IRS Proposed Rules for Section 1031 Like-Kind Exchanges
By Adam Liebman
June 24, 2020
On June 11, 2020, the Internal Revenue Service (“IRS”) issued proposed regulations under Section 1031 (REG-117589-18) in response to the changes under the Tax Cuts and Jobs Act (“TCJA”) for like-kind exchanges. They provide guidance and clarity on what is considered real property that is eligible for a like-kind exchange under Section 1031 and include a safe harbor for transfers of real property that include personal property.
Overview and Impact of the TCJA on Like-kind exchanges
Prior to the enactment of the TCJA in December 2017, real property and personal property used in a trade or business, or held for investment, were eligible for exchange and tax deferral treatment under Section 1031. One requirement for tax deferral is that the properties exchanged are of like-kind (i.e a building for a building, a plane for a plane). Under the TCJA, Section 1031 was amended and like-kind exchange treatment for transactions occurring after December 31, 2018 was restricted to exchanges of real property.
The Industry Response
Taxpayers and practitioners requested additional clarity on what was considered real property. There were concerns that certain exchanges failed to meet the requirements due to the inclusion of a minor amount of personal property (i.e. real estate in the form of a building with minor amounts of furniture). A failed exchange could result in constructive receipt of the exchange funds and taxable income to the taxpayer.
Definitions of Real Property
For Section 1031 like-kind exchanges, the definition of what is considered real property has been uncertain, as clear guidance was not provided by the code and/or regulation. The proposed regulations created the following definitions for real property specific to Section 1031, to determine if the multiple components that comprise a structure can be classified as real property and, thereby, eligible for tax deferral treatment as a like-kind exchange. These include a list of inherently permanent structures and structural components that will be considered real property under certain factors.
- Real property: (1) land and (2) improvements to land, (3) unsevered natural product of land and (4) water and air space superjacent to land
- Improvements to land: inherently permanent structures and structural components of inherently permanent structures
- Inherently permanent structures: building or other structure that is a distinct asset and is permanently affixed to real property and that will ordinarily remain affixed for an indefinite period of time (examples are in-ground-pools, roads, paved areas, fences).
- Structural components: any distinct asset that is a constituent part of, and integrated into, an inherently permanent structure (examples are walls, wiring. HVAC systems, pipes).
- Facts and circumstances test: for inherently permanent structures and structural components that are not listed in the proposed regulations, a facts and circumstance test can be used to determine if the assets and components will qualify as real property for 1031 treatment.
- Unsevered natural products of land: Including growing crops, plants, and timber, mines, wells and other natural deposits. Natural products and deposits cease to be real property when they are severed, extracted or removed from the land.
- Intangible property: Will be considered as real property for the purpose of Section 1031 if: (1) it derives its value from real property or an interest in real property, (2) is inseparable from that real property or interest in real property, and (3) does not produce or contribute to the production of income other than consideration for the use or occupancy of space.
- Eligible property includes licenses and permits for the use of a permanent structure such as a leasehold or easement right.
- Licenses to engage in a business are not considered real property for the purpose of Section 1031.
Incidental Personal Property Safe Harbor
Taxpayers and Qualified Intermediaries (“QI”) entering into 1031 exchanges post-TCJA needed to be concerned with transactions that included the possible transfer of personal property which was not like-kind and ineligible for 1031 exchange treatment. The taxpayer could have been considered to be in receipt of all the funds from sale if the QI acquired replacement property with the proceeds from the sale that were not like-kind to the sold property. Actual or constructive receipt of funds would create a sale transaction, not a 1031 like-kind exchange.
To address this issue, the proposed regulations provide 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 Reg. Section 1.1031(k)-1(g)(6).
Personal property is incidental to real property acquired in an exchange if:
- In standard commercial transactions the personal property is typically transferred together with the real property; and
- Its aggregate fair market value does not exceed 15% of the aggregate fair market value of the replacement property.
The 15% safe harbor is a win for taxpayers and qualified intermediaries. It will make it easier to purchase real property assets without the need to structure the 1031 exchange to prevent the transfer of personal property.
Along with the 15% safe harbor, the definitions have provided much needed guidance as to what is eligible for a 1031 exchange post-TCJA. With specific definitions of what is considered real property as it relates to 1031 exchanges, we anticipate an uptick in taxpayers taking advantage of the tax deferral benefits with like-kind exchanges.
Please contact your Mazars USA professional for additional information.