By Samantha Ramirez, CPA, Tax Manager
ASL Real Estate Group
A like-kind exchange, commonly referred to as a “1031 exchange”, allows for the deferral of gains from the sale or exchange of business or investment property, as long as the exchanged properties are considered like-kind. Any money or property received that is not like-kind is ineligible for gain deferral and is considered a taxable event. After the 2017 Tax Cuts and Jobs Act (TCJA), the classification of like-kind was limited to include only real property. With the new, narrower definition of like-kind, the IRS issued proposed regulations in June 2020 that defined real property for the first time for purposes of Internal Revenue Code Section 1031. Recently, the IRS issued final regulations that adopted most of these proposed regulations, with some notable changes and clarifications. Below is a summary of the most recent changes.
Final Regulations T.D. 9935
The final regulations describe five categories of property that may be classified as real property in a Section 1031 exchange:
- Land
- Land improvements (which include inherently permanent structures and their structural components)
- Unsevered natural products of land
- Water and air space superjacent to land
- Leaseholds or other certain intangible interests in real property
If property is not specifically listed, the final regulations consider any property to be real property if it is:
- Classified as such under the state and local law in which the property is located (with exceptions); or
- Considered real property based on all the facts and circumstances under various factors provided in the regulations.
State and Local Law
After receiving comments from taxpayers, Treasury reconsidered the degree to which state and local law may determine the definition of real property. If on the date the property is transferred in an exchange, the property is classified as real property under the state or local jurisdiction where the property is located, it will be considered real property eligible for tax deferred treatment under Section 1031. By classifying property under state or local law, Treasury made it clear that the final regulations were not intended to allow property that was ineligible for like-kind exchange treatment prior to the TCJA, to now be eligible.
Structural Components
A structural component, as specifically listed in the final regulations as real property, is any distinct asset that is a constituent part of, and integrated into, an inherently permanent structure. If state or local law is silent, then determination of whether a component is a structural component is determined by the following factors –
- The manner, time, and expense of installing and removing the component;
- Whether the component is designed to be moved;
- The damage that removal of the component would cause to the item itself or to the inherently permanent structure to which it is affixed; and
- Whether the component is installed during construction of the inherently permanent structure.
It is important to note that the final regulations removed the “purpose or use test” restriction that was introduced in the proposed regulations. This use test excluded property from the definition of structural components if the tangible property produced or contributed to the production of income. By eliminating the use test, the focus is on the degree to which the property is considered permanently affixed, and not to the degree that the asset contributes to the production of income. Under the final regulations, machinery or equipment could be considered real property for purposes of Section 1031, if classified as an inherently permanent structure or structural component.
Incidental Property Rule
The final regulations adopt the rule addressed in the proposed regulations for receipt of incidental personal property that a taxpayer may receive in conjunction with the acquired real property. In order for the personal property to be considered incidental to real property acquired in the exchange, the personal property must meet the following two tests:
- The aggregate fair market value (FMV) of the personal property transferred with the replacement property cannot exceed 15% of the aggregate FMV of the replacement property; and
- The personal property must customarily be transferred together with the acquired real property.
If considered incidental to the real property, the receipt of personal property will not fail the requirements of the exchange.
The final regulations also clarify that in determining whether personal property acquired is incidental, the value of all of the acquired personal properties should be compared to the value of all of the replacement real properties acquired in the same exchange. For instance, if three properties are acquired in an exchange and the value of all three properties are factored into the denominator, it is more likely that the personal property in the exchange will be incidental.
Future is Uncertain
While these final regulations are applicable for exchanges beginning after December 2, 2020, now having a new administration in the White House, it is unclear whether these rules could change again or be eliminated altogether. Stay tuned for any future developments which will be reported by the Abbott, Stringham & Lynch’s Real Estate Group. If you have questions about the information contained above or would like to discuss a potential like-kind exchange, please call us at 408-377-8700 or click here to contact us. We look forward to speaking with you soon!