Editor: Lori Anne Johnston, CPA, J.D.
As most tax practitioners know, an interest in real property is the only type of property that currently qualifies for a like-kind exchange because the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, narrowed the application of Sec. 1031. That legislative change left an important question unresolved — exactly what does Sec. 1031 consider real property? The IRS recently supplied an answer in new regulations.
On June 11, 2020, the IRS and Treasury released highly anticipated proposed regulations on Sec. 1031 (REG-117589-18) that provided a definition specific to Sec. 1031, including a list of examples of real property and a framework for analyzing anything not listed. The final regulations (T.D. 9935) were published Dec. 2, 2020, and mostly adopted the proposed regulations but with a few important deviations.
The following discussion provides some background on like-kind exchanges and then examines how the final regulations define real property for purposes of like-kind exchanges.
Like-kind exchange basics
Sec. 1031(a)(1) provides that no gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind, which is held either for productive use in a trade or business or investment. This provision is dense with requirements, but the core concept is simple: Taxpayers may sell business or investment property (relinquished property) and defer tax on the gain if the taxpayers reinvest in similar property (replacement property). Personal property and property held primarily for sale do not qualify per Secs. 1031(a)(1) and (2).
Sec. 1031 is very form-driven, and taxpayers must satisfy a number of requirements and timing elements or the deal fails. One particularly important requirement addressed by the new regulations requires that the deal must be structured as an exchange; taxpayers cannot sell, get the proceeds, and then buy. Rather, they must either trade the property directly or use a qualified intermediary (QI) to buy and sell such that it looks like an exchange from the taxpayer's perspective.
How the TCJA changed the landscape
Before the TCJA, taxpayers often used Sec. 1031 to swap personal property and intangible assets. Although real estate was by far the most common property involved in like-kind exchanges, real estate transactions that include more than just raw land almost always involve some amount of personal property. Even under the old rules, Sec. 1031 did not consider real property and personal property to be of "like kind" to one another. Taxpayers could not exchange a building for personal property — including certain fixtures within a building — but most real property exchanges include a swap of some property classified as personal property. As a practical matter, taxpayers could often offset relinquished personal property with replacement personal property to defer most or all of the gain on the exchange.
Following the TCJA, Sec. 1031 only applies to real property. Any personal property transferred in a like-kind exchange is considered separately bought and sold, with undeferrable gain on the sale. Qualifying relinquished and replacement property now must satisfy two core requirements: (1) The property must be real property, and (2) the two types of property must be of like kind to one another. Regs. Sec. 1.1031(a)-1(b) states that the words "like kind" refer to the nature or character of property, and courts generally hold that to mean virtually any real property is of like kind to virtually any other real property, regardless of whether improved or unimproved. In sum, the TCJA made the key inquiry in most cases the examination of what constitutes real property.
Determining what counts as real property
The new regulations provide a much-needed definition specific to Sec. 1031. Before the new regulations, taxpayers relied on a patchwork of Code sections and other sources to evaluate property to determine whether it counted as real property. Case law generally used state law property classifications as the best guide. But there is a problem with relying on state sources because, for instance, a pipeline crossing state lines might be real property in one state and personal property in the other, as CCA 201238027 highlighted. The Office of Chief Counsel memorandum stated that while state law property classifications are relevant, federal law ultimately controls the determination of whether two properties are of like kind. This is just one of the issues the new regulations address.
New Regs. Sec. 1.1031(a)-3 provides a unifying definition of real property for Sec. 1031. The starting point under Regs. Sec. 1.1031(a)-3(a)(1) holds that real property includes "land and improvements to land, unsevered natural products of land, and water and air space superjacent to land." From there, taxpayers have a facts-and-circumstances analysis to determine whether their assets qualify in one of those categories. Importantly, new Regs. Sec. 1.1031(a)-3(a)(4) provides that each distinct asset must be analyzed separately from any other assets to determine whether it counts as real property.
New Regs. Sec. 1.1031(a)-3(a)(2)defines "improvements to land" as inherently permanent structures and the structural components of inherently permanent structures. It then provides more detailed definitions of "inherently permanent" and "structural components" with examples of each. This section helps address one question that loomed in the minds of many taxpayers: How should taxpayers treat different types of assets that make up one system?
Under new Regs. Sec. 1.1031(a)-3(a)(2)(iii), if interconnected assets work together to serve an inherently permanent structure (e.g., systems that provide a building with electricity, heat, or water), the assets should be analyzed together as one distinct asset that may qualify as a structural component of real property. The proposed regulations gave the example of a gas line running into a building. If the gas line provides fuel to the building's heating system, it is a structural component of an inherently permanent structure and likely counts as real property. If the gas line provides fuel to nonstructural components in the building (e.g., an oven), then the gas line is personal property for Sec. 1031 purposes.
Intangible assets related to land often challenge taxpayers, and new Regs. Sec. 1.1031(a)-3(a)(5) lists examples of intangible assets that count as real property, while specifically excluding others. The regulations specifically include leaseholds, options, easements, and land development rights. Note that the duration of an easement or leasehold interest may determine whether it is of like kind to a permanent interest. For example, in GCM 39182, the IRS Chief Counsel's Office analyzed a temporary easement and cited Regs. Sec. 1.1031(a)-1(c), which establishes that leases of 30 years or more are of like kind to a fee interest in real property. Shorter interests may not be. Some taxpayers hoped the final regulations would provide more detail on easements and other limited interests in real property, but the IRS and Treasury declined to address them further.
Notably, the final regulations state in new Regs. Sec. 1.1031(a)-3(a)(1) that any property that is considered real property under the law of the relevant state or local jurisdiction counts as real property for purposes of Sec. 1031. In the conference report for the TCJA, Congress stated its intent that any property qualifying for like-kind exchanges before the TCJA should continue to qualify after its enactment (H.R. Conf. Rep't 115-466, at 396, fn. 726 (2017)). Thus, the new regulations reemphasize state law classifications and now arguably affirm state law as the final voice on the matter. Because the final regulations appear to incorporate everything that counted as real property before the TCJA, pre-TCJA case law most likely remains valid where it concludes assets represent real property. Where case law and agency guidance present unfavorable precedent, the new rules may lead taxpayers to more favorable conclusions.
The final regulations address one more personal property-related concern by allowing taxpayers to receive some personal property without violating exchange requirements. Existing Regs. Sec. 1.1031(k)-1(c)(5) permits taxpayers to identify a large unit of real property for a like-kind exchange that includes incidental personal property constituting up to 15% of the aggregate fair market value. For example, a taxpayer may identify a hotel it will acquire for $1,000,000 as replacement property, even if the purchase involves $850,000 of real property and $150,000 of furniture and fixtures incidental to the real property. This rule only applies to the identification of the replacement property; thus, the taxpayer in this example is still acquiring $850,000 of real property for purposes of the exchange and separately purchasing $150,000 of personal property.
This type of situation had created some concern prior to the issuance of the final regulations, as Regs. Sec. 1.1031(k)-1(g)(4) prohibits taxpayers from receiving any money or other property before the taxpayer receives the like-kind replacement property. This concern was allayed by new Regs. Sec. 1.1031(k)-1(g)(7), which clarifies that personal property incidental to real property received in an exchange is exempt and does not represent early receipt of exchange proceeds. However, the incidental personal property still does not count as part of the like-kind exchange and does not qualify for deferral.
The new final regulations for Sec. 1031 provide a much-needed set of rules for determining what constitutes real property. Though the new rules involve an asset-by-asset approach and rely on facts-and-circumstances determinations, taxpayers now have a single set of rules and answers to a number of long-standing questions.
Lori Anne Johnston, CPA, J.D., is a manager, Washington National Tax for RSM US LLP.
For additional information about these items, contact the author at John.Charin@rsmus.com.
Contributors are members of or associated with RSM US LLP.