Final Regulations Issued Defining Real Property Under IRC §1031December 1, 2020
The IRS recently announced final regulations under IRC §1031. The final regulations amend proposed regulations to address the definition of real property for 1031 purposes considering changes under the Tax Cuts and Jobs Act (TCJA) that limit, as of January 1, 2018, like-kind exchange treatment (LKE) to exchanges of real property held for use in a trade or business or for investment.
The ﬁnal regulations largely adopted proposed regulations issued in June 2020, discussed here, with certain modifications which include a “state or local law" test to deﬁne real property and the elimination of the “purpose and use” test (discussed below) originally set forth in the proposed regulations.
In addition, the ﬁnal regulations categorize cooperative housing corporation stock and land development rights as real property and similarly provide that a license, permit or other similar right is generally real property if it is (1) solely for the use, enjoyment or occupation of land or an inherently permanent structure; and (2) in the arrangement of a leasehold, an easement or a similar right.
State or Local Jurisdiction
Under the ﬁnal regulations, property is classiﬁed as real property for LKE purposes if, on the date it is transferred in the exchange, it is real property under the law of the state or local jurisdiction in which it is located. The proposed regulations had limited this “state or local law” test to shares in a mutual ditch, reservoir or irrigation company. However, the ﬁnal regulations also clarify that real property that was ineligible for an LKE before the TCJA remains ineligible. For example, intangible assets that could not be like-kind property before the TCJA (such as stocks, securities and partnership interests) remain ineligible regardless of how they are characterized under state or local law.
Accordingly, under these ﬁnal regulations, property is real property if it is classiﬁed as real property under state or local law, speciﬁcally listed as real property in the ﬁnal regulations or considered real property based on all the facts and circumstances, under factors provided in the regulations. These tests mean that property that is not real property under state or local law might still be real property for LKE purposes if it satisﬁes the second or third test.
Under both the proposed and ﬁnal regulations, real property for LKE purpose is land and land improvements, unsevered crops and other natural products of land, and water and air space superjacent to land. Land improvements still include inherently permanent structures and the structural components of these inherently permanent structures. Each individual asset must be separately analyzed to determine if it is land, an inherently permanent structure or a structural component of an inherently permanent structure, and the final regulations identify several speciﬁc items, assets and systems as distinct assets and provide factors for identifying other distinct assets.
Tangible and Intangible Property
The proposed regulations initially imposed a "purpose or use" test on both tangible and intangible property. Under this test, neither tangible nor intangible property was real property if it contributed to the production of income unrelated to the use or occupancy of space. The ﬁnal regulations eliminated this test for both tangible and intangible property. Accordingly, tangible property is generally an inherently permanent structure and is considered real property if it is permanently aﬃxed to real property and will ordinarily remain aﬃxed for an indeﬁnite period of time. Additionally, if a structural component is integrated into an inherently permanent structure it is real property. Consequently, machinery and equipment are deemed real property if they contain an inherently permanent structure or a structural component, or if they are real property under the state or local law test, notwithstanding the purpose or use of the items or whether they contribute to the production of income. Additionally, whether intangible property produces or contributes to the production of income is disregarded in determining whether the intangible property is real property for LKE purposes, although the purpose of the intangible property remains relevant to the determination of whether it is real property.
Incidental Personal Property
Lastly, the incidental property rule in the proposed regulations provided that when an LKE involved a qualiﬁed intermediary, incidental personal property included with the replacement real property (incidental personal property) should be disregarded in determining whether a taxpayer’s rights to receive, pledge, borrow or otherwise obtain the beneﬁts of money or non-like-kind property held by the qualiﬁed intermediary are expressly limited as defined in the regulations.
Personal property is incidental to real property acquired in an exchange if in standard commercial transactions, the personal property is typically transferred together with the real property and the aggregate fair market value (FMV) of the incidental personal property transferred with the real property does not exceed 15% of the aggregate FMV of the replacement real property. The ﬁnal regulations adopted these rules with some minor modiﬁcations to improve clarity and readability. For example, the ﬁnal regulations clarify that the receipt of incidental personal property is still personal property and as such results in taxable gain, and the 15% limitation compares the value of all the incidental properties to the value of all of the replacement real properties acquired in the same LKE.
These final regulations are significant since they now provide a sharper framework for determining whether a particular property, or component of that property, constitutes real property for purposes of Section 1031, and thus would mitigate uncertainties currently in existence concerning the definition of real property for purposes of Section 1031. Always speak to your tax advisor to ensure compliance in a 1031 exchange transaction.