Even though the Tax Cuts and Jobs Act (TCJA) was signed into law at the end of 2017, many of its provisions are still being interpreted by the IRS. In June 2020, the IRS issued proposed regulations addressing the TCJA’s changes to Section 1031, the tax code section that allows taxpayers to defer capital gains for like-kind exchanges. Just six months later, in December 2020, the IRS finalized those regulations. The final regulations help clarify what property exchanges qualify for preferential tax treatment under Section 1031.
Overview of TCJA Changes
The TCJA’s changes to Section 1031 were striking. Beginning in 2018, the like-kind exchange rules could no longer be applied to exchanges of personal property (e.g., machinery, equipment, vehicles, etc.). Only exchanges of real property are eligible for tax deferral under Section 1031. The TCJA also narrowed the definition real property for purposes of this code section.
When personal property was excluded from 1031 treatment, taxpayers wondered how personal property that was incidental to their sale of real property sale may be treated. Other taxpayers wondered if they would lose out on like-kind exchange treatment if their property did not meet the law’s narrow definition of real property. The final regulations address these issues and others.
Definition of Real Property
Based on taxpayer comments after the proposed regulations were released, the final regulations expanded the definition of real property. Now, property is generally considered “real property” if the property would have been eligible for 1031 treatment under pre-TCJA law, and if the property is:
- Explicitly listed as real property in the final regulations,
- Classified as real property under the taxpayer’s state or local laws, or
- Considered real property based on all the facts and circumstances.
This was a welcome change for taxpayers. Relying on state or local law to help classify their property eliminated ambiguity and gave taxpayers peace of mind that they were following the letter of the law.
But, as one might guess, there are exceptions to the real property definition.
Assets That Cannot Be Treated as Real Property
The final regulations state that the following property cannot be treated as real property for purposes of Section 1031:
- Stock, bonds, and notes (except for developmental rights and stock in a cooperative housing corporation, mutual ditch, reservoir, or irrigation company)
- Other securities or evidences of indebtedness or interest
- Interest in a partnership (other than interests in partnerships that have elected not to be treated as partnerships for tax purposes)
- Certificates of trust or beneficial interests
- Choses in action
Property That Can Be Treated as Real Property
In addition to buildings that meet the standard definition of real property, the IRS listed five asset categories that can be exchanged under Section 1031:
- Air and water space superjacent to land
The example provided in the regulations described a scenario where the owner of a marina also owned a section of boat slips that extended into the water. The boat slips and water space that contains the boat slips are considered real property.
- Land improvements
This includes both permanent structures (like buildings) and the structural components of permanent structures. For structural components to qualify, they must be integrated into and inherently permanent to the structure, must serve the structure itself, and must be owned by the same person who owns the permanent structure. This means that the following structural components could qualify: heating and cooling systems, pipes and ducts, elevators and escalators, floors and ceilings, insulation, fire alarms, security systems, and similar property.
- Unsevered natural products of land
This includes crops, trees, mines, wells, natural deposits, and minerals, to name a few. Once those assets are removed from the land (e.g. crops are harvested, ore is extracted, mines are mined, etc.), those assets cease to be considered real property.
- Certain intangible interests in real property
This includes intangible interests in buildings and in assets that belong to any of the other four categories.
The property definition in the final regulations deviated from the proposed regulations in one other noteworthy factor: the purpose and use test. Under the proposed regulations, real property would not qualify for Section 1031 treatment if the property contributed to the production of income unrelated to the use or occupancy of the space. The final regulations removed this test, stating that applying it would have disqualified property that would have historically been treated as Section 1031 property prior to the passage of the TCJA.
Incidental Personal Property
Before the proposed or final regulations were published, taxpayers were concerned that their otherwise eligible exchange would be disqualified if they accepted personal property that was incidental to their exchange of real property. When purchasing a building, for example, it might be customary for personal property to be included as part of the purchase price of the building (e.g. machinery in a warehouse, office furniture in an office building, etc.). The final regulations provide a safe harbor that protects taxpayers whose exchanges include such property. If (1) the personal property is customarily transferred with the real property, and (2) the fair market value of the personal property is 15% or less than the fair market value of the real property, the exchange will not be disqualified in an otherwise eligible like-kind exchange. However, the taxpayer must recognize gain equal to the lesser of the realized gain on the relinquished property or the fair market value of the personal property that they acquired in the exchange.
Applying the Regulations
The final regulations became effective the date they were published, on December 2, 2020.
The limitations on 1031 exchanges that began when former President Trump passed the TCJA might continue under President Biden. The Biden administration has expressed interest in restricting like-kind exchanges to investors with incomes below $400,000. This means that high earners may soon lose their ability to utilize like-kind exchanges at all, on both real and personal property exchanges.
If your business has relied on like-kind exchanges in the past, contact a member of LaPorte’s Real Estate Industry Group. We can help you make a plan for property exchanges in 2021 and into the future.