Tax Considerations in a Section 1031 Exchange That Includes a Personal Property ComponentBy Steve Brodsky | July 14, 2020
The Tax Cuts and Jobs Act (TCJA) repealed like-kind exchanges (Section 1031) for all other types of property that are not real property. This means like-kind exchanges of personal or intangible property such as machinery, equipment, vehicles, aircraft, boats, artwork, collectibles, patents and other intellectual property generally no longer qualify for non-recognition of gain or loss. Because of this change, the exchange of personal property of like-kind is now considered a taxable event.
The IRS recently released proposed regulations defining “real property” under amended Section 1031 and clarified that the receipt of certain incidental personal property in a 1031 exchange will not violate the qualified intermediary (QI) safe harbor rules, which I describe in a separate article. This article’s primary focus is on certain tax considerations on the disposition of real property in a Section 1031 exchange that includes a personal property component.
How a 1031 Exchange Works
The basic mechanics of a Section 1031 exchange haven’t changed. A taxpayer must still identify their replacement property within 45 days and exchange within 180 days. Properties are of a like-kind if they’re of the same nature or character, even if they differ in grade or quality. All real property in the United States, improved and unimproved, remains like-kind to all other domestic real property. Foreign real property continues to be treated as not like-kind to real property located in the United States, and an exchange of real property held primarily for sale is still prohibited from qualifying as a like-kind exchange.
To report a like-kind exchange, taxpayers must file Form 8824, “Like-Kind Exchanges,” with their tax return for the year the taxpayer transfers property as part of a like-kind exchange. This form helps a taxpayer figure the amount of gain deferred as a result of the like-kind exchange, as well as the basis of the like-kind property received. If cash or property that isn't of like kind is involved in the exchange, Form 8824 helps compute the amount of gain the taxpayer must report.
Maintaining the ability to defer the gain on a sale of real property by means of a like-kind exchange remains critical to taxpayers involved in the real estate market. The question now is how to deal with personal property, such as furniture and fixtures, that can accompany the sale of a real property that qualifies as a like-kind exchange.
Generally, sales proceeds are not allocated to personal property with the sale of real property, since personal property is not primarily the driver of the sale. Rather, the intent of the buyer is to purchase the real property, such as the land and building. Having minimal-to-no sales proceeds allocated to personal property will alleviate the issue of not being able to defer gain on the personal property through a like-kind exchange.
Alternatively, since the personal property is typically not the motivating factor in the sale, when there is no purchase price allocation, one option would be to allocate a portion of the sales price to the remaining tax basis of the personal property and report that portion of the transaction as a taxable event. However, since the sales price allocation will equal the remaining tax basis of the personal property disposed of, there will be no gain or loss on the transaction.
Another available strategy is to treat the disposition of any personal property as an abandonment prior to and not as part of the like-kind exchange. Determining the existence of an abandonment is a factual matter. The courts have generally applied a two-pronged test to demonstrate abandonment. The taxpayer must show an intent to abandon the asset and must overtly act to abandon it. Neither intent nor non-use alone is sufficient to accomplish abandonment, and although abandonment is considered a disposition of property, it is not considered a sale or exchange. Abandonment losses are normally treated as ordinary losses to the extent of the remaining adjusted basis of the abandoned property and not capital losses since there has not been a sale or exchange of a capital asset. An abandonment loss is claimed as an ordinary loss on Form 4797 and would be deemed occurring prior to the sale of the real property constituting a like-kind exchange.
One final option would be for the seller to donate the personal property to a qualified charitable organization in order to benefit from a charitable contribution deduction prior to the like-kind exchange. If the charitable deduction claimed for the donated property exceeds $5,000, then the taxpayer would be required to obtain a qualified written appraisal from a qualified appraiser to support the donation, which would then require some additional tax-reporting requirements.
Overall, each of these strategies anticipates removing personal property from the transaction prior to the like-kind exchange, since gain on personal property can no longer be deferred under Section 1031. At the same time, in some instances, the taxpayer can generate an ordinary deduction upon the elimination of the personal property if it is either abandoned or donated. It is imperative that prior to the like-kind exchange, tax planning should be performed to create the most tax-advantageous outcome.
About Steve Brodsky
Steve D. Brodsky, CPA, JD, LL.M., is a director in the Real Estate Group at Marks Paneth LLP. To this role, Mr. Brodsky brings 20 years of accounting experience, with a focus on advising clients on complex tax matters related to the real estate industry. Mr. Brodsky’s areas of specialization include Real Estate Investment Trust (REIT) planning and compliance, tax consulting, and filing of federal and state returns for partnerships/limited liability companies, C and S-Corps,... READ MORE +