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General Counsel Memorandum 38975

Internal Revenue Service (I.R.S.)

General Counsel Memorandum (G.C.M.)

Date Numbered: April 14, 1983

June 15, 1982

Section 4033

IN RE: WHETHER A TIMELY ACQUIRED FEE SIMPLE INTEREST QUALIFIES AS REPLACEMENT PROPERTY UNDER SECTION 1033(A) IF IT IS USED IN THE SAME BUSINESS AND FOR A PURPOSE IDENTICAL TO THAT OF THE CONDEMNED PROPERTY

 

TO: GERALD G. PORTNEY

Assistant Commissioner (Technical)

Attention: Director, Corporation Tax Division

By memorandum (T:C) dated November 14, 1980, a proposed revenue ruling  (Control No. 7911081391) based on the subject case was referred to us for concurrence or comment. This referral was made pursuant to a decision made at a Directors Review and Assistant Commissioner briefing session (DR/ACB of 11/06/80).

ISSUE

Whether, for purposes of I.R.C. Section 1033, the investment of condemnation proceeds in a fee simple property interest will qualify as replacement property similar or related in service or use to a 15-year leasehold interest involuntarily converted.

CONCLUSION

The proposed revenue ruling concludes that under section 1033 a fee simple property interest does not qualify as replacement property similar or related in service or use to an involuntarily converted 15-year leasehold interest. We believe that this conclusion is inconsistent with Davis Regulator Co. v. Commissioner, 36 B.T.A. 437 (1937), acq., 1937-2 C.B. 7, as well as with several analogous cases in which the Service has acquiesced. Since we now believe that it is inadvisable to modify these acquiescences, we recommend that the proposed revenue ruling be revised to reflect the Service's longstanding acquiescences.

FACTS

M, a domestic corporation, is engaged in the business of hauling, handling, and storage of furniture.

M leased from individual A ten acres of land improved by an office building and several small warehouses in which it stored furniture. The lease was a net lease and commenced on August 1, 1975, for a term of 20 years. There were no renewal options under the lease.

In 1980, city X, under its condemnation authority, condemned the property M was leasing from A.

M (lessee) received a portion of the condemnation proceeds as compensation for M's property interest in the unexpired term of the leasehold. The taxpayer realized a gain upon the receipt of its share of the condemnation proceeds.

M, within the period specified in section 1033(a)(2)(B) of the Code, acquired a fee simple interest in real property improved with a warehouse and an office building. The property is to be used by M in the same business and for the identical purposes as the condemned leasehold.

ANALYSIS

Section 1033(a)(2)(A) of the Code provides that if property is compulsorily or involuntarily converted into money and the taxpayer during the period specified purchases other property similar or related in service or use to the property so converted, at the election of the taxpayer, the gain shall be recognized only to the extent that the amount realized upon such conversion exceeds the cost of such other property.

Section 1033(g) of the Code provides that, for purposes of  section 1033(a), if real property (not including stock in trade or other property held primarily for sale) held for productive use in trade or business or for investment is (as a result of its seizure, requisition or condemnation, or threat or imminence thereof) compulsorily or involuntarily converted, property of a like kind to be held for productive use in trade or business or for investment shall be treated as property similar or related in service or use to the property so converted.

Thus, involuntarily converted real property held for productive use in trade or business or for investment may be replaced by property similar or related in service or use under section 1033(a)(2) or by property of 'like kind' under section 1033(g).

Treas. Reg. Section 1.1033(g)-1(a) provides that the principles set forth in  Treas. Reg. Section 1.1031(a)-1(b) shall be used in determining whether replacement property is property of like kind.

Treas. Reg. Section 1.1031(a)-1(b) provides that the words 'like kind' have reference to the nature or character of the property and not to its grade or quality. Treas. Reg. Section 1.1031(a)-1(c) illustrates this point by providing that the exchange of a leasehold of a fee with 30 years or more to run for real estate will be treated as a like kind exchange.

We agree with the conclusion of the proposed revenue ruling that a fee simple interest is not a like kind replacement for an involuntarily converted 15-year leasehold interest. In McShain v. Commissioner, 68 T.C. 154 (1977), the Tax Court considered whether a leasehold interest and a fee simple interest are 'like kind' property for purposes of section 1033(g). The taxpayer in that case owned an undivided 85 percent interest in two parcels of unimproved real estate. The District of Columbia condemned the property and awarded the taxpayer $2,890,000 for the loss of his interest. The taxpayer invested the condemnation proceeds in a leasehold interest (the taxpayer built a hotel on leased land) with a duration of 35 years. When the taxpayer's attempt to revoke the 1033 election failed (See, McShain v. Commissioner, 65 T.C. 686 (1976)), he contended that the replacement property was not like kind property for purposes of section 1033. The court looked to the Internal Revenue Code and the regulations thereunder to refute the taxpayer's contentions.

The court stated that Treas. Reg. s 1.1031(a)-1(c) has acquired the force of law; thus, a leasehold interest is considered of like kind to a fee simple interest in real estate if the leasehold interest has 30 years or more to run. Consequently, the court determined that the taxpayer's contention that the 35-year leasehold was not a like kind replacement for the fee simple interest was without merit.

The Service has also considered the issue presented in McShain. In Rev. Rul. 68-394, 1968-2 C.B. 338, land owned by the taxpayer was condemned for a state freeway. The taxpayer also owned land adjacent to the condemned property which it had leased to X. The taxpayer used part of the condemnation proceeds to purchase the outstanding leasehold from X. At the time of the purchase, the lease had 45 years more to run. Rev. Rul. 68-394 concluded that the leasehold was qualified replacement property because the leasehold had more than 30 years to run and thus was like kind replacement property under Treas. Reg. Section 1.1031(a)-1(c).

McShain and Rev. Rul. 68-394 involve an involuntarily converted fee simple interest replaced by a leasehold interest; however, we believe that they are determinative of the section 1033(g) issue in the present case. Clearly, the example of Treas. Reg. Section 1.1031(a)-1(c), in which a fee interest qualifies as replacement property for a leasehold interest with 30 or more years to run, is relevant whenever the issue is whether a fee simple interest and a leasehold are like kind property under section 1033(g). Thus, under the facts of the proposed revenue ruling, a fee simple interest is not of like kind to the involuntarily converted 15-year leasehold interest.

Property may also constitute qualified replacement property if it is similar or related in service or use to the involuntarily converted property. The proposed revenue ruling concludes that a fee simple interest is not similar or related in service or use to a 15-year leasehold interest. The proposed ruling reasons that the extent of the taxpayer's rights to use the converted and replacement properties has changed. Moreover, the taxpayer has altered the nature of its capital investment through involuntary conversion.

In your November 14, 1980 memorandum, you questioned whether the conclusion of the proposed revenue ruling is correct in view of the decision in Davis Regulator Co. v. Commissioner, 36 B.T.A. 437 (1937), acq., 1937-2 C.B. 7. You also questioned whether the Davis case could be distinguished on its facts or whether a substitution of acquiescence in result only should be made for the acquiescence currently outstanding.

In Davis, the Board of Tax Appeals considered whether a fee simple interest is qualified replacement property for a converted leasehold interest. Davis holds that a taxpayer who invests the proceeds from the condemnation of its leasehold interest in the construction of a building on land owned by the taxpayer may elect nonrecognition treatment under section 112(f) of the Revenue Act of 1928, the predecessor of section 1033. In reaching its decision, the Board of Tax Appeals reasoned that the amount received from the sale of a leasehold interest need not be invested in another leasehold interest . Rather, the test is 'whether there is a replacement in the character of the service or use.' See 36 B.T.A. at 443. The Board found that there had been such a replacement. The taxpayer used the new building for the identical purpose that the old building was used. Thus, the Board's holding was premised on the end use of the replacement property.

The proposed revenue ruling attempts to distinguish Davis on its facts. The lease in Davis was extendable at will, while the lease in the proposed ruling had a remaining term of only 15 years when the property was condemned. In Davis, however, the term of the lease was not mentioned as a factor in the Board's reasoning. Instead, the Board based its decision on the end use of the replacement property . Thus, although Davis may, at first blush, appear to be distinguishable from the proposed ruling, we believe that the Board's rationale precludes any distinction on its facts from the proposed revenue ruling in view of the Service's acquiescence in the case.

In Rev. Rul. 64-237, 1964-2 C.B. 319, the Service takes the position that, in the case of an owner-user of involuntarily converted property, replacement property must have a close functional similarity to the converted property in order to qualify as 'similar or related in service or use' within the meaning of section 1033. Under this test, the physical characteristics and end uses of the converted and replacement properties must be closely similar.

The proposed revenue ruling states that this test requires that the extent of the taxpayer's right to use the converted and replacement property be considered. The ruling goes on to cite Filippini v. United States, 318 F.2d 841 (9th Cir. 1963), for the proposition that whether property is 'similar or related in service or use' turns upon whether in all the circumstances it represents a substantial continuation of the taxpayer's prior commitment, or a departure from it . The ruling concludes that a fee interest cannot qualify as a replacement property within the meaning of section 1033.

Thus, the argument can be made that the rationale of Davis Regulator is not legally correct. In fact, in O.M. 17990, * * *, I-369-73 (Jan. 30, 1974), we recommended that the acquiescence in Davis be changed to acquiescence in result only and also recommended the modification of the acquiescences in the following analogous cases: Williams Furniture Corp. v. Commissioner, 45 B.T.A .928 (1941), acq., 1942-1 C.B. 17; Flaxlinum Insulating Co. v. Commissioner, 5 B.T.A. 676 (1926), acq., VI-1 C.B. 2 (1927), acq. withdrawn, nonacq. substituted, X-1 C.B. 79 (1931), nonacq. withdrawn, acq. substituted, 1942-2 C.B. 7; Piedmont Mt. Airy-Guano Co., 5 B.T.A. 1009 (1926), acq., V-2 C.B. 3 (1926), acq. withdrawn, nonacq. substituted, X-1 C.B. 89 (1931), nonacq. withdrawn, acq. substituted, 1942-2 C.B. 15. Also in O.M. 17929, * * *, I-369-73 (Sept. 24, 1973), we recommended the modification of the acquiescences in Williams Furniture, Flaxlinum Insulating and Piedmont Mt. Airy-Guano. However the changes we recommended in O.M. 17990 and O.M. 17929 have not been made.

Moreover, in I.T. 3793, 1946-1 C.B. 96, obsoleted by Rev. Rul. 69-45, 1969-1 C.B. 313, the Service concluded, on facts substantially similar to those in Davis, that when money received by a lessee as an award for damages from condemnation of the leased property (the length of the lease is not indicated) by the United States is invested in the construction of a building upon land owned by the taxpayer, and such building is to be devoted to the same business which was formerly conducted on the condemned property, the investment constitutes an acquisition of property similar or related in service or use to the property condemned within the meaning of section 112(f) of the Revenue Act of 1928. Thus, the Service concluded, citing Davis, that a fee simple property interest does qualify as replacement property for an involuntarily converted leasehold interest.

Although I.T. 3793 is not determinative with respect to transactions occurring after 1969, it does demonstrate the Service's long reliance on the test enunciated in Davis. Additionally, although I.T. 3793 was obsoleted, Davis has expressed Service position since the acquiescence in 1937.

Even though an argument can be made that the Service should not have acquiesced in Davis Regulator, Williams Furniture, Flaxlinum Insulating, or Piedmont Mt. Airy- Guano or published I.T. 3793, we do not believe that the statute, regulations, or case law has significantly changed with respect to the issue under consideration since those acquiescences and publication. Nor do we believe that any of these authorities is clearly inconsistent with such acquiescences and publication.

Thus, we do not think it is advisable to change our outstanding acquiescence at this time. We will revoke O.M. 17929 and modify O.M. 17990 to the extent it is inconsistent with this memorandum.

Your memorandum also questioned whether the position taken in the proposed ruling is inconsistent with Rev. Rul. 71-519, 1971-2 C.B. 309. Rev. Rul. 71-519 holds that when a lessee invests the proceeds from the condemnation of the leased property, the lessee may elect nonrecognition under section 1033. Thus, Rev. Rul. 71-519 addresses the issue of whether the nonrecognition provisions of section 1033 are applicable to a lessee while the proposed ruling considers what constitutes qualified replacement property when a leasehold interest is condemned. Hence, there is no inconsistency between the two rulings.

Your final question was whether present value consideration has any application in determining whether a 15-year leasehold is equivalent to a fee simple interest for purposes of section 1033. We agree with your conclusion, in the background information note, that present value consideration does not have any application in determining whether a 15-year leasehold is equivalent to a fee simple interest for purposes of section 1033.

In conclusion, we agree that a fee simple interest does not constitute property of like kind to a converted 15-year leasehold interest. However, we believe that the proposed ruling's conclusion that a fee simple interest used for the same purpose as the converted leasehold interest is not qualified replacement property for purposes of section 1033(a)(2) is inconsistent with the acquiescence in Davis Regulator. We have attached a draft of a proposed ruling that reflects our conclusion.

KENNETH W. GIDEON

Chief Counsel

By:

MICHAEL D. FINLEY

Assistant Chief, Branch No. 3

Interpretative division

 

DRAFT RULING

PROPOSED REVENUE RULING

ISSUE

Whether, for purposes of section 1033 of the Internal Revenue Code, the investment of condemnation proceeds in a fee simple property interest, under the circumstances described below, can qualify as replacement property similar or related in service or use to a leasehold interest involuntarily converted.

FACTS

M, a domestic corporation, is engaged in the business of hauling, handling, and storage of furniture.

M leased from individual A ten acres of land improved by an office building and several small warehouses in which it stored furniture. The lease was a net lease and commenced on August 1, 1975, for a term of 20 years. There were no renewal options under the lease.

In 1980, city X, under its condemnation authority, condemned the property M was leasing from A.

M (lessee) received a portion of the condemnation proceeds as compensation for M's property interest in the unexpired term of the leasehold. The taxpayer realized a gain upon the receipt of its share of the condemnation proceeds.

M, within the period specified in section 1033(a)(2)(B) of the Code, acquired a fee simple interest in real property improved with a warehouse and an office building. The property is to be used by M in the same business and for the identical purposes as the condemned leasehold.

LAW AND ANALYSIS

Section 1033(a)(2)(A) of the Code provides that if property is compulsorily or involuntarily converted into money and the taxpayer during the period specified purchases other property similar or related in service or use to the property so converted, at the election of the taxpayer, the gain shall be recognized only to the extent that the amount realized upon such conversion exceeds the cost of such other property.

Section 1033(g) of the Code provides that, for purposes of section 1033(a), if real property (not including stock in trade or other property held primarily for sale) held for productive use in trade or business or for investment is (as the result of its seizure, requisition, or condemnation, or threat or imminence thereof) compulsorily or involuntarily converted, property of a like kind to be held either for productive use in trade or business or for investment shall be treated as property similar or related in service or use to the property so converted.

Section 1.1033(g)-1(a) of the Income Tax Regulations provides that the principles set forth in section 1.1031(a)-1(b) shall be used in determining whether replacement property is property of like kind.

Section 1.1031(a)-1(b) of the regulations provides that the words 'like kind' have reference to the nature or character of the property and not to its grade or quality. Section 1.1031(a)-1(c) illustrates this point by providing that the exchange of a leasehold of a fee with 30 years or more to run for real estate will be treated as a like kind exchange.

Therefore, for purposes of determining whether a leasehold interest will be treated like a fee interest under section 1033(g) of the Code, the leasehold interest must have a remaining term of at least 30 years in order to be of the same 'nature' as a fee interest in real property. Under the facts described above, the condemned leasehold interest had a remaining term of only 15 years. Because the leasehold interest condemned had a remaining term of less than 30 years, the taxpayer cannot rely on the 'like kind' provisions of section 1033(g) to defer recognition of the gain.

However, a leasehold interest may be 'similar or related in service or use' to a fee interest. In Davis Regulator Company v. Commissioner, 36 B.T.A. 437 (1937), acq., 1937-2 C.B. 7, the Board of Tax Appeals held that a taxpayer did not have to recognize gain on the receipt of proceeds received with respect to the condemnation of a leasehold interest to the extent that the proceeds were invested in the construction of a building on land owned by the taxpayer. The new building was used for the identical purpose as the converted leasehold. The court's decision was based on the 'similar or related in service or use' standard currently found in section 1033(a)(2)(A) of the Code.

HOLDING

M's timely acquired fee simple property interest qualifies under section 1033(a) of the Code as replacement property similar or related in service or use to M's involuntarily converted 15-year leasehold because the fee property is to be used by M in the same business and for the identical purposes as the condemned leasehold.

This document is not to be relied upon or otherwise cited as precedent by taxpayers.

END OF DOCUMENT

 

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