The IRS has recently concluded in a legal memorandum (ILM 2012-38-027) that state law classifications do not determine whether property is of like kind under Section 1031.
Section 1031 provides that no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind that is to be held either for productive use in a trade or business or for investment. Under Section 1031, properties are generally of like kind if they are of the same nature and character.
The memorandum states that relying solely on state property classifications can lead to absurd results and would make federal tax law dependent on state laws and state policies. The factors and considerations used by states to classify property as real or personal are generally irrelevant for determining what is like kind for federal tax law. Accordingly, the memorandum concludes that state law property classifications do not determine whether property is of like kind. Rather, the IRS must consider all facts and circumstances, including state law and federal law classifications as appropriate.
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