In late November 2020, the US Department of the Treasury issued final regulations reversing positions in their proposed regulations released in June 2020.
The finalized regulations address the definition of real property for purposes of Internal Revenue Code (IRC) Section 1031 and provide a rule for receiving personal property that is incidental to real property received in a like-kind exchange. These regulations present a broader definition of real property than was offered by the proposed regulations, clarifying what constitutes like-kind property for purposes of IRC Section 1031.
Below, we cover key points addressed by final IRC Section 1031 regulations and potential benefits for businesses and individuals.
The determination of what constitutes real property under IRC Section 1031 like-kind exchange rules has long been uncertain, due in large part to neither the IRC nor the regulations providing a definition of real property for purposes of IRC Section 1031.
As a result, case law and IRS guidance often looked to federal tax rules in other IRC provisions for insight into what constitutes real property under IRC Section 1031. Some cases and guidance even looked to state and local law to determine what constitutes real property.
2017 Tax Reform
The 2017 Tax Cuts and Jobs Act (TCJA) limited like-kind exchange treatment to exchanges of real property. As of January 1, 2018, exchanges of personal property or intangible property no longer qualify for nonrecognition of gain as like-kind exchanges. Also, like-kind exchange treatment applies only to exchanges of real property held for use in a trade or business or held for investment.
An exchange of real property held primarily for sale doesn’t qualify as a like-kind exchange, and real property located in the United States isn’t considered like-kind to real property located outside the United States.
2020 Proposed Regulations
In June 2020, the IRS issued proposed regulations to clarify what constitutes real property for purposes of IRC Section 1031. Essentially, each part of the property had to be analyzed separately to determine if it was land, an inherently permanent structure, or a structural component of an inherently permanent structure.
The proposed regulations further indicated that state and local definitions of real property weren’t relevant when determining real property characterization for IRC Section 1031. The US Treasury received many comments on the proposed regulations, including several that argued the new framework failed to carry out Congressional intent that property qualifying as real property before TCJA should continue to qualify after TCJA.
Final IRC Section 1031 Regulations
The final regulations under IRC Section 1031 contain some substantial changes from the proposed versions.
Real Property Qualifications
Most notably, property is now considered real property if it’s any of the following:
- Listed as real property in the regulations
- Classified as real property under state and local law, subject to certain exceptions
- Considered real property based on all the facts and circumstances, using factors provided in the regulations
In addition, the following also generally qualify as real property under the final regulations:
- Certain intangible property, such as leaseholds or easements
- Certain permits and licenses to use inherently permanent structures
- Tangible property that is permanently affixed to real property and will ordinarily remain affixed for an indefinite period of time
- Structural components integrated into real property
The final regulations contain several specific examples of what qualifies as real property. They also provide a framework to determine if any individual asset not specifically listed in the regulations qualifies as real property.
Incidental Property Rule
The final regulations introduced another taxpayer-favorable rule. After the TCJA disallowed exchanges of personal property, there were concerns that exchanges could be put at risk if exchange funds were used to purchase replacement property whose purchase price included a personal property component. This could be seen as an unpermitted use of exchange funds on the part of a taxpayer, which, in turn, compromised the entire exchange.
To provide a solution for this potential dilemma, the final regulations borrowed from a provision in the original exchange regulations regarding identifying personal property that is typically incidental to the real property. This rule, known as the incidental property rule, states that personal property:
- Doesn’t have to be separately identified from the real property but must be incidental to the replacement property
- Must have an aggregate fair market value of no greater than 15% of the fair market value of the real estate
- Must typically be transferred with the real property in a standard commercial transaction
Under the final regulations, if part of the purchase price of the replacement real property includes the value of personal property fitting this definition, the exchange won’t be considered actual or constructive receipt of exchange funds by the taxpayer—which could otherwise compromise the tax deferral benefits of IRC Section 1031. Any personal property received with the replacement property would not be considered like kind to real estate, and potentially represent taxable boot, but would not jeopardize the entire exchange.
Therefore, as part of the replacement property, this safe harbor provides that a taxpayer may receive up to 15% of the total value of the real estate in property other than like-kind property without placing the exchange transaction in danger of failing to meet the statutory requirements.
We’re Here to Help
Taxpayers will benefit from applying these final regulations on an asset-by-asset basis to confirm what qualifies as real property for purposes of IRC Section 1031.
If you have questions about how to determine what qualifies as real property for purposes of IRC Section 1031 exchanges or how to receive the greatest available tax deferral, contact your Moss Adams professional.