Today the Tax Court looked at a §1031 Exchange case. The question before the court was whether a partnership (Peabody) could exchange gold mines for coal mines. The problem: the coal mines were encumbered with supply contracts that sent the coal to electric utilities. Does the encumbrances constitute “boot” that causes tax to be due?
Under a §1031 Exchange, like property is exchanged for like property. The exchanger avoids capital gains tax. Like property need not be exactly the same property. You can exchange a rental house for a rental duplex, for example. (There significant restrictions to &1031 exchanges; make sure you talk to your own tax advisor about your situation.)
When cash gets involved in the transaction, it’s considered “boot.” Boot is taxable. The IRS argued that the contracts weren’t real property, but were the equivalent of cash or personal property received along with like-kind property. (There’s no question that you can, in a § 1031 exchange, exchange one mine for another mine, even if each mines different substances, assuming the other provisions of § 1031 are followed.)
The court had to determine, (1) are supply contracts considered real property and, thus, can be part of a § 1031 exchange (the IRS argued that they are contracts to sell personal property); (2) are the servitudes created by the supply contracts real property; and (3) are the supply contracts boot or not?
The court noted that like-kind doesn’t mean exactly the same kind:
In determining whether the like-kind requirement of section 1031 had been met, we found it significant in Koch v. Commissioner, 71 T.C. at 65, that section 1031(a) refers to property of a like, not an identical, kind. The required comparison of the old and new exchanged properties, we reasoned, should be directed to whether the taxpayer, in making the exchange, has used its property to acquire a new kind of asset or has merely exchanged its property for an asset of like nature or character.
The court did note that not all real property exchanges are like-kind exchanges, though.
The idea behind a § 1031 exchange is that the taxpayer is exchanging one piece of property for another, and that his original investment has not been sold or liquidated. The court noted,
It is true Peabody is obligated to mine and supply coal to meet the operating needs of power stations and that Peabody is prohibited from impairing the contracted-for supply by selling coal to other buyers. In our view those contract obligations and restrictions constitute a distinction in the grade or quality of the old and new mining properties rather than a difference in their kind or class. The new coal mine property is of a like nature or character to the gold mining property Peabody exchanged. By exchanging the gold mining property for the coal mining property subject to the supply contracts, Peabody is essentially continuing the original investment which remains fully unliquidated.
The court concluded, “In the light of that holding and because the supply contracts cannot be separated from Peabody’s ownership of the Lee Ranch mine coal reserves, it follows that those contracts are not taxable as other property or boot under section 1031(b).”
So Peabody is allowed to turn gold into coal, tax-free.
Case: Peabody Natural Resources Company v. Commissioner, 126 T.C. No. 14
