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 only permit 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 “boot” and may result in gain recognition. On June 11, 2020, the Treasury released proposed regulations related to the definition of real property for purposes of a Section 1031 like-kind exchange (the “Proposed Regulations”).
The Proposed Regulations, rather than utilizing an existing definition found in the Code or the Treasury regulations thereunder, provide a definition of what will constitute real property for purposes of Section 1031. Specifically, the Proposed Regulations define real property as land and improvements to land, unsevered natural products of land, and water and air space superjacent to land. For purposes of this definition, an interest in real property includes fee ownership, co-ownership, a leasehold, an option to acquire real property, or a similar interest. However, save for state laws related to mutual ditch, reservoir, or irrigation companies, local law definitions of real property may not be relied on for purposes of Section 1031. While state law may treat a particular asset as real property, the Proposed Regulations state that such state law definition is not controlling.
With respect to the types of ownership interests that represent an interest in real property, the Proposed Regulations hold that any interest in real property constitutes real property for purposes of Section 1031. However, a license or permit to operate a business, or an interest in real property giving rise to income other than for the use of the real property itself, are not considered real property for Section 1031. Therefore, while a lease to occupy a restaurant space is an interest in real property, the liquor license associated with that business is not. However, a license or business permit which is specifically tied to a piece of land and which grants rights related to that land is considered an interest in real property. While the Proposed Regulations define what constitutes real property, they do not modify the existing regulations as to what constitutes “like-kind” property. Generally, a piece of real property is like-kind to any other piece of real property. Under the current regulations, a fee interest in real property and a leasehold interest of 30 or more years is considered like-kind property.1 The Proposed Regulations hold that any leasehold interest in land or a building may be real property, however, the “like-kind” rule would still need to be met.
Inherently Permanent Structures
Under the Proposed Regulations, real property includes not only land itself, but also improvements to land, which are defined as inherently permanent structures and the structural components of inherently permanent structures. Inherently permanent structures are any building or other structure that is permanently affixed to real property and which will ordinarily remain affixed for an indefinite period. Buildings are defined as any structure or edifice enclosing a space within its walls, and covered by a roof, the purpose of which is to provide shelter or housing. The Proposed Regulations provide that inherently permanent structures that are considered buildings include, but are not limited to:
Other inherently permanent structures which are not considered buildings but are considered real property include:
For any structure not specifically defined as an inherently permanent structure, the Proposed Regulations provide that the determination as to whether property qualifies should be made by considering the followings factors:
In considering these factors, it is important to note that the weight of an object may be considered, and an asset may be considered affixed by virtue of being too heavy to practically move. The Proposed Regulations provide as an example a large, five-ton sculpture located in the atrium of an office building. Though the sculpture is not per se an inherently permanent structure, because it is affixed to the building’s foundation and too large and heavy to move without damaging the sculpture or the building, it is considered an inherently permanent structure, and therefore, real property under the above factors. Conversely, the Proposed Regulations contain an example in which a temporary raised floor installed to support a 3D printer is not considered real property. Though installed during construction of the building, the raised floor is not real property because it was installed quickly and with little expense, was designed to be moved and not intended to function only in that particular part of the building, and removal of the floor will cause no damage to either the floor or the building itself.
In general, assets in the nature of machinery are not considered inherently permeant structures, and therefore are not real property. However, if the machinery is in the nature of a structural component and serves the inherently permanent structure, it may be considered a structural component, so long as it does not produce or contribute to the production of income. A structural component is any distinct asset that is a constituent part and integrated into an inherently permanent structure. Structural components may only be considered real property if the taxpayer holds an interest in the real property being served by the structural component as well as the structural component itself. Tenant improvements which are inherently permanent are considered a structural component treated as real property.1 The Proposed Regulations provide the following list of per se structural components:
For structural components not per se listed above, a determination as to whether the asset is a structural component based on the following factors:
To clarify these factors and how they might be applied, the Proposed Regulations provide, as an example, that permanent drywall partitions in an office space which would be damaged if removed are a structural component, whereas modular partitions which can be easily installed and removed without damage would not qualify and are considered personal property.
The Proposed Regulations require that a taxpayer make a separate determination as to whether each asset involved in the transaction is real property. Buildings, other inherently permanent structures, and systems listed as structural components under the Proposed Regulations are distinct assets. Otherwise, the determination as to whether an asset is a distinct asset is based on all facts and circumstances, considering in particular:
This rule requires that taxpayers engaged in a like-kind exchange segregate all assets to the extent practical, and then make an asset-by-asset determination as to what qualifies as real property and what does not. This asset segregation will therefore require taxpayers to treat as boot all non-qualifying personal property. Based on the rules above, some assets will clearly qualify as land, inherently permanent structures, or structural components, and will be treated as real property for purposes of Section 1031. Other assets, such as office furniture, will clearly fail to qualify, and will be non-qualifying personal property. For other property not otherwise included in the proscribed per se lists, a case-by-case analysis will be necessary to determine which assets are real property and which will be treated as boot.
Finally, the Proposed Regulations make the point that these rules are only applicable for purposes of Section 1031 and not for any other purpose under the Code, including but not limited to depreciation. The determination that property is real property for purposes of Section 1031 does not change its class life for purposes of calculating depreciation and cost recovery under Code Section 168 and does not impact a taxpayer’s ability to take accelerated or bonus depreciation on the asset. The Proposed Regulations also do not eliminate potential gain under Section 1245 (providing potential ordinary income depreciation recapture) for such property in a Section 1031 exchange.
Safe Harbor for Incidental Personal Property
The Code and the regulations thereunder allow a taxpayer to engage in a “deferred exchange”, in which the taxpayer sells and acquires property through the use of a “qualified intermediary” and, assuming the proscribed rules are adhered to, the sale and purchase will be treated as a like-kind exchange under Section 1031 (“Deferred Exchange”). Considering the definition of real property included in the Proposed Regulations, particularly due to the fact that an asset-by-asset analysis is required for like-kind exchanges, a modification was needed to prevent all Deferred Exchanges from being imperiled.
Under the current Treasury regulations, for purposes of the identification rules in a Deferred Exchange, property that is incidental to a larger item of property is not treated as property separate from the larger item if, in standard commercial transactions, the property typically transferred with the larger item of property, and the aggregate fair market value of all the incidental property does not exceed fifteen percent of the aggregate fair market value of the larger item.2 However, under the current Treasury regulations, if a taxpayer actually or constructively receives money or property that is not of a like-kind to the taxpayer’s relinquished real property, gain or loss may be recognized, and the exchange may fail to qualify for tax deferral under Section 1031. The current Treasury regulations provide several safe harbors for this rule which allow the taxpayer to not be treated as in actual or constructive receipt of money or other non-like-kind property, so long as it is held by a qualifying intermediary.3 However, there was concern, after passage of the TCJA, that a taxpayer who could direct funds held by a qualified intermediary to acquire property which is not real property or otherwise like-kind, might be deemed to be in constructive receipt of such funds, and would therefore not be a valid Deferred Exchange agreement between the taxpayer and the qualified intermediary, resulting in the exchange being treated as a taxable sale and purchase of property rather than a Section 1031 like-kind exchange.
The Proposed Regulations provide a safe harbor allowing the acquisition of personal property within the confines of a Section 1031 exchange without eliminating tax-free treatment on the real property portion of the exchange. Specifically, the safe harbor adopts the rule under current Treasury regulations, whereby personal property is incidental if the personal property is typically transferred with the real property, and the aggregate fair market value of all the personal property does not exceed fifteen percent of the aggregate fair market value of the real property. If the safe harbor is met, then the personal property is considered incidental and will be ignored for purposes of determining whether a taxpayer and a qualified intermediary have an agreement which expressly limits the taxpayer’s rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property. As such, the Section 1031 like-kind exchange will not be invalidated despite the relinquishment or receipt of personal property as part of the exchange.
It is important to note that the new safe harbor, as with the existing rule, does not allow for nonrecognition of the incidental personal property. Such incidental personal property will still be treated as “boot” and may result in ordinary income. The safe harbor only provides comfort with respect to the use of a qualified intermediary in a Deferred Exchange. This is made clear in an example contained within the Proposed Regulations. In the example, a taxpayer transfers to a qualified intermediary for sale a building with a fair market value of $1,100,000 but a tax basis of only $400,000. The taxpayer then, through the qualified intermediary, receives in an exchange an office building worth $1,000,000, as well as office furniture worth $100,000. Since the office furniture is customarily the kind of property that may be included with an office building and it is worth less than fifteen percent of the total fair market value of the real property, the office furniture is incidental and the qualified intermediary rules are not violated by the taxpayer’s direction to the qualified intermediary to acquire personal property. However, the taxpayer still recognizes gain as a result of the receipt of the personal property office furniture of $100,000 under Section 1031(b).
The Proposed Regulations will be effective when they are finalized, though taxpayers are allowed to adopt the Proposed Regulations earlier than the effective date. In general, these Proposed Regulations are reasonably consistent with the understanding of Section 1031 exchanges prior to their release and serve to provide additional comfort and certainty to taxpayers as to how their transaction will be treated. That being said, a facts and circumstances analysis will still be required in many transactions to determine which assets qualify as real property. Taxpayers have additional incentive to utilize cost segregation studies in their transactions given the nature of the Proposed Regulations. Any taxpayer contemplating entering into a like-kind exchange should consult with their FGMK tax advisor.
1Treas. Reg. §1.1031(a)-1(c)
2Treas. Reg. §1.1031(k)-1(c)(5)
3Treas. Reg. §1.1031(k)-1(g)(2-5)
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