Editor: Mark G. Cook, CPA, CGMA
Nearly 100 years after Congress wrote the concept of a tax-deferred property exchange into the Internal Revenue Code, the IRS has finally provided guidance on defining real property for the purposes of those exchanges with the release of proposed regulations on June 12 (REG-117589-18).
Sec. 1031 allows the deferral of gain recognition on the sale of business property if the relinquished property is replaced with a similar type of property. Prior to the December 2017 passage of the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, tax deferral was allowed on exchanges of personal property and real property used in a trade or business or for investment. The TCJA amended Sec. 1031 to limit its applicability to real property. The new focus on real property resulted in a need for guidance on how real property should be defined. A definition was especially important to taxpayers engaged in cost-segregation studies. Cost-segregation studies identify components of real property that may be reclassified and depreciated as personal property, accelerating depreciation expense. How should components of real property segregated and depreciated as personal property be treated in a like-kind exchange? Newly issued proposed regulations help answer this question by providing a definition of real property for Sec. 1031 purposes.
Definition of real property for Sec. 1031
In creating a definition for real property, the IRS looked to the legislative history of Sec. 1031 to ensure that the proposed definition does not exclude any property that previously would have been included in the category of real property. Taxpayers and tax advisers can, therefore, expect that if real property would have qualified for a like-kind exchange before the proposed regulations were issued, it will qualify as real property under the proposed definition.
Prop. Regs. Sec. 1.1031(a)-3 defines real property as including:
- Improvements to land;
- Unsevered natural products of land; and
- Water and air space superjacent to land.
Improvements to land
The term "improvements to land" means inherently permanent structures and the structural components of inherently permanent structures (Prop. Regs. Sec. 1.1031(a)-3(a)(2)(i)).
Inherently permanent structures: Inherently permanent structures are those buildings or other structures that are distinct assets and are permanently affixed to the land and that will ordinarily remain affixed for an indefinite period of time. Permanently affixed buildings include any structure enclosing a space within its walls and covered by a roof. Nonbuildings may also qualify as inherently permanent structures. In-ground swimming pools, roads, bridges, parking facilities, and fences are among the structures specifically listed as qualifying in Prop. Regs. Sec. 1.1031(a)-3(a)(2)(ii)(C). Structures that do not appear on the list may still qualify as inherently permanent. The proposed regulations offer the following factors for determining if a structure is inherently permanent:
- The manner in which the distinct asset is affixed to the property;
- Whether the distinct asset is designed to be removed or to remain in place;
- The damage that removal of the distinct asset would cause the item itself or the real property to which it is affixed;
- Any circumstances that suggest the expected period of affixation is not indefinite; and
- The time and expense required to move the distinct asset.
Structural components: Should assets distinguished from real property in a cost-segregation study be considered real property for a like-kind exchange? Structural components are considered real property. A structural component is any distinct asset that is a constituent part of, and integrated into, an inherently permanent structure.
If multiple assets work together to serve an inherently permanent structure, for example, a system providing a building with heat, the entire system is analyzed as a whole to make the structural component determination. Walls, doors, wiring, plumbing, HVAC systems, elevators, floors, and security systems are all specifically mentioned in Prop. Regs. Sec. 1.1031(a)-3(a)(2)(iii)(B) as examples of structural components. Distinct assets that are not specifically mentioned in the proposed regulations may still qualify based on the following facts and circumstances:
- The manner, time, and expense of installing or removing the component;
- Whether the component is designed to be moved;
- Whether the component is installed during construction of the inherently permanent structure; and
- The extent to which removal would cause damage to itself or to the inherently permanent structure.
Distinct asset: The determination of whether an item of property is a distinct asset is based on all the facts and circumstances. Prop. Regs. Sec. 1031(a)-3(a)(4)(ii) states that the following factors must be taken into account in making the distinct asset determination:
- Whether the item is customarily sold or acquired as a single unit rather than as a component part of a larger asset;
- Whether the item can be separated from a larger asset and, if so, the cost of separating the item from the larger asset;
- Whether the item is commonly viewed as serving a useful function independent of a larger asset of which it is a part; and
- Whether separating the item from a larger asset of which it is a part impairs the functionality of the larger asset.
Unsevered natural products of land
Natural products of the land included in the exchange, such as growing crops, timber, mines, wells, water, and ores, are treated as real property so long as the natural products are unsevered from the land. Crops that have been harvested or ore that has been extracted, for example, have been severed and are no longer considered real property for Sec. 1031.
Intangible assets are considered real property if they derive their value from real property, are inseparable from real property, and do not produce or contribute to the production of income other than consideration for the use or occupancy of space. Intangibles that qualify as real property include licenses, permits, and other similar rights to use land or an inherently permanent structure so long as the license or permit does not give the user the right to engage in or operate a business.
A formal definition
When a taxpayer desires to defer the gain on the sale of real property, it may make an exchange for a like-kind real property. What qualifies as real property is now formally defined in Prop. Regs. Sec. 1.1031(a)-3.
Mark G. Cook, CPA, CGMA, MBA, is the lead tax partner with SingerLewak LLP in Irvine, Calif.
For additional information about these items, contact Mr. Cook at 949-261-8600 or firstname.lastname@example.org.
All contributors are members of SingerLewak LLP.