The IRS has released highly anticipated proposed regulations that provide critical guidance on Section 1031, or like-kind, exchanges in the wake of changes made by the Tax Cuts and Jobs Act (TCJA). Most importantly, the proposed regs define the term “real property” for purposes of determining whether property qualifies for a Sec. 1031 exchange. Taxpayers can rely on the proposed rules for all exchanges of real property beginning after December 31, 2017, and before the final regulations are published.
The TCJA changed the rules for like-kind exchanges, generally limiting them to exchanges of real property. As a result, personal property and certain intangible property sold through a like-kind exchange don’t enjoy the gain deferral that makes such exchanges appealing.
But, until now, neither the tax code nor tax regulations defined “real property” for purposes of Sec. 1031. The Treasury Department and the IRS determined that regulations were necessary to give taxpayers some certainty as to whether any part of the replacement property received in an exchange won’t qualify as like-kind real property and, therefore, will be subject to gain recognition.
Under the proposed regs, real property includes:
You must analyze each distinct asset separately to determine if it fits the definition. The proposed regulations include nonexclusive lists of items that qualify as buildings, inherently permanent structures and structural components, each of which is a distinct asset. They also provide factors for evaluating nonlisted items.
According to the proposed regs, inherently permanent structures include any building or other structure that’s permanently affixed to real property and ordinarily will remain affixed for an indefinite period. The regulations include a lengthy list of nonbuilding structures that qualify.
Machinery generally isn’t an inherently permanent structure. If, however, a building or inherently permanent structure includes machinery as a structural component, the machinery is real property. That assumes the machinery serves the structure and doesn’t produce or contribute to the production of income other than for the use or occupancy of space.
A structural component is any distinct asset that’s a part of, or integrated into, an inherently permanent structure. If interconnected assets work together to serve such a structure (for example, a system that provides a building electricity, heat or water), the assets are analyzed together as one asset.
So, if a gas line provides fuel to a building’s heating system, it’s a structural component and real property. But, if the gas line provides fuel to nonstructural components, like an oven, it’s personal property.
Structural components aren’t real property unless the taxpayer holds an interest in the component along with a real property interest in the structure the component serves. Tenant improvements that are inherently permanent or otherwise classified as real property are real property under the proposed regs.
Intangible property may qualify as real property under the proposed regulations. Specifically, intangible property is real property if it:
For example, a license, permit or similar right solely for the use, enjoyment or occupation of land or an inherently permanent structure — that’s in the nature of a leasehold, easement or fee ownership — generally counts as a real property interest. By contrast, a license or permit to engage in or operate a business isn’t real property or a real property interest if it produces income.
The like-kind exchange regulations include a taxpayer-favorable rule addressing how to treat personal property when determining whether a taxpayer has actual or constructive receipt of money or other property held by a qualified intermediary. The issue arises when replacement real property includes some personal property (for example, an office building with office furniture).
Under the proposed rule, such property will be considered incidental, and therefore disregarded, if:
The rule is based on an existing rule that provides certain incidental property is ignored when determining whether a taxpayer has properly identified replacement property. Note, though, that the taxpayer must recognize gain on the receipt of incidental personal property because it doesn’t qualify as like-kind property under current tax law. Thus, while the portion of the gain attributable to the incidental property is taxable, the incidental property will not disqualify the rest of the property from like-kind treatment.
Overall, the proposed regulations bring welcome clarification, but their application is fact-specific. Work directly with your tax team to maximize your use of like-kind exchanges.
Contact Kim Palmer or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law with your professional advisers.