On June 12, 2020, the IRS released proposed regulations that once finalized would clarify a few key factors for taxpayers participating in like-kind exchanges after the enactment of the Tax Cuts and Jobs Act (TCJA). Under Section 1031 of the Internal Revenue Code, taxpayers can defer gain recognition on sales of real property held for investment or for use in a trade or business if they reinvest the proceeds from that sale in real property (i.e. property that is of “like-kind”). The proposed regulations are significant in that they provide a definition of “real property” under Section 1031, and they provide a safe harbor for real property exchanges that also include an incidental amount of personal property.
History of Section 1031 and Where We Are Today
Until recently, property exchanges of many types were eligible for tax deferral treatment under Section 1031. For example, Section 1031 was a popular mechanism for deferring gain on the sale of artwork. This changed with the enactment of the TCJA in December 2017. The expansive tax reform bill limited Section 1031 exchanges to real property.
The limitation of deferral to real property exchanges raised two key questions: how is “real property” defined, and what should taxpayers do when real and personal property are inextricably tied to one another? These grey areas are what the proposed regulations seek to make clear.
Taxpayers need to understand what transactions qualify under the tax law before they embark on a property exchange, and they cannot do that if the terms of the law are not clearly defined. The proposed regulations define “real property” by stating that the term used in Section 1031 is similar, but not identical, to how the term is used in other areas of federal tax law, particularly with regard to Real Estate Investment Trusts (“REITs”), and that real estate transactions that qualified under pre-TCJA law would qualify post-TCJA.
In providing a definition of real property, the proposed regulations do not purport to change the definition of real property from its pre-TCJA definition, but rather to clarify existing law. They also specify that real property includes:
- Land, buildings, and permanent structures (along with the water and air space superjacent to these items)
- Interests in land, buildings, or permanent structures like certain leaseholds, easements, and co-ownerships
- Options to acquire real property
- Unsevered crops (e.g. potatoes still in the ground, untapped oil wells, etc.)
- Permanent structures, including the structural components themselves
- Machinery that serves the structure and does not directly contribute to the production of income
- Intangible assets that derive their value from the real property and do not directly contribute to the production of income (e.g. a permit to occupy land). Licenses and permits to operate a business on real property (i.e., a liquor license) are excluded from this definition.
Though the real property definition is helpful, the proposed regulations are arguably the most beneficial to taxpayers who enter into exchanges where personal property is incidental portion of the sale of real property.
Incidental Personal Property
Because real property exchanges are almost never simultaneous, taxpayers must utilize the help of certain permitted arrangements including qualified intermediaries (QIs) to accomplish the exchange. QIs act as third-party facilitators of these exchanges. They receive an assignment of the contract of sale and the funds from the disposition of the relinquished property(s) and acquire the replacement property(s) at the direction of the taxpayer. If the QI uses the funds for purposes other than the acquisition of qualifying replacement property, the transaction may fail to qualify as a deferred exchange under Section 1031.
This is an important issue when the identified replacement property includes personal property. If a taxpayer purchases an office building that comes outfitted with cubicles, desks, and office chairs, the receipt of those cubicles, desks, and office chairs would not be considered real property, and could jeopardize the gain deferral.
Fortunately, the proposed regulations established a safe harbor that protects taxpayers in these situations where incidental personal property is acquired along with the replacement real property. In an otherwise qualifying exchange, if the aggregate fair value of the incidental personal property is 15% or less of the aggregate fair value of the real property, the personal property will not disqualify the exchange, and the taxpayer will not be in constructive receipt of the exchange funds.
However, it’s important to note that this safe harbor does not exempt taxpayers from paying tax on the receipt of that personal property to the extent value is ascribed to personal property in the exchange. Because personal property is still considered “boot” in the transaction, the fair value of that personal property is taxable. The safe harbor simply states that the incidental receipt of personal property will not disqualify the real property exchange from Section 1031 tax deferral.
The proposed regulations provide a welcome definition of real property and safe harbor for the acquisition of incidental personal property. Until they are finalized, taxpayers can rely on the proposed rules for exchanges.
Issues arising in a Section 1031 exchange remain complex, and utilizing the help of an experienced tax advisor is crucial. Frequently, for example, a property may be held by multiple parties through a partnership where some partners want to participate in a Section 1031 exchange and some partners want to “cash out”. A partnership interest (an intangible asset), even a real estate partnership interest, remains ineligible for deferred gain treatment under Section 1031. Proper structuring is critically important in these scenarios to accomplish the goals of all parties.
We can help with these scenarios and any other real-property transaction you need assistance with.