On June 11, 2020, the Internal Revenue Service (the “IRS”) issued proposed regulations that define the term “real property” for purposes of Section 1031 of the Internal Revenue Code of 1986, as amended (the “Code”).
Prior to 2018, where various requirements were satisfied, Section 1031 made it possible for taxpayers to engage in tax-free “like-kind” exchanges of property held for productive use in a trade or business or for investment, and the types of property that could be exchanged included tangible personal property as well as real property. Public Law 115-97, commonly referred to as the Tax Cuts and Jobs Act (the “TCJA”), amended Section 1031 to limit its application to exchanges of real property, for transactions consummated after 2017 (subject to a transition rule). The TCJA made it essential for taxpayers engaging in Section 1031 like-kind exchanges to distinguish between real property and other types of property, and the proposed regulations provide much needed guidance in this area. As discussed below, however, the proposed regulations also have critical shortcomings.
Real Property Defined
Under the proposed regulations, real property includes land and improvements to land, unsevered crops and other natural products of land, and water and air space superjacent to land. Improvements to land would include inherently permanent structures and the structural components of inherently permanent structures. Inherently permanent structures would include any building or other structure that is permanently affixed to real property and that will ordinarily remain affixed for an indefinite period of time.
Under the proposed regulations, each “distinct asset” must be separately analyzed to determine if it constitutes real property. Local law definitions generally would not be controlling for purposes of determining the meaning of the term “real property” under Section 1031.
The proposed regulations provide a list of structures that qualify as inherently permanent structures and that would therefore qualify for like-kind exchanges. If property is not included in the list, the determination of whether the property is an inherently permanent structure would be based on the following factors:
- The manner in which the distinct asset is affixed to real property;
- Whether the distinct asset is designed to be removed or to remain in place;
- The damage that removal of the distinct asset would cause to the item itself or to the real property;
- Any circumstances that suggest the expected period of affixation is not indefinite; and
- The time and expense required to move the distinct asset.
Property that is in the nature of machinery or is essentially an item of machinery or equipment generally would not constitute real property under Section 1031. In the case of a building or an inherently permanent structure that includes machinery as a structural component, the machinery would be real property if “it serves the inherently permanent structure and does not produce or contribute to the production of income other than for the use or occupancy of space.”
A structural component would mean any distinct asset that is a constituent part of, and integrated into, an inherently permanent structure.
While the proposed regulations do not discuss whether a cost segregation study would affect the real property analysis, they provide that no inference is intended with respect to the classification of property for other purposes of the Code, such as depreciation and Sections 1245 and 1250. The proposed regulations expressly state that a structure may be Section 1245 property for depreciation purposes, notwithstanding that the structure is real property for Section 1031 purposes.
Under the proposed regulations, intangible assets may qualify as real property under narrow circumstances. The proposed regulations provide that an intangible asset is real property for purposes of Section 1031 to the extent it derives its value from real property, is inseparable from such real property, and does not contribute to the production of income other than consideration for the use or occupancy of space.
Incidental Personal Property
A very common type of exchange that is authorized under Section 1031 is a so-called “deferred” like-kind exchange. In one type of deferred exchange, called a “forward” exchange, a transferor who wishes to engage in a Section 1031 exchange may use a “qualified intermediary” to facilitate the exchange. Through the use of a qualified intermediary, the property being relinquished by the transferor may ultimately be transferred to the transferee, and the “replacement” property may later be acquired from a person other than the transferee. Deferred like-kind exchanges effected through a qualified intermediary are subject to strict requirements, including the requirement that prior to the transferor’s receipt of the replacement property, the transferor must generally have no rights “to receive, pledge, borrow, or otherwise obtain the benefits of money or other property
before the end of the exchange period [emphasis supplied],” as specified under Treasury Regulation Section 1.1031(k)-1(g)(6).
“Other property” includes property that is not eligible for like-kind exchange treatment, and since January 1, 2018 other property has included personal property. The requirement that the transferor not have rights in other property prior to the conclusion of the exchange creates a potential problem, because in many, if not most cases, a taxpayer engaging in a like-kind exchange will receive some personal property (e.g.
, office furniture) pursuant to the exchange. Following the enactment of the TCJA, commentators were concerned that a transferor’s selection of replacement property that included personal property might inadvertently violate the prohibition on obtaining rights in other property prior to the conclusion of the exchange.
The proposed regulations lessen the adverse impact of personal property by providing that personal property that is incidental to replacement real property is disregarded in determining whether a taxpayer’s rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by a qualified intermediary are expressly limited as provided in Treasury Regulation Section 1.1031(k)-1(g)(6). Personal property is incidental to real property acquired in an exchange if (i) in standard commercial transactions, the personal property is typically transferred together with the real property and (ii) the aggregate fair market value of the incidental personal property does not exceed 15% of the aggregate fair market value of the replacement real property.
The incidental personal property rule in the proposed regulations, while welcome, has two very critical shortcomings. First, if the fair market value of the personal property exceeds 15% of the fair market value of the replacement real property, the deferred exchange may fail to qualify for Section 1031 treatment altogether. A taxpayer might find that it has inadvertently received personal property in excess of the limit if, for example, the IRS were to challenge the valuation of the real or personal property.
The second shortcoming is that even if the value of the personal property were 15% or less of the value of the replacement real property, such that the receipt of the replacement real property would not be taxable, the receipt of the personal property could nonetheless still be taxable. It appears that any incidental personal property would constitute non-like-kind property, even if the value of such property were relatively insignificant in relation to the value of the replacement real property.
These regulations are likely to give rise to significant disputes between the IRS and taxpayers, because even a tiny amount of personal property might cause an otherwise tax-free exchange to be partially taxable, and because an exchange might become completely taxable if the IRS were to find that the value of the personal property exceeded 15% of the value of the replacement real property.
The proposed regulations are to apply to exchanges beginning on or after the date they are published as final regulations. Prior to the issuance of final regulations, a taxpayer may elect to rely on the proposed regulations, if they are followed consistently and in their entirety.