Internal Revenue Service (I.R.S.)
General Counsel Memorandum (G.C.M.)
Date Numbered: November 18, 1986
September 17, 1984
Section 1033 — Involuntary Conversion
Charles M. Morgan III
Associate Chief Counsel (Technical)
Attention: Director, Corporation Tax Division
Reference is made to your memorandum dated June 6, 1984, in which you requested our consideration of a request for technical advice made with respect to the above-referenced case.
1. Whether the acquisition of mineral leases within the prescribed time period and subsequent development of the property (including expenditures for intangible drilling costs) will constitute replacement property under section 1033 of the Internal Revenue Code?
2. Whether the acquisition of oil and gas properties through the purchase of partnership interests will constitute replacement property under section 1033 of the Code?
1. The acquisition of mineral leases within the prescribed time period will constitute replacement property under section 1033 of the Code. The expenditures for intangible drilling costs will constitute replacement property under section 1033 only if (1) the taxpayer capitalizes such costs so that they become part of the taxpayer's bases for the newly-acquired interests in oil and gas and (2) such costs are paid or incurred during the appropriate replacement period.
2. The acquisition of oil and gas properties through the purchase of partnership interests will not constitute replacement property under section 1033 of the Code.
The taxpayers, as husband and wife, owned certain property interests (as community property) consisting of interests in developed and undeveloped mineral leases, a fee interest in real property, and personal property (lease and well equipment) associated with several oil and gas wells. The taxpayers held these properties for productive use in their oil and gas business. In 1981, these properties were the subject of condemnation proceedings which resulted in a $700,000 award for the taxpayers. They received the $700,000 award in 1982. In that year, however, the taxpayers filed a suit contesting the amount of the award.
The taxpayers intend to reinvest the proceeds of the involuntary conversion within the prescribed time period in: (1) interests in oil and gas in place, expenditures for intangible drilling and development costs to be incurred in developing such interests and, if necessary, equipment needed to produce oil and gas; and (2) interests in limited partnerships, the assets of which are primarily invested in interests in oil and gas in place, and which may involve expenditures for intangible drilling and development costs and equipment necessary to produce oil and gas.
The taxpayers request rulings that (1) the acquisition of mineral leases within the prescribed time period and subsequent development of the property (including expenditures for intangible drilling costs) and (2) the acquisition of oil and gas properties through the purchase of partnership interests, will constitute replacement property under section 1033 of the Code.
1. Section 1033 Generally
Section 1033(a)(2) of the Code provides, in pertinent part, the general rule that if property (as a result of its destruction in whole or in part, theft, seizure, or requisition or condemnation or threat or imminence thereof) is compulsorily or involuntarily converted into money, the gain (if any) shall be recognized except to the extent provided in section 1033(a)(2)(A).
Section 1033(a)(2)(A) of the Code provides that if the taxpayer during the period specified in subparagraph (B), for the purpose of replacing the property so converted, 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)(1) provides a special rule that 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 1033(g)(4) indicates that the converted property must be replaced within the period commencing with the date of the disposition of the converted property, or the earliest date of the threat or imminence of requisition or condemnation of the converted property, whichever is earlier, and ending three years after the close of the first taxable year in which any part of the gain upon the conversion is realized. For all other involuntary conversions, section 1033(a)(2)(B)(i) provides a two-year period in which the converted property must be replaced.
Section 1.1031(a)-1(B) of the Income Tax Regulations states that, as used in section 1031(a), the words 'like kind' have reference to the nature or character of the property and not to its grade or quality. One kind or class of property may not, under that section, be exchanged for property of a different kind or class. The fact that any real estate involved is improved or unimproved is not material, for that fact relates only to the grade or quality of the property and not to its kind or class.
As an initial matter, it should be noted that the taxpayers here appear to have received a lump sum condemnation award to compensate them for the taking of various types of property used in their oil and gas business. In particular, the award covers both real property (i.e., the interests in developed and undeveloped mineral leases and the fee interest in real property) and personal property (lease and well equipment).
Rev. Rul. 70-465, 1970-2 C.B. 162, recognizes that where the assets of a going business are sold in a single transaction under threat of condemnation, or are taken by condemnation, for purposes of section 1033, the gain and proceeds attributable to the real property and the gain and proceeds attributable to the other property are to be considered separately. Thus, Rev. Rul. 70-465 holds that an electrical distribution company which sold all of its assets under threat of condemnation, but which was able to apply the sale proceeds to replace its real property only and not its other electrical distribution property, had to allocate the proceeds among all the assets sold and could get section 1033(g) nonrecognition treatment of the gain realized on the involuntarily converted real property only. Applying Rev. Rul. 70-465 to the instant case, we note that the taxpayers will be required to allocate the condemnation award among the real property and personal property that were involuntarily converted. To the extent the proceeds are not applied towards qualified replacement property, the taxpayers will not be afforded section 1033 nonrecognition treatment of any gain realized.
A second point worth noting is that different standards will be applied in determining whether the taxpayers have reinvested the condemnation proceeds in qualified replacement property. Specifically, the more liberal 'like kind' standard set forth in section 1033(g), and defined by Treas. Reg. section 1.1031(a)-1(b), will govern the determination whether the condemnation proceeds allocated to the involuntarily converted real property are to be reinvested in qualified real property. SEE G.C.M. 34651, supra (holding that a taxpayer who reinvested the proceeds from unimproved real estate that was sold under threat of condemnation in interests in overriding oil and gas royalties had met the 'like kind' standard of section 1033(g) and could, therefore, defer recognition of gain). See also Rev. Rul. 68-331, supra . With respect to the taxpayers' personal property that has been involuntarily converted, however, the standard to be applied is that set forth in section 1033(a)(2)(A) of the Code, requiring that the proceeds be used to purchase other property 'similar or related in service or use' to the converted property.
Under the 'like kind' standard, Treas. Reg. section 1.1031(a)- 1(b) indicates that the words 'like kind' have reference to the nature or character of the property and not to its grade or quality. Because this standard has been liberally construed, the replacement of one real property interest held for productive use in trade or business or for investment by another that is similarly held generally would be deemed to fall within the definition of a like kind exchange. As the court stated in Crichton, supra, with respect to the 'like kind' standard under section 112(b)(1), Revenue Act of 1936, forerunner to section 1031:
It will not do for him [the commissioner] to now marshal or parade the supposed dissimilarities in grade or quality, the unlikenesses, in attributes, appearance and capacities, between undivided real interests in a respectively small town hotel, and mineral properties. For the regulation and the interpretation under it, leave in no doubt that no gain or loss is realized by one, other than a dealer, from an exchange of real estate for other real estate, and that the distinction intended and made by the statute is the broad one between classes and characters of properties, for instance, between real and personal property. It was not intended to draw any distinction between parcels of real property however dissimilar they may be in location, in attributes and in capacities for profitable use.
122 F.2d at 182. Thus, like kind exchanges have been deemed to exist in the following instances: G.C.M. 34651, supra (exchange of undivided interest in unimproved real estate for interest in overriding oil and gas royalties); Rev. Rul. 68-331 (exchange of interest in a producing lease of an oil deposit in place for a fee interest in an improved ranch); Commissioner v. Crichton, supra (undivided interest in minerals in unimproved country land exchanged for undivided interest in improved city land); Fleming v. Campbell, 205 F.2d 549 (5th Cir. 1953) (exchange of an undivided fractional oil, gas, and other mineral interest for overriding royalty and mineral interests).
Based upon the foregoing authorities, we are of the opinion that the taxpayers' proposal to reinvest that portion of the condemnation proceeds that relates to the taxpayers' former real property holdings--that is, the developed and undeveloped mineral leases and the fee interest in real property--in interests in oil and gas in place (which are real property interests for Federal income tax purposes pursuant to Rev. Rul. 68-226) clearly satisfies the 'like kind' standard described above. Thus, such reinvestment would qualify for the nonrecognition treatment provided under section 1033(g) of the Code.
2. Investment of Condemnation Proceeds in Intangible Drilling and Development Costs
The taxpayers also propose to reinvest a portion of the condemnation proceeds in expenditures for intangible drilling and development costs (IDC) to be incurred in developing the newly- acquired oil and gas leases. They contend that such expenditures will constitute replacement property under section 1033 because IDC can be capitalized, pursuant to section 263(c), and recovered through depreciation or depletion, pursuant to Treas. Reg. section 1.612-4, and, hence, that such costs are similar to improvements to real property. We believe the taxpayers position to be supportable with some modification as discussed below.
Section 263(a)(1) provides the general rule that no deduction shall be allowed for any amount paid for new buildings or for permanent improvements or betterments made to increase the value of any property or estate. Treas. Reg. section 1.263(a)-1(b) states that, in general, capital expenditures include amounts paid or incurred (1) to add to the value, or substantially prolong the useful life, of property owned by the taxpayer, such as plant or equipment, or (2) to adapt property to a new or different use. Amounts paid or incurred for incidental repairs and maintenance of property are not capital expenditures.
Section 263(c) states notwithstanding subsection (a), regulations shall be prepared by the Secretary corresponding to the regulations which granted the option to deduct as expenses intangible drilling and development costs in the case of oil and gas wells and which were recognized and approved by the Congress in House Concurrent Resolution 50, Seventy-ninth Congress. Treas. Reg. section 1.263(c)-1 refers to Treas. Reg. section 1.612-4 for rules relating to the option to deduct as expenses intangible drilling and development costs in the case of oil and gas wells.
From the foregoing statutory and regulatory provisions, it seems clear that IDC must be capitalized and added to a taxpayer's basis in property to which such costs relate unless the taxpayer makes an election pursuant to section 263(c) to deduct such expenses as they are incurred or paid. See G.C.M. 33536 at 8, I-2220 (June 19, 1967), where we noted that, in a section 1031 exchange of leasehold interests in oil and gas, it is not proper to break down the depletable basis of the interest into leasehold costs and capitalized intangibles. In that G.C.M. we discussed the nature of IDC:
Those portions of the well costs which are represented by intangible expenditures exist only as a betterment of the leasehold since they have no salvage value. CFR sec. 1.612- 4(a)(3). For example, well costs may be composed of expenditures for clearing ground, draining, road-making, excavation and grading, as well as the cost of drilling the well itself. CFR sec. 1.612-4(b)(1). These items have no value apart from the leasehold which they enhance, and it is factually impossible to effect an exchange of these items apart from the leasehold.
Thus, while the expenditures incurred for IDC generally do not result in the typical physical improvement to land that one thinks of when discussing improvements, it is apparent that such costs result in a betterment that readies the oil and gas interest for production.
We know of no authority directly on point which has allowed condemnation proceeds that are applied towards IDC, incurred in connection with the development of an interest in oil and gas, to be considered qualified replacement property under section 1033(g). We believe, however, that such a result is not unwarranted in the light of analogous precedent and the legislative intent behind the enactment of section 1033.
In Rev. Rul. 59-8, 1959-1 C.B. 202, the Service ruled (1) that the destruction by hail of a standing crop of wheat constitutes an involuntary conversion to which section 1033 may apply, (2) that the gain realized from the receipt of insurance proceeds on account of such destruction is not recognized when an amount equal to such proceeds is used to purchase a replacement standing crop or harvested crop within the requisite replacement period, and (3) that the use of the insurance proceeds to cover the costs of planting a new crop does not constitute the acquisition of replacement property under section 1033.
In Rev. Rul. 62-161, 1962-2 C.B. 175, considered in * * * service or use to apple orchards requisitioned by a state agency through its eminent domain power. The costs incurred in connection with bringing the young apple trees to productive maturity were held not to be qualified replacement costs.
Rev. Rul. 81-279, 1981-2 C.B. 163, considered in * * *, G.C.M. 38558, I-123-79 (Nov. 4, 1980), modified Rev. Rul. 59-8 and amplified Rev. Rul. 62-161, holding that:
The costs of planting and raising a similar new crop to replace a standing crop involuntarily converted under section 1033 of the Code qualify as replacement costs under section 1033(a)(2)(A) for farmers using the crop method for such costs pursuant to section 1.162-12(a) of the regulations, to the extent that they are expended to bring the crop to the same level of maturity as the converted crop and provided they are incurred within the time specified in section 1033(a)(2)(B). 1981-2 C.B. at 164.
The rationale for the holding in Rev. Rul. 81-279 was that, where the farmer elected to use the crop method under Treas. Reg. section 1.162-12(a), the expenses of planting and raising crops became capital in nature and could be considered as part of the cost of the crops under section 1012 and for purposes of section 1033(a)(2)(A).
G.C.M. 38558, which considered Rev. Rul. 81-279, provides what we believe to be an even more significant reason for the ruling's conclusion. Specifically, we relied upon the analysis in * * *, G.C.M. 37324, I-294-75 (Nov. 15, 1977), to find that section 1033 was intended to be a relief provision and that permitting a taxpayer to receive nonrecognition treatment was consistent with the legislative policy behind section 1033, with respect to money received to compensate for costs that the taxpayer was required to expend to replace property involuntarily converted.
G.C.M. 37324 involved a farmer who was ordered by the Federal government to destroy a number of diseased feeder pigs. The taxpayer was indemnified for the destruction of his pigs and, with the proceeds therefrom, the taxpayer replaced the destroyed feeder pigs with an equal number of weanling pigs. The taxpayer subsequently incurred certain expenses to raise the weanling pigs to bring them to the same level of maturity as the destroyed feeder pigs. We expressed the opinion that the purchase of weanling pigs constituted replacement property 'similar or related in service or use' to the destroyed feeder pigs under section 1033(a)(2)(A). Moreover, we stated that because Treas. Reg. section 1.162-12(a) granted the taxpayer the option to expense or capitalize the costs of raising the weanling pigs, such costs would be includible in the pigs' bases if the taxpayer elected to capitalize the costs, and, thus, could be considered as part of the replacement cost under section 1033(a)(2). In conclusion, we held that:
If the taxpayer-farmer here elected to capitalize such costs, and they were incurred within the replacement period specified in Code section 1033(a)(3)(B), we believe that, to the extent that they bring the weanling pigs to the same level of maturity as the destroyed pigs, they are qualified replacement costs for purposes of Code section 1033(a)(3)(A).
G.C.M. 37324 at 6. Furthermore, we stated that this result is consistent with the policy behind section 1033:
In G.C.M. 34651, * * * I-4096 (Oct. 30, 1971), this office stated that the general policy behind the nonrecognition provisions, and specifically Code section 1033, is: 'to relieve the taxpayer from the burden of paying tax on gain that has not resulted in an economic benefit to him, while his money is still invested (in the replacement property) and he does not have the cash representing the realized gain with which to pay the taxes that would otherwise have been imposed.' Here, the taxpayer is merely trying to restore is prior position. In order to do so, the money received by taxpayer-farmer is necessarily tied up in the purchase of the weanling pigs and the costs of raising them.
G.C.M. 37324 at 6-7.
We believe the aforementioned cases provide ample support for the instant taxpayers' argument that expenditures for IDC can qualify as replacement property under section 1033. As was previously noted, such costs are to be capitalized and become part of the taxpayers' basis for the newly-acquired interests in oil and gas unless the taxpayer specifically elects under section 263(c) and Treas. Reg. section 1.612-4 to deduct such costs. The taxpayers must satisfy two requirements in order to consider IDC as replacement property. First, such costs must be capitalized. Second, such costs must be paid or incurred during the appropriate replacement period. Because the 'like kind' standard applies with respect to the replacement of the converted real property, we do not believe that the amount of the proceeds used for IDC which qualify as replacement property should be limited to that amount necessary to cause the new oil and gas interests to attain the same level of development as the converted interests. Such a requirement would relate to the grade or quality of the replacement property and not to its kind or class, and, as such, does not fall within the definition of 'like kind' property under Treas. Reg. section 1.1031(a)-1(b).
We are of the view that the result reached herein comports with the notion that 'section 1033 was to provide relief for a wronged taxpayer.' G.C.M. 34651 at 7. In this case, like that presented in G.C.M.s 37324 and 38558, the taxpayers are merely attempting to restore their prior position as owners of interests in developed and undeveloped mineral leases by acquiring new mineral leases and incurring expenditures for IDC to develop such interests for productive use in their oil and gas business. There is no indication here that the taxpayers are attempting to strengthen their tax posture so as to be much better off after the condemnation than before without suffering the consequences for which section 1033 was intended to provide relief. See G.C.M. 34651 at 8. Nor is there any evidence that the taxpayers are relying upon section 1033 to change the nature of their investment. Lakritz v. United States, 418 F. Supp. 210, 214 (E.D. Wis. 1976). Thus, we believe the expenditures to be incurred by the taxpayer for IDC may qualify as replacement property under section 1033(g).
3. Investment of Condemnation Proceeds in Limited Partnership Interests
The taxpayers have also indicated their intention to reinvest the proceeds of the involuntary conversion within the prescribed time period in interests in limited partnerships, the assets of which are primarily invested in interests in oil and gas in place, and which may involve expenditures for IDC and equipment necessary to produce oil and gas. We are of the opinion that the taxpayers are incorrect in their assertion that the acquisition of oil and gas properties through the purchase of partnership interests will constitute replacement property under section 1033 of the Code.
That the purchase of an interest in a partnership that owns property similar to the involuntarily converted property is not an investment in property that is 'similar or related in service or use' or of 'like kind' to the converted property is well established. In Rev . Rul. 55-351, 1955-1 C.B. 343, the Service ruled that:
The purchase by a corporation of an interest in a partnership within the time specified in section 112(f)(3)(B) of the Internal Revenue Code of 1939 [predecessor to section 1033], for purposes of replacing property involuntarily converted, is not a purchase of 'other property similar or related in service or use to the property converted,' within the meaning of section 112(f)(3)(A) of the 1939 Code, even though the partnership owns and operates property similar to the property converted.
See also Rev. Rul. 57-154, 1957-1 C.B. 262, considered in * * *, G .C.M. 29431, A-619413 (April 23, 1956) (use of proceeds from condemned real property to purchase interest in partnership that holds real property does not qualify as section 1033 replacement property; however, purchase of an interest in real property as a tenant in common would qualify); Collins v. Commissioner, 29 T.C. 670 (1958) (section 1033 does not apply when a taxpayer, whose property in a poultry business was condemned, used the condemnation award to purchase rental property and a partnership interest in a gasoline service station).
In * * *, G.C.M. 32778, I-1142 (Jan. 30, 1964), we determined that a taxpayer's purchase of two 1/1100th interests in a general partnership, which was formed for the purpose of acquiring the master lease on a particular building, to receive rent under a sublease, and to make distributions of partnership profits, did not qualify as replacement purchases for purposes of section 1033 where the taxpayer's individual interest in real property was involuntarily converted. We provided the following rationale for this conclusion:
A partners' co-ownership right in the partnership property does not vest him with exclusive ownership of any specific firm property or portion thereof but merely with a joint interest in the whole of it. A partner, cannot have any individual interest in any part of the firm property nor deal with it as his own.
The only interest in the partnership which a partner owns separately as distinguished from jointly is his partnership interest, i .e., his right to share in the profits and surplus upon settlement of the firm's obligations as disclosed by a partnership accounting. A partnership interest in general is a capital asset which is separate and distinct from the underlying firm assets. Therefore, purchase of a partnership interest for purposes of replacing property involuntarily converted, is not a purchase of 'other property similar or related in service or use to the property converted,' within the meaning of section 1033 of the 1954 Code, even though the partnership owns and operates property similar to the property converted.
G.C.M. 32778 at 3. Thus, it would appear that our rationale for the conclusion reached in Rev. Rul. 55-351 and its progeny was based upon the premise that the same entity whose property has been involuntarily converted must itself be the owner of the replacement property in which the involuntary conversion proceeds are reinvested. Because a partnership is an entity distinct from the partners who hold the interests therein, and holds property in its own name, we concluded that a person whose property is involuntarily converted cannot replace such property by purchasing an interest in a partnership that holds property similar to that which was converted.
As recently as 1976, the holding of Rev. Rul. 55-351 was extended to a situation in which the 'like kind' standard rather than the 'similar or related in service or use' standard was applied. In M.H.S. Company v. Commissioner, T.C.M. 1976-165, 45 T.C.M. (P-H) paragraph 76,165 (1976), aff'd, 575 F.2d 1177 (6th Cir. 1978), petitioner reinvested the proceeds it received upon the condemnation of real property held by it for productive use in its trade or business or for investment in a joint venture that purchased real estate. The court was thus presented with the issue whether the proceeds received pursuant to the condemnation award were reinvested in 'like kind' property as required by section 1033(g) of the Code. The court first observed that '[u]nder Tennessee law, an interest acquired in a partnership is an interest in personality regardless of the fact that the underlying assets of the partnership include interests in real property.' 45 T.C.M . (P-H) at 76-734. In determining that the petitioner did not acquire 'like kind' property, the court stated:
Section 1033 is not applicable if one kind of property is exchanged for another kind. An exchange of an interest in real property for an interest in personal property is not an exchange of 'like kind' property since the property interests are not of the same kind or class . . . . The differences in a partnership interest and ownership of real property are substantial and an investment of funds from a condemnation of real estate in a partnership interest does not result in the continuity in the nature of the investment necessary to bring the transaction within the nonrecognition of gain provisions of section 1033. See Estate of Rollin E. Meyer, Sr., 58 T.C. 311, 314 (1972). Id. at 76-734, 76-735. See also Lakritz v. United States, 418 F. Supp. 210 (E.D. Wis. 1976), in which the court held the taxpayers' reinvestment of fire insurance proceeds, received because of the destruction of the taxpayers' business building, in shares of real estate investment trusts was not a reinvestment in property of 'like kind' or 'similar or related in service or use.'
The clear import of [section 1033(a)(2)(A)] is that the taxpayer himself (or his straw party) must directly purchase the replacement property to qualify for nonrecognition treatment, and cannot indirectly achieve this same result by having his controlled corporation make the acquisition.
418 F. Supp. at 213, quoting Feinberg v. Commissioner, 377 F.2d 21 (8th Cir. 1967). The court in Lakritz also noted that '[t]he 'like kind' standard of section 1031 is broader than and inclusive of the 'similar or related in service or use' test of section 1033' and that if a 'transfer cannot meet the broader 'like kind' language of section 1033, it can hardly be argued that it meets the narrower standard of 'similar or related in service or use.'' 418 F. Supp. at 214. Thus, the court concluded that the taxpayer had 'taken advantage of the involuntary conversion of his investment to change the nature of that investment.' Id.
We have located only one situation in which the Service permitted a taxpayer who purchased an interest in a partnership that owned property similar to the taxpayer's condemned property to have nonrecognition treatment under section 1033(a)(2)(A). We believe that situation to be distinguishable from the instant case and the foregoing authorities. In Rev. Rul. 70-144, 1970-1 C.B. 170, a taxpayer, an individual, owned property which was condemned by the appropriate governmental authority. The taxpayer also owned a 50 percent interest in a partnership that owned property similar to the condemned property. During the replacement period, the taxpayer purchased the remaining 50 percent interest in the partnership. The Service held that this purchase qualified as replacement property under section 1033(a)(2)(A) because the purchase of the remaining partnership interest resulted in a termination of the partnership and the ownership by the individual taxpayer of all of the partnership property including the property that was similar to the condemned property. Thus, this set of facts was distinguished from Rev. Rul. 55-351 and Rev. Rul. 57-154 because the taxpayer here did not hold a mere interest in a partnership, but rather became the sole owner of the partnership's assets. See also * * *, G.C.M. 30909 at 1-2, A- 627905 (Oct. 2, 1958), which considered a proposed ruling letter involving the same facts as Rev. Rul. 70-144 ('[T]he service haS regarded a partnership as an entity for purposes of section 1033 * * * Therefore, an interest in a partnership should not be regarded as an interest in the underlying property, and, accordingly, the taxpayer's acquisition of the remaining partnership interest would amount to acquiring the underlying property outright and for the first time').
Based upon the foregoing authorities, we think there can be no doubt in this case that the instant taxpayers' proposal to reinvest the proceeds received because of the condemnation of its real property interests in limited partnerships whose assets are primarily invested in real property interests will not satisfy the 'like kind' standard under section 1033(g). The taxpayers here would be replacing their real property with personal property contrary to Treas. Reg. section 1.1031(a)-1(b) which makes it clear that one kind or class of property may not be exchanged for property of a different kind or class and achieve nonrecognition treatment.
The taxpayers argue further, however, that because tax legislation has been enacted after the issuance of Rev. Rul. 55-351 (e.g., sections 613A(c)(6)(B)(ii), 613A(c)(7)(D), and 4996(a)(1)(C)) which treats a partner of a partnership holding oil and gas properties as the owner of the oil and gas properties, that Rev. Rul. 55-351 is no longer valid and that the partnership interests will, therefore, qualify as replacement property under section 1033. We believe this argument to be insupportable.
The taxpayers are referring to those sections of the Internal Revenue Code which allow the basic principles of taxing partnerships, that establish the partnership as a separate entity, to be disregarded for purposes of computing the percentage depletion deduction. Under the Code sections just cited, as well as section 703(a)(2)(F), the oil and gas depletion deduction is to be separately accounted for and passed through to the partners. The rationale for ignoring the partnership entity in this situation is to avoid double deductions that would result to the partnership and its partners. It is well known that the law of partnership taxation requires that, in certain circumstances, the partnership is to be viewed as an entity separate from its partners (i.e., for adopting a method of accounting or a taxable year, to make certain elections, for computing taxable income). In other situations, the law of partnership taxation views the partnership as an aggregate of its partners (i.e., only the partners and not the partnership are subject to taxation of partnership income, the depletion deduction may be taken by the partners only), [FN8] We do not believe that the fact that a partnership may be ignored for purposes of computing the depletion deduction requires a determination that a partnership is to be ignored in determining whether a taxpayer has invested the proceeds from involuntarily converted property in qualified replacement property. Indeed, all of the authority that we have found on this subject leads us to a contrary conclusion.
Moreover, section 1033(a)(2) specifically provides that the taxpayer need not recognize gain if the taxpayer reinvests the involuntary conversion proceeds in 'other property similar or related in service or use to the property so converted, or PURCHASES STOCK IN THE ACQUISITION OF CONTROL OF A CORPORATION OWNING SUCH OTHER PROPERTY.' It seems clear from the foregoing provision that Congress intended that only the CORPORATE entity should be disregarded and only when the taxpayer had control thereof. It is apparent that Congress could easily have drafted this code section so as to apply to partnerships as well. Having failed to do so, we decline to interpret this statute in the manner suggested by the taxpayers so as to broaden the applicability of section 1033.
Finally, as previously discussed, to the extent the taxpayers receive condemnation proceeds that are allocated to the condemned personal property (i.e., the lease and well equipment), the taxpayers, pursuant to section 1033(a)(2)(A), must reinvest such proceeds in property that is 'similar or related in service or use' to the condemned property. Whether replacement property acquired by an owner-user of property is similar in service or use to the converted property requires a determination that the physical characteristics and uses of the converted and replacement properties are closely similar. See * * *, G.C.M. 36718, I-464-74 (May 4, 1976). Under this test, the taxpayers will receive nonrecognition treatment of the gain realized upon the conversion of their personal property only if the condemnation proceeds, as allocated, are reinvested in other lease and well equipment that are physically similar to the converted property and used for a similar purpose. To the extent the proceeds from such converted property are invested in interests in limited partnerships whose assets may be used to purchase equipment necessary to produce oil and gas, such property will not be qualified replacement property. It seems clear that there are significant physical differences between oil and gas equipment, being tangible personal property, and an interest in a limited partnership, being intangible personal property. Moreover, while the equipment was used in the taxpayers' oil and gas business, limited partnership interests generally are held for investment. Thus, as to this final issue, we believe the taxpayers' request for a ruling that the acquisition of oil and gas properties and equipment through the purchase of partnership interests constitute qualified replacement property under section 1033 of the Code must be denied.
James F. Malloy
Sarah W. Garrett
Chief, Branch No. 3
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