Final regulations issued – Section 1031 exchanges

Background

Under Section 1031, no gain or loss is recognized on the exchange of  real property for other  real property as long as such real property is held for productive use in a trade or business or held for investment.  Like-kind refers to the nature or character of the property and not to the quality or grade of property; i.e. whether property is improved or unimproved is not relevant to a like-kind determination.

Highlights of the final regulations

The final regulations continue to define real property under several broad categories:  land; land improvements, including inherently permanent structures and structural components; unsevered natural products of land (e.g., growing crops, plants and timber, mines, wells and other natural deposits); and certain intangible property, such as a license or permit for use of a permanent structure such as a leasehold or easement right.

The final regulations make important changes to the proposed regulations discussed below.

State or Local Jurisdiction Law Impact

In marked contrast to the provisions of the proposed regulations,  the final regulations generally provide that property that is treated as real property under State or local law is treated as real property for purposes of Section 1031.[1]  However, the final regulations  retain the rule of the proposed regulations  that the real property definition  for purposes of Section 1031 does not apply for other purposes of the Code (such as depreciation under  Section 1245 (personal property) or Section 1250 (real property).

Consequently, under the final regulations, property is classified as real property for purposes of section 1031 if the property is (i) so classified under the State and local law test, (ii) specifically listed as real property in the final regulations, or (iii) considered real property based on all the facts and circumstances under the various factors provided in the final regulations. In addition, a determination that property is personal property under state or local law does not preclude the conclusion that property is real property under the final regulations.

In addition, property that was not eligible for like kind exchange treatment prior to enactment of the TCJA will continue to be ineligible, regardless of State and local law classification of such property.  Thus, stocks, securities and debt instruments, partnership interests, choses in action, and certificates of trust or beneficial interests are still not eligible for tax deferred treatment.

Purpose or Use

The proposed regulations specified that a structural component of a building was not real property if its purpose or use was to produce income other than income from the use or occupancy of real property. Thus, an industrial printer permanently attached to a building, or a steam turbine used to produce electricity, both generated non- real property related income and were not treated as real property.  The final regulations reverse this rule and treatment as real property depends on whether such property is permanently affixed to real property and will ordinarily remain affixed for an indefinite period of time, irrespective of the purpose or use of the property or whether it contributes to the production of income.

Thus, items of machinery and equipment are characterized as real property if they comprise an inherently permanent structure, a structural component, or are real property under the state or local law test.

With respect to intangible property the final regulations make another change to the proposed regulations and remove the requirement that intangible assets do not contribute to income other than rental type income.  As a result, whether intangible property produces or contributes to the production of income other than consideration for the use or occupancy of space is not considered in determining whether intangible property is real property for section 1031 purposes. However, the purpose of the intangible property remains relevant to the real property determination.  The intangible property must either (i) be real property under State or local law at the time of the exchange, or (ii) derive its value from real property or an interest in real property and cannot be separated from such real property or interest in real property.

Stock in cooperative housing corporations and land development rights are expressly designated as real property in the final regulations.

Incidental Personal Property

The proposed regulations contained a beneficial rule concerning “incidental” personal property transferred in an otherwise qualifying like-kind tax deferred exchange to a qualified intermediary.  The transaction will still qualify for like-kind exchange treatment if:

• the personal property is of a type typically transferred along with real property in standard commercial transactions; and;
• the fair market value of the personal property to be received does not exceed 15% of the aggregate fair market value of the replacement real property.

The final regulations clarify that the 15% limitation is applied on an aggregate, and not a property-by-property, basis.

The final regulations also clarify that the incidental personal property rule does not protect against the recognition of gain.  While such incidental personal property will not disqualify the tax-deferred nature of an exchange of real property, such property constitutes “boot” (i.e., property other than real property) and will generally result in taxable gain to the extent of the fair market value of the personal property received.

Mazars’ Insight

The addition of a state or local criterion to establish an asset as real property provides welcome certainty for qualification for Section 1031 tax-deferred treatment.  In addition, the removal of the requirement that machinery or equipment affixed to a building not be used to produce non-real estate related income will now not require taxpayers to segregate such assets by purpose or use.  Finally, the ability to apply the 15% incidental personal property rule on an aggregate instead of a property-by-property basis will make it easier to satisfy the incidental property rule.

Please contact your Mazars LLP professional for additional information.

Published on December 14, 2020

The information provided here is for general guidance only, and does not constitute the provision of tax advice, accounting services, investment advice, legal advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal or other competent advisers.