First, the Big Picture

In 2017, the Tax Cuts and Jobs Act (TCJA) made a significant change in a taxpayer’s ability to defer gain under the like-kind exchange rules of Code Section 1031 – including narrowing the applicability of section 1031 to an exchange of real property.

That property had to be held for productive use in a trade or business or for investment, and not held primarily for sale. As a result, the sale of personal property, including personal property associated with real property, generally is no longer eligible for deferral under section 1031.

The changes created raised a number of issues and the need for clarification; Treasury issued Proposed Regulations in June 2020, and Final Regulations in December 2020.

What is Real Property?

Real property under section 1031 is generally defined as land, improvements to land, unsevered natural products of land (such as crops, timber, mines, wells, and natural deposits), water and air space superjacent to land, and certain intangible interests in real property (leaseholds & easements, for example).

Final Regulations Provide Welcome Change

The final regulations reversed course on the impact of state law classification of real property, now providing that property classified as real property under State or local law will be treated as real property for section 1031 purposes (except for certain intangible assets) – a welcome change from the proposed regulations.

Historically, the IRS position has been that only federal law determines the characterization of property for purposes of section 1031.  It’s important to note that states do not characterize property consistently, so this analysis will need to be on a case by case basis.

What if personal property is included in the sale of real property?

In a change that’s favorable to taxpayers, the final regulations eliminated a purpose or use test for tangible property.  This change allows items of machinery or equipment to be treated as real property for purposes of section 1031 if they comprise an inherently permanent structure, a structural component, or are real property under the state and local law test – regardless of their purpose or use or whether they contribute to the production of income.  The bottom line being that tangible property that is permanently affixed to real property and ordinarily will remain affixed for an indefinite period of time generally is an inherently permanent structure and real property under section 1031, regardless of its purpose or use.

Furthermore, the final regulations addressed personal property that was considered incidental to the real property, and therefore would be disregarded as part of the exchange under 1031.  The personal property would not cause a taxpayer to fail the deferred exchange safe harbors if the following conditions apply:

  1. In standard commercial transactions, the personal property is typically transferred together with the real property; and
  2. The aggregate fair market value of the incidental personal property transferred with the real property does not exceed 15% of the aggregate fair market value of all the replacement real property or properties received in the exchange.

It’s important to note that this guidance does not serve as a “bright-line” test meaning that simply exceeding the 15% threshold does not equate to an automatic failure for purposes of section 1031.

Cost Segregation Study Relief

This guidance as it addressed personal property was a welcome relief to taxpayers who have utilized cost segregation studies in the past to accelerate depreciation on real property.  Property such as a building’s process plumbing or electrical components characterized as shorter-lived property, would be considered permanently affixed and therefore eligible for a 1031 exchange.

Important Notes

Keep in mind that taxpayers must report all like-kind exchanges to the IRS using Form 8824, Like-Kind Exchanges, with their tax year for the year they transfer property as part of the exchange.  It should be noted that President Biden’s campaign tax proposals included a call to eliminate “tax preferences for real estate.”  This proposal may include Section 1031 exchanges, but we’ll keep you updated as more formal legislation is put in place.

Want to Know More?

Have a question about like-kind exchanges or want to talk with a tax professional about what the final regulations mean for your business? Contact us – we’re here to help.