New Proposed Regulations for §1031 Exchanges

The IRS just released proposed regulations that clarify and help to better define “real property” that qualifies for a §1031 exchange. After TCJA §1031 exchanges are only applicable to real property used in a trade or business or held for investment. The proposed regulations make it clear that local definitions of real property are not a controlling factor in deciding as to whether property qualifies federally for a §1031 exchange.

Prior to TCJA §1031 exchanges were permitted for various real property and personal property so long as the exchange of property was for a similar type. Under TCJA §1031 was limited to real property exchanges for transactions occurring after 12/31/2017. The change in the law did not include detailed definitions of what constitutes real property for purposes of these exchanges.

§1031 requires that a taxpayer identify both the relinquished property that is exchanged as well as the replacement property acquired in the exchange. Often personal property is included within the real property that is exchanged. Taxpayers who receive money or incidental personal property in a qualifying §1031 exchange have an obligation to recognize gain or loss for the property or money received as “boot” unless the taxpayer can completely separate the real property and personal property transactions.

Proposed Regulations
The new proposed regulations have specifically defined real property in the context of a §1031 exchange. The proposed regulations highlight that these new definitions control for purposes of §1031 exchanges and that state law definitions of real property will not apply to these analyses.

Pursuant to the new proposed regulations real property includes:

  • Land and improvements to land
  • Unserved crops and other natural products of the land
  • Water and air space superjacent to land

Real property includes improvements to the land. Improvements include:

  • inherently permanent structures, and
  • the structural components of inherently permanent structures

Inherently permanent structures include buildings and other structures that are permanently affixed to real property and are intended to remain affixed for an indefinite period. Examples include shelters with walls and a roof for walking or parking. Additionally, machinery can constitute real property if it is a structural component of an inherently permanent structure and does not contribute to the production of income other than income derived from the use of space (e.g., electrical generator servicing a building). Intangible property will be classified as real property if it is “inseparable” from real property and does not contribute to the production of income other than income derived from the use of space. Licenses and permits solely for the use of real property that are in the nature of a leasehold or easement generally are interests in real property.

When making a determination as to whether the asset can be considered real property the IRS states that a determination needs to be made whether the property constitutes a “distinct asset” based on a facts and circumstances analysis, which considers four factors: (i) whether the item is customarily sold or acquired as a single unit or as a component of a larger asset; (ii) whether the item can be separated from a larger asset and, if so, the cost of doing so; (iii) whether the item is commonly viewed as serving a useful function independent from a larger asset of which it is a part; and (iv) whether separating the item from the larger asset impairs the larger asset’s functionality. If the property is not specifically defined by these regulations this four-factor analysis should be used.

Tangible Personal Property Safe Harbor
Finally, the proposed regulations provide a safe harbor for taxpayers who receive personal property as part of a real property acquisition. If a taxpayer receives personal property as part of a §1031 exchange the safe harbor provided that the acquisition of this personal property will not violate the §1031 rules so long as:

  • The FMV of the personal property is no more than 15% of the FMV of the replacement property received in the exchange
  • AND
  • The personal property received is of a type that is typically transferred together with real property in a commercial transaction

These proposed regulations provide certainty in defining qualifying real property for §1031 exchanges. Although these regulations are proposed taxpayers can rely on these regulations for any exchanges of real property beginning after 12/31/2017.

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About the Author(s)

Cassandra Baubie is an Associate at HBK CPAs & Consultants and is a member of its Tax Advisory Group (TAG). Cassandra joined HBK in 2017. She works in the firm’s Youngstown, Ohio office. She has experience in tax law research and writing.

Cassandra focuses on issues pertaining to State and Local Taxation (SALT), as well as flow through entity taxation. She has been involved in numerous sales and use tax, franchise tax, and corporate income tax audits, VDA’s, and refund requests. She focuses on complex sales and use tax compliance planning, nexus studies and on-site review and training for all SALT related issues, and has managed various engagements as the in-charge team member and has significant experience in multi-state tax issues.

Hill, Barth & King LLC has prepared this material for informational purposes only. Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.