On June 11, 2020, the IRS released the highly anticipated proposed regulations on section 1031 (REG-117589-18). These proposed regulations clarify a number of rules either created or elevated by Public Law 115-97 (131 Stat. 2054), commonly referred to as the Tax Cuts and Jobs Act, or TCJA.
Most notably, the proposed regulations define ‘real property’ to clarify what property qualifies for a 1031 exchange. The new proposed regulations also address personal property transferred incidentally to real property, which can complicate certain exchanges.
Taxpayers may rely on the proposed regulations for all exchanges of real property beginning after Dec. 31, 2017, and before the final regulations are published.
The rule for a successful like-kind exchange has always required that the relinquished property be similar in character to the replacement property. Prior to TCJA, real property used in a trade or business or held for investment was exchangeable for virtually any real property used in a trade or business or held for investment, and personal property was exchangeable for similar types of personal property. Thus while a building could not be exchanged for personal property or certain fixtures within a building, most real property exchanges include some property classified as personal property in both properties. As a practical matter, taxpayers could often offset relinquished personal property with replacement personal property, and defer most or all of the gain on the exchange.
The process changed when section 13303(c) of TCJA amended section 1031 to limit its application to exchanges of real property for transactions completed after Dec. 31, 2017. Now determining what constitutes real property versus personal property is vital, as any personal property sold through the exchange is treated as separately sold and purchased without the benefit of gain deferral.
Section 1031 rules require taxpayers to identify the relinquished and replacement properties with descriptions of each. Identifying a unit of real property may bring in certain personal property that can complicate the exchange. Personal property that is incidental to the real property may be part of the identification if that property is typically transferred with the larger item of property and does not exceed 15% of the aggregate fair market value of the real property. Note that the 15% incidental property rule only applies to the identification requirement. It does not convert incidental personal property into real property. If a taxpayer receives money or property not of a like-kind (including incidental personal property) to the taxpayer’s relinquished real property, the taxpayer has to recognize gain or loss (generally called ‘boot’). Taxpayers that fail to structure exchanges to avoid this problem may receive the personal property and create boot on the transaction. At best, the taxpayers have a separate sale and purchase of personal property.
Perhaps even more concerning, some commentators have speculated that an exchange fails to meet the requirements of Reg. section 1.1031(k)-1(g)(6)(i) if funds from the transfer of relinquished property held by the qualified intermediary (QI) are used to acquire a building, including the personal property in the building. A taxpayer may be in constructive receipt of all of the exchange funds held by the QI if the taxpayer is able to direct the qualified intermediary to use those funds to acquire property that is not of a like kind to the taxpayer’s relinquished property. This would disqualify the exchange and turn it into a taxable sale. The proposed regulations make it clear that receipt of incidental personal property that does not exceed 15% of the aggregate value of the replacement property and which is paid for with exchange funds will not disqualify the exchange, but will result in gain being recognized due to exchange proceeds being used to purchase non-like-kind property.
Determining exactly what constitutes real property has long confounded taxpayers. The definition has not been stated directly in the Code or Regulations. State law classifications have generally been considered the most influential factor, but do not strictly determine the federal tax treatment. The federal Code contains numerous definitions of real property for various purposes, but some conflict and none specifically apply to section 1031. Additionally, the legislative history of TCJA shows that the drafters intended property that qualified as real property prior to TCJA should continue to qualify after the fact.
The new provisions
The new proposed regulations create a definition of real property specific to section 1031. The Treasury Department and IRS concluded that the other definitions within the Code were too tailored to specific purposes or would conflict too much for broad use. For the same reasons, the new rules apply only to section 1031 and the proposed regulations specify that they should not be used to draw inferences for other Code sections.
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 include inherently permanent structures and the structural components of inherently permanent structures. State and local law definitions are not controlling. While this was true before these regulations, this likely indicates that state law classifications are now less important to the analysis.
The proposed regulations address one difficult question – what to do with different types of assets that comprise one system? Under the new rules, if interconnected assets work together to serve an inherently permanent structure (for example, systems that provide a building with electricity, heat, or water), the assets are analyzed together as one distinct asset that may qualify as a structural component (and thus represent real property). The proposed regulations give the example of a gas line running into a building. If the gas line provides fuel to the building’s heating system, it would be a structural component that may count as real property. If the gas line is providing fuel to non-structural components in the building (e.g., an oven), then the gas line is personal property for section 1031 purposes. The proposed regulations also address pipeline transmission systems, which have typically tested the boundaries of state law classifications and existing federal rules.
The proposed regulations offer a list of properties that are structural components for purposes of section 1031. For components not included in the list, there are factors for use in a facts and circumstances test.
One of the most significant new provisions provides rules for determining the unit of property to analyze when dealing with large groups of assets. Each distinct asset must be analyzed separately from any other assets to determine if the asset is real property, whether as land, an inherently permanent structure, or a structural component of an inherently permanent structure. Items specifically listed in the proposed regulations as buildings and other inherently permanent structures represent distinct assets. Assets and systems expressly listed as types of structural components also are treated as distinct assets. The proposed regulations then provide factors for determining other distinct assets. All listed factors must be considered, and no one factor is determinative. These rules are based on similar rules concerning distinct assets in Reg. section 1.856-10(e).
Certain intangible property is considered real property under the new regulations. An intangible may be treated as real property if it derives its value from real property or an interest in real property, is inseparable from that real property or interest in real property, and does not produce or contribute to the production of income other than consideration for the use or occupancy of space. Listed examples include licenses, permits, or other similar rights. Notably, a license or permit to operate a business on real property is not considered a real property interest. This generally distinguishes mineral and extraction rights (real property based on the land) from operating rights.
The proposed regulations add taxpayer-favorable provisions for incidental personal property. Personal property incidental to replacement real property is expressly listed in Proposed Reg. section 1.1031-1(g)(7) as exempt from the prohibitions in Reg. section 1.1031-1(g)(6). Accordingly, if a taxpayer is within the 15% safe harbor described above, the incidental property will not jeopardize an exchange but the incidental personal property is still not part of the real property which qualifies for gain deferral under section 1031.
As noted above, these regulations only determine the definition of real property for purposes of section 1031. The regulations specifically provide that an asset can be section 1245 property for depreciation purposes while at the same time being treated as real property under section 1031. This issue has been debated for many years and has caused uncertainty when performing a cost segregation study on like-kind exchange property. As a result, the clarification is very welcome.
These new proposed regulations provide much more certainty over what property will qualify for a like-kind exchange under section 1031. The new definitions are specific to section 1031, and provide a set of principles for dealing with property that is not explicitly listed or described in the new proposed regulations. These rules are heavily fact-based, and as with any new law, taxpayers are strongly encouraged to consult with their tax advisor on how to interpret the new rules and how these rules affect them.
The IRS and Treasury included a call for comments and requests for a public hearing, which must be received by Aug. 11, 2020. RSM encourages taxpayers who may be particularly affected or need additional clarification to contact us to help assess whether a comment letter is appropriate.