLC's as a Planning Tool

There are some situations where the use of a different legal entity to hold the replacement property may be preferable due to regulatory, state tax or business considerations. Such considerations are often at odds with the position of the IRS regarding the "held for" requirement when the taxpayers are seeking to make a tax-free exchange under IRC § 1031. In the past, taxpayers caught in that situation were often faced with a difficult choice between taking a conservative position with respect to their tax-free treatment on the exchange and obtaining the benefits associated with the use of a separate entity to hold the replacement property. Recent changes in state corporate law, as well as new regulations regarding the federal tax treatment of single member limited liability companies ("LLCs") now allow the taxpayer to obtain both objectives under certain circumstances.

Limited liability companies have been accepted as an alternative business vehicle in one form or another by all fifty states and the District of Columbia. LLCs combine some of the more favorable attributes of corporations and partnerships. The state statutes authorizing limited liability companies generally adopt the corporate traits of limited liability as well as clearly defined and effective governance rules. At the same time, the arrangements that can be made by the owners under those rules are relatively flexible, allowing for more participation of the owners in the day-to-day affairs of the company, if that is the preferred mode of operation. Traditionally such flexibility and widespread management had been the hallmark of partnerships.

The IRS now allows both LLCs and partnerships to overtly elect whether they would be treated as a corporation or partnership for federal tax purposes. Treas. Reg. § 301.7701-1. This election, in turn, provides even more flexibility for LLCs in drafting their internal rules and has contributed to their increasing popularity.

While most state statutes initially required an LLC to have more than one member, some of the more recent enactments and amendments to LLC statutes have liberalized this requirement and now allow for the formation of a LLC by a single member.(3) The permissibility of single member LLCs, when combined with the treatment of such entities under the federal tax regulations as described below, provides a powerful planning option.

Specifically, the tax regulations declare that a single member LLC may be either treated as a corporation or disregarded as a distinct entity for federal tax purposes, at the election of the taxpayer. Treas. Reg. § 301.7701-2. The availability of the "tax nothing" option allows taxpayers some flexibility in obtaining certain business, regulatory or state tax objectives through the use of a single member LLC. Since the single member LLC is disregarded for federal tax purposes (if so elected by the taxpayer) the transfer of the relinquished or replacement property to such an entity does not jeopardize a tax-free exchange. The IRS has confirmed this conclusion in recent rulings. P.L.R. 9807013 (November 13, 1997); P.L.R. 9751012 (September 15, 1997). The absence of recognition for the single member LLC for federal tax purposes also may provide other tax planning options. This may include the ability of the taxpayer to overcome passive loss implications that might otherwise result from renting aircraft between related entities. 

The separate existence of the LLC, however, is often respected for liability, regulatory or state sales and use tax purposes. This may allow taxpayers to take advantage of some of the benefits of holding aircraft in a separate entity, such as the protection of assets from the liability associated with the operation of an aircraft or a state sales and use tax exemption, while not creating a Section 1031 or passive loss problem.

B. The Exchange Requirement

For purposes of Section 1031, a transaction constitutes an exchange if there is a reciprocal transfer of property for property, as opposed to a transfer of property for money only. For many years, the IRS took the position that, in order to qualify as a reciprocal transfer of property, a like-kind exchange must be simultaneous. The Ninth Circuit decided otherwise, however. Starker v. U.S., 602 F.2d 1341 (9th Cir. 1979). The 1984 Tax Reform Act resolved the issue in favor of according tax-free treatment to non-simultaneous exchanges, but imposed two important time limitations: from the day of the sale of the relinquished property, (i) the replacement property must be identified within forty-five days, and (ii) the replacement property must be acquired within one hundred eighty days. These statutory changes were amplified by regulations issued by the Department of Treasury in 1991 (the "Regulations"). The Regulations, which will be discussed in greater detail below, specify that all aspects of a like-kind exchange must constitute an integrated, mutually dependent transaction. In evaluating whether an exchange has taken place, the Tax Court looks to interdependence, intent, timing, and commitment of the parties to the exchange.

The courts have also determined that, in order for a transaction to qualify as an exchange, the parties involved must have intent at the time of the transaction to engage in an exchange. An attempt to retroactively treat a completed sale as an exchange will not be respected by the IRS or the courts. Mars v. Commissioner, 54 T.C.M. 636 (1987). On the other hand, mere intent to engage in an exchange is not sufficient to transform a sale into an exchange. A taxpayer who purchases property and finances the purchase by immediately selling a different property has not engaged in an exchange, no matter the taxpayer's intent. Bezdjian v. Commissioner, 845 F.2d 217 (9th Cir. 1988); Dibsy v. Commissioner, 70 T.C.M. 918 (1995).

C. Like-Kind Requirement

Section 1031 requires that the relinquished property and the replacement property be of "like-kind." The statute provides no guidance on how to determine whether one property is of like-kind with respect to other property. Over time, two interpretations of the term "like-kind" have developed, one with respect to real estate, the other with respect to personal property (i.e., non-real estate). When real estate is exchanged for other real estate, the like-kind principle has been applied quite liberally. For example, an interest in minerals was found to be like-kind with respect to an interest in a hotel. Commissioner v. Crichton, 122 F.2d 181 (5th Cir. 1941). With respect to personal property, on the other hand, like-kind property can be construed more narrowly. For instance, the Ninth Circuit has ruled that numismatic coins (i.e., coins held for collection purposes) are not like-kind to foreign currency used as a medium of exchange. California Federal Life Insurance Co. v. Commissioner, 680 F.2d 85 (9th Cir. 1982). Since 1991, the Regulations have provided a new set of rules for determining whether two (or more) kinds of personal property are of like-kind. These are discussed in detail below.

Property received in a like-kind exchange that is not like-kind, such as money, is called "boot." Boot also includes any liabilities assumed or attaching to property received in an exchange. Generally, a taxpayer that receives boot in a like-kind exchange must pay tax on the boot or on the taxpayer's "realized gain," whichever is less. Realized gain means the excess of the amount realized over the adjusted basis of the relinquished property. The amount realized in the exchange is the sum of the fair market value of the properties received, cash received and liabilities assumed by the other parties. For purposes of calculating realized gain, one may deduct all non-deductible expenses related to the transaction. What kind of payments may be used to offset boot received in a like-kind exchange is discussed in detail below.

D. Excluded Property

1. Generally

Limitations are imposed upon the means by which one may transfer certain aircraft under IRC § 1031 based upon the ownership structure. Section 1031 also excludes certain types of aircraft based upon the characterization of the aircraft in the hands of the taxpayer. The exclusions of 1031 include, but are not limited to:

1. Inventory - aircraft held primarily for sale;

2. Beneficial interests in an ownership trust;

3. Interests in a partnership which owns an aircraft (discussed below);

4. Certain securities or evidences of indebtedness in an entity that owns an aircraft.

IRC § 1031(a)(2).

2. Partnership Interests - Aircraft Ownership by a Partnership or LLC

After a lengthy battle in the courts between the IRS and taxpayers over whether the exchange of partnership interests would qualify for like-kind treatment, Congress sided with the Treasury Department and declared in 1984 that partnership interests were not to be considered like-kind property to other partnership interests. The IRS has issued regulations requiring the strict application of this rule. The exchange of partnership interests, whether in the same partnership or in different partnerships, or in general partnerships or limited partnerships, is completely excluded from tax-free exchange treatment under IRC § 1031.(4)

These rules may be particularly relevant in connection with "fractional ownership" or "joint ownership" arrangements which sell units in a partnership rather than interests in an aircraft. The rule against the application of 1031 to partnership interests can also be seen as restricting the means by which a like-kind exchange of an aircraft can be effectuated. This is particularly true where some of the historic beneficial owners of the aircraft or partnership do not want to engage in an exchange and some do. In such circumstances careful attention to the manner in which the transactions are consummated and a command of the recent authority on related party exchanges (see below) will be necessary in order to obtain the tax goals of the respective parties with the minimum amount of risk.

For example, in P.L.R. 9818003, the IRS ruled that tax deferral treatment under IRC § 1031 was not available when replacement properties were deeded directly to partners, instead of to the partnership that had disposed of the relinquished property. On the other hand, the Tax Court has previously indicated that the formation of a partnership in connection with the receipt of property in a 1031 exchange would not deny the taxpayers tax deferral. Maloney v. Commissioner, 93 T.C. 89 (1989). It would seem that the above mentioned authority, along with the rules regarding single member LLCs and the ability of taxpayers to exchange fractional interests in real property, would lead one to conclude that the ability of multiple owners to obtain disparate results (i.e., exchange and non-exchange treatment) on their disposition of an aircraft entails some amount of tax risk and good counsel to minimize that risk.

3. Inventory (Stock in Trade or Other Property Held Primarily for Sale)

The disposition of "(s)tock in trade or other property held primarily for sale" does not qualify for like-kind exchange treatment. IRC § 1031(a)(2). The exclusion of stock in trade and other property held primarily for sale incorporates inventory concepts found elsewhere in the Code. See, IRC § 1221, 1231.

Generally, whether or not an aircraft is considered to be held primarily for sale is determined under a primary purpose test. See, Malat v. Riddell, 383 U.S. 569 (1966); PLR 9811004. If the principal purpose of purchasing and owning the aircraft is for the purchasing entity to use the aircraft in its trade or business or for the production of income, then the aircraft will not be considered inventory. Hence, an aircraft that is leased or committed to the taxpayer's business should not be treated as inventory. This is true even for taxpayers who might be aircraft dealers. The IRS has taken the position, however, that as soon as such an aircraft is removed from leasing activity or discontinues being used in connection with the business itself and is held for sale, it will immediately become an inventory item.

Certain factors should be considered in evaluating whether or not an aircraft should be considered to be inventory. One such factor would be what the taxpayer's motive was in purchasing the aircraft and what the probability is that such aircraft will be used by the taxpayer itself (including leasing activity), as opposed to being sold. The past history of the taxpayer, and possibly related entities, should also be considered in determining whether the aircraft will be considered to be inventory. Another factor to be considered is whether the taxpayer, and possibly related entities, are viewed by the public and others as a company in the business of selling aircraft, or merely engage in occasional or casual sales as an incidental consequence of its other business activities.

The test for whether or not an aircraft is to be considered to be stock in trade or held primarily for sale is largely one of facts and circumstances. Careful planning is required for aircraft dealers to qualify for 1031 deferral treatment on an exchange of such an aircraft.