On June 11, the IRS released Proposed Treasury Regulations under Section 1031 of the Internal Revenue Code, as amended (the Code), which provide a much-awaited definition of “real property” and offer a safe harbor for taxpayers engaged in deferred like-kind exchanges who receive “incidental” personal property as part of their replacement property acquisition.
Under Section 1031 exchange, no taxable gain or loss on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment. A Section 1031 exchange can be structured as either a “simultaneous” exchange or a “deferred” exchange. A simultaneous exchange occurs when there are two parties to a transaction and the parties engage in a true “exchange” of properties. The more common type of Section 1031 exchange, however, is the deferred exchange, in which the taxpayer generally sells relinquished property to one party and then, at some later date, acquires one or more replacement properties from a different party (or parties). However, even in these deferred exchanges, there must still be an exchange with some party, typically a so-called qualified intermediary.
These deferred exchanges are conducted pursuant to various rules contained in Code Section 1031 and the Treasury Regulations promulgated thereunder, and they often include the use of a qualified intermediary as a middleman to consummate an exchange and also to hold the cash from the sale of the relinquished property to avoid actual or constructive receipt by the taxpayer until the cash can be reinvested in qualifying replacement property within a certain time frame. As part of any deferred exchange that includes a qualified intermediary, subject to certain limited exceptions, the taxpayer must have no right “to receive, pledge, borrow, or otherwise obtain the benefits of” money or other property (i.e., non-qualifying replacement property) from the sale of the relinquished property before the end of the aforementioned reinvestment time frame (or the exchange period).
Definition of Real Property
While Section 1031 used to apply to most all types of property, the Tax Cuts and Jobs Act (TCJA) limited it to exchanges of real property after Dec. 31, 2017. No definition for “real property,” however, was provided by the TCJA. Instead, legislative history simply stated that real property eligible for like-kind exchange treatment under prior law would continue to be eligible for like-kind exchange treatment after the passage of the TCJA. Under prior law, though, even if certain components of a building that was sold constituted personal property, it was often possible that such personal property could be “matched up” with like-kind personal property in the replacement property acquisition and exchanged therefor, resulting in no negative tax consequences. However, now that personal property is excluded from Section 1031 treatment, what constitutes real property takes on added importance. Thus, in an effort to provide clearer guidance on what qualifies as real property under Section 1031, the IRS released the Proposed Regulations.
Pursuant to the Proposed Regulations, “real property” is now defined as land and improvements to land, unreserved natural products of land (e.g., crops, timber, natural deposits), and water and air space super-adjacent to land (e.g., boat slips). The majority of the Proposed Regulations go on to further define what is meant by “improvements to land.” Specifically, improvements to land include inherently permanent structures and the structural components of inherently permanent structures (i.e., property that is a constituent part of, and integrated into, an inherently permanent structure). An example list of inherently permanent structures is provided, and if a particular asset is not included in the list, a determination must be made as to its qualification by analyzing a list of factors (e.g., how the asset is affixed to other real property, whether the asset is designed to be removed). Similarly, an example list of structural components of inherently permanent structures is provided along with a list of factors to analyze for those assets not specifically listed (e.g., whether the asset is installed during construction of an inherently permanent structure, the extent of damage that would result from removal). Examples of property analyzed under these new definitions in the Proposed Regulations include a bus terminal, a steam turbine, office partitions and a pipeline transmission system.
In addition to providing examples and factors to analyze in determining whether an asset constitutes real property, the Proposed Regulations also explain how one determines the unit of property to be analyzed in the first place. Drawing on rules from the real estate investment trust (REIT) regime, the IRS states that the determination of whether an item of property constitutes a “distinct asset” to be analyzed is generally based on a facts and circumstances analysis, which considers four factors: (i) whether the item is customarily sold or acquired as a single unit or as a component part of a larger asset; (ii) whether the item can be separated from a larger asset and, if so, the cost of doing so; (iii) whether the item is commonly viewed as serving a useful function independent from a larger asset of which it is a part; and (iv) whether separating the item from the larger asset impairs the larger asset’s functionality.
Other relevant clarifications in the Proposed Regulations are as follows:
Machinery can constitute real property if it is a structural component of an inherently permanent structure and does not contribute to the production of income other than income derived from the use of space (e.g., electrical generator servicing a building).
Intangible property can constitute real property if it is “inseparable” from real property and does not contribute to the production of income other than income derived from the use of space.
Licenses and permits solely for the use of real property that are in the nature of a leasehold or easement generally are interests in real property (e.g., permit to place a cell tower on government land).
The Proposed Regulations make clear that these definitions apply only to Section 1031 and are not to be used to classify property under other Code sections.
Deferred Exchange Safe Harbor (Incidental Personal Property)
The Proposed Regulations also provide a helpful safe harbor for taxpayers who receive some modest amount of personal property as part of an acquisition of real property in a deferred exchange. Under the proposed rule, a taxpayer receiving personal property as part of a like-kind exchange will not be in violation of the prohibition on receiving non-qualifying property prior to the end of the deferred exchange period if (i) the fair market value (FMV) of the personal property is no more than 15% of the FMV of the replacement real property received in the exchange and (ii) the personal property received is “typically” transferred together with the real property in standard commercial transactions. An included example posits the receipt by the buyer of an office building of a modest amount of office furniture as part of the acquisition. While this is a helpful safe harbor for taxpayers, it is important to remember that any personal property received still is not qualifying replacement property for gain deferral purposes; the receipt of such property prior to the end of the exchange period simply does not jeopardize the validity of the entire deferred like-kind exchange because of a violation of one of the qualified intermediary safe harbor limitations.
Applicability and Request for Comments
Although not yet finalized, the Proposed Regulations give taxpayers the option to rely on them for exchanges of real property beginning after Dec. 31, 2017, if the taxpayer follows them consistently and in their entirety.