## Facts

- The IRS interpreted the nonrecognition provisions for involuntary conversions under I.R.C. § 112(f) (1939 Code) and I.R.C. § 1033(a) (1954 Code), which require reinvestment in “property similar or related in service or use.”
- The IRS had previously applied a strict “functional use” approach, requiring close similarity in physical characteristics and end uses between the converted and replacement properties.
- Federal appellate decisions rejected that strict functional-use approach as applied to investors/lessors (taxpayers holding property for investment and leasing it to tenants).
- The ruling distinguishes between (1) owner-users who operate their own business on the property and (2) investors/lessors who rent property to others.
- The ruling illustrates that a lessor may replace property leased for one tenant use (e.g., light manufacturing) with property leased for a different tenant use (e.g., warehouse) if the lessor’s landlord role remains similar; by contrast, an owner-user changing from operating manufacturing to operating a wholesale warehouse would generally fail the test.

## Issues

1. How should “property similar or related in service or use” be applied under § 1033 (and § 112(f)) when the taxpayer is an investor/lessor whose property is involuntarily converted?
2. Whether the IRS should continue applying the functional-use test to owner-users of converted property.

## Decision

- For investors/lessors, the IRS modified its approach and will not primarily require close functional similarity of physical characteristics and end uses.
- For investors/lessors, the IRS will focus primarily on whether the converted and replacement properties bear a similar relationship to the taxpayer-owner (landlord-investor relationship test).
- For owner-users, the IRS will continue to apply the functional-use test; a material change in the taxpayer’s own operational use generally disqualifies the replacement property from § 1033 nonrecognition.

## Legal Principles

- Section 1033 nonrecognition requires that replacement property be “similar or related in service or use” to the involuntarily converted property.
- Owner-user standard: similarity is tested by functional comparability, emphasizing the taxpayer’s end use of the property; a change in the taxpayer’s operational use places the replacement outside § 1033.
- Investor/lessor standard: similarity is tested primarily by the taxpayer-owner’s relationship to the properties, including:
  - whether the properties provide a similar service to the taxpayer (e.g., rental investment use),
  - whether the business risks to the owner are similar, and
  - whether the properties demand similar management efforts, services to tenants, and tenant relations.
- Under the investor/lessor standard, differences in tenants’ ultimate uses do not, by themselves, prevent replacement property from qualifying if the landlord’s role and risks remain sufficiently similar.

## Conclusion

The IRS adopted a bifurcated § 1033 “similar or related in service or use” analysis: owner-users must satisfy a functional-use comparison keyed to their operational end use, while investors/lessors qualify based on whether the replacement property maintains a substantially similar landlord-investor relationship, risks, and management demands despite changes in tenant use.


Rev. Rul. 64-237, 1964-2 C.B. 319 (1964)