RATIONALE FOR DEFERRED ExchangeS

Have you ever wondered why our government allows owners of business or investment held property the opportunity to Pay No Capital Gains Tax, when disposing of these types of properties? Well there are two rationales offered as justification for nonrecognition of gain or loss on an Exchange: (1) continuity of investment or liquidity, and (2) administrative convenience. The continuity of investment or liquidity rationale for nonrecognition of gain or loss on an Exchangederives from HP Rep No. 704, 73d Cong, 2d Sess (1934), reprinted in 1939-1 (Pt 2) CB 554, 564, which states in pertinent part: "If the taxpayer's money is still tied up in the same kind of property as that in which it was originally invested, he is not allowed to compute and deduct his theoretical loss on the Exchange, nor is he charged with the tax upon his theoretical profit. The calculation of the profit or loss is deferred until it is realized in cash, marketable securities, or other property not of the same kind having a fair market value." This rationale is also based upon congressional concern that taxpayers would not have the cash to pay the tax if an Exchangetriggered recognition of the gain.#1 At least one case#2 has cited HP Rep No.704 to support the continuity of investment rationale. A number of cases have provided a detailed discussion of this rationale.#3 Administrative convenience is also cited as a rationale for IRC 1031. In 1921, when the predecessor to IRC 1031, the 1921 Revenue Act Section 202, became part of the tax law, "horse trades and similar barter transactions" justified non recognition of gain or loss because the administrative burden of valuing such properties for tax purposes could not be justified by the increased revenue to be derived from taxing such Exchanges.#4 At the time of enactment of Section 202, Congress envisioned it only applying to simple two-party Exchanges such as horse trades. Congress did not envision multiparty, multiproperty, nonsimultaneous Exchanges common today. Therefore, with the expanded scope and types of transactions taking advantage of IRC 1031, the administrative convenience rationale has lost much of its validity. The valuation of the relinquished property typically occurs on the closing of that property by the purchase price the buyer is willing to pay for the relinquished property. The valuation of the replacement property is similarly accomplished at the closing of the acquisition of the replacement property by the sale price the seller is willing to accept for the replacement property. Therefore, if Congress did decide to tax Exchanges, the amount recognized could be easily determined in a multiparty Exchange. Further, the value of the relinquished property and the replacement property must even be determined in a two-party Exchangeif the taxpayer is receiving cash boot or other nonlike-kind property in order to compute the amount realized. When Congress enacted the 180-day time limitation for acquiring replacement property (Exchangeperiod) in the Tax Reform Act of 1984, it noted that the administrative convenience rationale was less applicable in the context of a nonsimultaneous Exchangebecause the relinquished property needs to be valued at the time of the Exchangeto determine the value of the replacement property to be received by the taxpayer in the future as part of the Exchange. Congress therefore believed the time limitations were justified because of the statutory limitation problems which may arise from Exchanges which are "left open" with no restrictions upon the time period for the acquisition of the replacement property.#5 Both the continuity of investment an administrative convenience rationales have been criticized by the courts as a justification for not recognizing gain in Exchanges.#6 Despite this criticism and the declining value of the original justifications for IRC 1031, IRC 1031 has survived several major changes to the tax laws, although it has been modified in some respects. #1 Starker v. United States, 602 F2d 1341 (CA9 1979) #2 Starker v. united States, 602 F2d 1341 (CA9 1979) #3 Magneson v. Comm., 753 F2d 1490 (CA9 1985) #4 Godine v. Comm., TC Memo 1977-393 #5 HP Rep No. 432, 98th Cong, 2d Sess (1984) #6 Starker v. United States, 604 F2d 1341 (CA9 1979)