In a Section 1031 exchange of properties, no gain or loss is recognized so long the properties are used for productive use in a trade or business or for investment purposes.
In 2009 the Internal Revenue Service, via Chief Counsel Advice 200911006, reversed the position that intangible assets (e.g. trademarks) and customer-based intangibles do not qualify within 1031 exchanges. The new regulations provide that tangible personal property is of like-kind if both properties are of "like class" (same general asset or product class). There are no general asset or product classes for intangibles (also intellectual property or IP). Thus, to qualify for tax free exchange treatment, the intangibles must be of the same "nature or character of the rights involved" (e.g. patent) or nature or character of the underlying property to which the intangible relates. However, goodwill and going concern value (GCV) are prohibited from qualifying as like-kind property.
The answer is obvious: competent valuation expertise must be applied to separate identifiable intangibles from goodwill and GCV. If the intangible asset has ascertainable value and a limited useful life, the intangible is subject to a Section 197 depreciation allowance over a tax life of 15 years.
This IRS pronouncement opens the door to buyers and sellers. Examples of the use of Section 1031 like-kind exchanges are:
- Swapping similar product lines, which may include both tangible and intangible assets.
- Based on the rules for non-simultaneous, deferred exchanges and reverse exchange parking transactions, cash sales or purchases may result in deferred taxable gain for all the assets disposed of in the transaction. While these forms of exchanges can be very complex, the Treasury allows for a safe harbor in a Section 1031 with a qualified intermediary (QI). The QI handles all of the cash and asset transfers, often via an escrow or trust agreement. This may be particularly important to park the intangibles (for up to 180 days) for which there is built-in gain.
- Exchanging IP between and among divisions of the same company.
- Potentially allocating value away from business goodwill to personal goodwill.
Prior to engaging a valuation professional, the taxpayer should receive competent tax advice regarding any proposed transaction. The next step is to ensure that the valuation person(s) is experienced and competent in IP valuations, which is easily the most difficult of valuation engagements.