IRS Issues Proposed Regulations Defining "Real Property" for Like-Kind Exchanges

6 min

Before the Tax Cuts and Jobs Act of 2017 (the TCJA), Section 1031 of the Code provided that a taxpayer could exchange real or personal property held for productive use in a trade or business or for investment for "like-kind" property and defer recognition of gain on such exchange. As revised by the TCJA, however, Section 1031 tax deferral is available only with respect to an exchange of "real property," not "personal property."

On June 11, 2020, the IRS issued proposed regulations governing post-TCJA like-kind exchanges. The proposed regulations address the following issues:

What is "real property" for Section 1031 purposes?

  • Land, "inherently permanent structures," "structural components" of inherently permanent structures, unsevered crops and other natural products of land, and water and air space adjacent to land.
  • Real property includes an interest in real property (i.e., fee ownership, co-ownership, a leasehold, an option to acquire real property, an easement, or a similar interest with respect to the foregoing).
  • Real property also includes a license, permit, or other, similar right that is solely for the use, enjoyment, or occupation of land or an inherently permanent structure and that is in the nature of a leasehold or easement.
  • Local law definitions generally are not controlling in determining whether property is "real property" for these purposes.
  • Each distinct asset must be analyzed separately to determine whether such asset qualifies as real property under this definition.
  • The guidance provides that its definitions apply only for purposes of Section 1031, and that no inference is intended with respect to the classification or characterization of property for other tax purposes, such as depreciation and Sections 1245 and 1250. This means that property can be classified as real property (which qualifies for like-kind exchange treatment) for purposes of Section 1031, but at the same time be classified as personal property (which qualifies for accelerated, and often bonus, depreciation) for purposes of Section 1245. Because the same property can qualify for both like-kind exchange treatment and bonus depreciation, cost segregation studies to support future increased depreciation deductions in the context of a like-kind exchange remain a viable strategy.

What are inherently permanent structures?

Inherently permanent structures include:

  • Any building or other distinct structure that is permanently affixed to real property and that ordinarily will remain affixed to such real property indefinitely.
    • A building is a structure enclosing a space, and includes houses, apartments, hotels, motels, enclosed stadiums and arenas, enclosed shopping malls, factory and office buildings, warehouses, barns, enclosed garages, enclosed transportation stations and terminals, and stores.
  • The following other distinct assets, if permanently affixed to the real property: in-ground swimming pools; roads; bridges; tunnels; paved parking areas, parking facilities, and other pavements; special foundations; stationary wharves and docks; fences; certain permanent advertising displays; certain outdoor lighting facilities; railroad tracks and signals; telephone poles; power generation and transmission facilities; permanently installed telecommunications cables; microwave transmission, cell, broadcasting, and electric transmission towers; oil and gas pipelines; offshore drilling platforms, derricks, and oil and gas storage tanks; and grain storage bins and silos.
  • In addition to the foregoing specifically listed items, an asset may be determined to be an inherently permanent structure based on an analysis of the following factors:
    • The manner in which the asset is affixed to real property;
    • Whether the asset is designed to be removed or to remain in place;
    • The damage that removal of the asset would cause to the asset or the real property;
    • Any circumstances that would suggest the expected period of affixation of the asset is not indefinite; and
    • The time and expense required to move the asset.

Machinery and equipment generally do not qualify as an improvement to land, unless such machinery or equipment serves the inherently permanent structure and does not contribute to the production of income from the real property (other than for the use or occupancy of space).

What are structural components?

Structural components are any distinct assets that are constituent parts of, and integrated into, an inherently permanent structure.

  • Assets that can be structural components include walls; partitions; doors; wiring; plumbing systems; central air conditioning and heating systems; pipes and ducts; elevators and escalators; floors; ceilings; permanent coverings of walls, floors, and ceilings; insulation; chimneys; fire suppression systems, including sprinkler systems and fire alarms; fire escapes; security systems; humidity control systems; and other, similar property
  • In addition to the foregoing specifically listed items, an asset may be determined to be a structural component based on an analysis of the following factors:
    • The manner, time, and expense of installing and removing the component;
    • Whether the component is designed to be moved;
    • The damage that removal of the component would cause to the component or the inherently permanent structure; and
    • Whether the component is installed during construction of the inherently permanent structure.

Whether an asset is a distinct asset is based on an analysis of the following factors:

  • Whether the asset is customarily sold or acquired as a single unit rather than as a component part;
  • Whether the subject asset can be separated from a larger asset, and if so, the cost of such separation;
  • Whether the subject asset is commonly viewed as serving a useful function independent of a larger asset; and
  • Whether separating the subject asset from a larger asset of which it is a part would impair the functionality of the larger asset.

Assets are analyzed together in determining whether they satisfy this definition if these assets are interconnected and work together to service an inherently permanent structure (for example, the components of a building's heating system are all analyzed together to determine if the heating system is a structural component).

To qualify, the taxpayer must hold the structural component together with a real property interest within the physical space of the inherently permanent structure served by the structural component.

Can intangible property be real property?

As noted above, an ownership interest in real property generally constitutes real property for purposes of Section 1031.

In addition, an intangible asset constitutes real property or an interest in real property if:

  • The intangible asset derives its value from real property or an interest in real property;
  • The intangible asset is inseparable from that real property or interest in real property; and
  • The intangible asset does not contribute to the production of income other than consideration for the use or occupancy of space.

What are the consequences of a taxpayer receiving personal property that is incidental to real property in an otherwise qualifying like-kind exchange?

After amendment of Section 1031 by the TCJA, taxpayers were concerned that the receipt of incidental personal property as part of replacement property would cause the entire transaction to fail to qualify as a Section 1031 exchange if the taxpayer was relying on the qualified intermediary safe harbor. Specifically, there was a concern that the taxpayer would be considered to be in constructive receipt of all of the exchange funds held by the qualified intermediary if the taxpayer was able to direct the qualified intermediary to use those funds to acquire personal property; if constructive receipt occurred, the taxpayer would be outside the safe harbor.

The proposed regulations address the foregoing issue and provide that if a taxpayer receives personal property that is incidental to real property, the receipt of such incidental property alone will not cause the taxpayer to lose the benefits of Section 1031 with respect to the real property exchanged.

Personal property is incidental to replacement real property if:

  • In a standard commercial agreement, such personal property typically would be transferred together with the real property; and
  • The aggregate fair market value of such personal property does not exceed 15% of the aggregate fair market value of the replacement real property.

A taxpayer may rely on these proposed regulations for exchanges after December 31, 2017 if the taxpayer applies the proposed regulations consistently and in their entirety.