The IRS has released proposed regulations to provide guidance on the changes made to Section 1031 (like-kind exchanges), enacted by the Tax Cuts and Jobs Act (TCJA). The proposed regulations define the term "real property" for purposes of determining whether property qualifies for a Section 1031 exchange. Taxpayers can rely on the proposed rules for property exchanges that occur after December 31, 2017, and before the final regulations are published.
Prior to 2018, Section 1031 provides nonrecognition of gain or loss for exchanges of both real and personal property (with some exclusions) if the property is held for productive use in a trade or business or for investment. The TCJA made amendments to these rules limiting nonrecognition treatment to exchanges of real property.
However, neither the tax code nor tax regulations provided a definition of "real property" for purposes of Section 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 will not qualify as like-kind and subject to gain recognition.
Related Read: 1031 Exchange - Beyond Deferring Capital Gains Tax
Under the proposed regulations, real property includes:
- Improvements to land, including inherently permanent structures and their structural components;
- Unsevered crops and other natural products of land, including mines, wells and other natural deposits; and
- Water and air space superjacent to land.
In order to assess whether the asset is real property, each distinct asset should be analyzed separately. 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.
Inherently permanent structures
According to the proposed regulations, inherently permanent structures include any building or other structure that is permanently affixed to real property and ordinarily will remain affixed for an indefinite period. The regulations also include a list of structures that qualify as inherently permanent structures and for property that is not included in this list, factors can be used to make the determination.
Machinery or equipment generally is not an inherently permanent structure and does not qualify as real property. However, if a building or inherently permanent structure includes machinery as a structural component, the machinery can be considered real property. This assumes the machinery serves the structure and does not produce or contribute to the production of income other than for the use or occupancy of space.
Structural components of inherently permanent structures
A structural component is any distinct asset that is a part of and 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.
Hence, a gas line that provides fuel to a building's heating system comprises a part of the structural component, but a gas line that provides fuel to a restaurant's cooking equipment, such as a stove or a fryer will not.
Structural components are not real property unless the taxpayer holds an interest in the component along with a real property interest within the physical space of the structure that the component serves. The proposed regulations also include a list of structural components for purposes of Section 1031. For structural components not on the list, factors can be used to make this determination.
Intangible property may qualify as real property under the proposed regulations. Specifically, intangible property is real property if it:
- Derives its value from real property or an interest in real property;
- Is inseparable from the real property or interest; and
- Is not income-producing or contribute to it other than for use or occupancy of space.
For example, a license, permit or similar right solely for the use, enjoyment or occupation of land can be considered real property, but a license or permit to engage in business on real property may not be.
In addition, an inherently permanent structure that is in the nature of a leasehold, easement or fee ownership generally counts as a real property interest.
The proposed regulations has defined real property for purposes of Section 1031, but the application may depend on different factors. Consult your ORBA tax advisor to see how they apply to your exchanges.
How is "incidental" personal property treated?
Recently proposed IRS 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:
- In standard commercial transactions, the personal property is typically transferred together with the real property; and
- The aggregate fair market value of the personal property that is transferred with the real property does not exceed 15% of the aggregate fair market value of the replacement of real property.
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 does not 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.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.