The U.S. Department of Treasury (“Treasury”) and the Internal Revenue Service (the “IRS”) recently released final regulations under Internal Revenue Code Section 1031. This provision governs the tax principles of like-kind exchanges. This FGMK article highlights the key modifications provided by the final regulations.
Prior to the Tax Cuts and Jobs Act of 2017 (the “TCJA”), under Section 1031 of the Internal Revenue Code (the “Code”) a taxpayer could exchange on a tax free basis any property used in a trade or business, or held for investment purposes, provided it was exchanged for property of a “like-kind”. The TCJA modified Section 1031 to permit only like-kind exchange treatment with respect to real property. As a result of this change, there was uncertainty as to the proper classification of property as “real property” as any other property will be considered non-like-kind property (known as “boot”) and may result in gain recognition. On November 23, 2020, the Treasury released final regulations related to the definition of real property for purposes of a Section 1031 like-kind exchange (the “Final Regulations”). These Final Regulations generally adopt the proposed regulations released on June 11, 2020 (the “Proposed Regulations”). However, there are two changes in the Final Regulations worth highlighting.
First, the Final Regulations stipulate that, other than with respect to certain defined intangible interests in real property, state law definitions are dispositive in determining whether or not an asset is properly classified as real property for purposes of Section 1031. This is a significant change from the Proposed Regulations which held that state law definitions were not controlling and could not be relied on by taxpayers. This is a welcomed change, as taxpayers can now confidently rely on state law definitions when entering a Section 1031 like-kind exchange, rather than engaging with the facts-and-circumstances-based analysis provided by the Final Regulations.
Second, the Final Regulations eliminate the “purpose or use” test included in the Proposed Regulations. Under the “purpose or use” test, taxpayers needed to consider the purpose or use of equipment and intangible property, and excluded from the definition of real property and equipment or intangible interest to the extent such asset was held for the production of income, regardless of the physical characteristics of the asset in question. For example, a large piece of machinery in a factory would not have qualified as real property if the taxpayer had used the machinery in a trade or business, even if the machinery was attached to the ground and could not be relocated without damaging the machinery itself and/or the factory building. The Final Regulations eliminate this test, and instead look only to the physical characteristics of the asset in question. Therefore, taxpayers may include under the definition of real property any asset that otherwise meets the definition of real property, even if the taxpayer earns income through the use of the asset. Under the above example, the machinery might now be considered real property, because it is effectively a permanent structure, even though the taxpayer earns income through the use of the machinery.
Other than these two changes, the Final Regulations effectively adopt the Proposed Regulations, save for some minor modifications. FGMK provided a detailed analysis of the Proposed Regulations upon their release, which can be accessed under FGMK’s Thought Leadership. If you have any questions about these Final Regulations, please contact your FGMK tax advisor to discuss.
Jeffrey L. Golds
Specialty Tax Manager
The summary information in this document is being provided for education purposes only. Recipients may not rely on this summary other than for the purpose intended, and the contents should not be construed as accounting, tax, investment, or legal advice. We encourage any recipients to contact the authors for any inquiries regarding the contents. FGMK (and its related entities and partners) shall not be responsible for any loss incurred by any person that relies on this publication.
FGMK is a leading professional services firm providing assurance, tax and advisory services to privately held businesses, global public companies, entrepreneurs, high-net-worth individuals and not-for-profit organizations. FGMK is among the largest accounting firms in Chicago and one of the top ranked accounting firms in the United States. For over 50 years, FGMK has recommended strategies that give our clients a competitive edge. Our value proposition is to offer clients a hands-on operating model, with our most senior professionals actively involved in client service delivery.