Private letter ruling 201024036 issued recently by the IRS concludes that the swap of two different types of emissions credits will be a tax-deferred exchange under Code Sec. 1031.

Background. In general, under Code Sec. 1031, no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment if the property is exchanged solely for property of a like kind which is held either for productive use in a trade or business or for investment, if statutory identification and receipt time limits are met. “Like kind” refers to the nature or character of the property and not to its grade or quality, and one kind or class of property can’t be exchanged for property of a different kind or class. (Reg. § 1.1031(a)-1(b))

Intangible personal property is of like kind to other intangible personal property only if (1) the nature or character of the rights involved are of like kind (e.g., a patent is of like kind to a patent and a copyright is of like kind to a copyright) and (2) the nature or character of the underlying property to which the intangible personal property relates is of like kind. For example, an exchange of a copyright on a novel for a copyright on a different novel is a like-kind exchange, but an exchange of a copyright on a novel for a copyright on a song is not. (Reg. § 1.1031(a)-2(c)) Under Rev Proc 92-91, 1992-2 CB 503, Q&A 5, emission allowances are like-kind property for Code Sec. 1031 purposes.

Ground Level Ozone (Smog)

Facts. The concentration of ground level ozone (i.e., smog) in Region often exceeds permissible air quality standards established by the Environmental Protection Agency (EPA). Ground-level ozone is principally created by two types of pollutants: nitrogen oxide (”NOx”) and volatile organic compounds (”VOCs”). NOx is produced during combustion of natural gas. VOCs are organic chemical compounds that evaporate under specific conditions. A program set up by a Region government agency we’ll call Authority develops and implement air pollution control measures in Region. To improve Region’s air quality and bring the area into compliance with state and federal law, Authority has established a program to review and control emissions in Region. Under this program, businesses that take measures to reduce their emissions of pollutants, for example by installing emission reduction equipment, may apply for and receive emission reduction credits. These credits are used by the holder to “offset” emissions that would otherwise exceed permitted levels. Each credit is a grant to the holder of the right to emit a specified amount of the pollutant per year for an indefinite period of time. Credits may be transferred temporarily or permanently. Credits for reducing ozone are designated by Authority as either NOx or VOCs credits.

Apart from the underlying pollutant, the terms and conditions of the two types of credits are identical. NOx credits may be used to offset VOCs emissions and VOCs credits may be used to offset NOx emissions, as long as the holder of the credits demonstrates that using the credits in this way will not cause or contribute to a violation of state or federal air quality standards.

Sub is a wholly owned subsidiary of Parent and a member of Parent’s consolidated group. Sub holds NOx credits for productive use in a trade or business or for investment. Parent anticipates the future need for VOCs credits in order to meet emission standards related to an undisclosed project. Authority has historically granted permission to use NOx credits to offset VOCs emissions, but this interpollutant use of credits is not economically optimal for Parent because the NOx credits are more valuable due to their relative scarcity. From a business perspective Parent would prefer to exchange NOx credits for VOCs credits held by unrelated third parties. This would generally allow Parent to emit a greater amount of VOCs than if it obtains authorization to use its NOx credits to offset its VOCs emissions.

Sub’s NOx credits exceed its needs. Parent proposes to cause Sub to distribute its NOx credits to Parent. Thereafter, Parent will swap the NOx credits it acquires from Sub for VOCs credits held by unrelated third parties. Parent would then use the VOCs credits to offset emissions from its trade or business.

Favorable ruling. Parent asked for a ruling that the exchange of emission credits was tax-deferred under Code Sec. 1031 and IRS responded positively. It ruled that the NOx and VOCs credits are like-kind property for Code Sec. 1031 purposes. It also ruled that Parent is considered to have, prior to the exchange, held the NOx credits for productive use in its trade or business. IRS concluded that gain or loss won’t be recognized on Parent’s exchange of NOx credits for VOCs credits immediately following the distribution of the NOx credits from Sub, provided all other Code Sec. 1031 requirements are met.

For more information regarding this PLR or any other 1031 questions, contact Alexandra L. Hart by e-mail at AHart@AllStates1031.com or by phone toll-free at 877-395-1031.