By: James T. Walther, Esq., LL.M.; David J. Feeser, Esq.; Todd R. Pajonas, Esq.
If you are an attorney, or accountant, or a commercial real estate professional, you may have heard that the IRS recently issued final regulations defining “real property” for the purpose of IRC §1031 exchanges. This Update is a brief overview into these new regulations and how they may affect the industry. If you would like a copy of a more detailed and technical article, please reach out to us.
On November 23, 2020, the IRS issued final versions of Treasury Regulations 1.1031(a)-3 and 1.1031(k)-1 (T.D. 9935) (the “Final Regulations”). Earlier in the year, on June 12, 2020, the IRS published proposed regulations (REG-117589-18)(“Proposed Regulations”).
The purpose of these regulations is to help clarify the meaning of “real property” (1.1031(a)-3) as it applies to 1031 exchanges after the Tax Cuts and Jobs Act of 2017 (“TCJA”) which limited exchanges only to “real property” and to provide a safe harbor for incidental property that is not “like-kind” but received in the transaction (1.1031(k)-1). The final regulations are effective as of December 2, 2020, the date that they were published in the Federal Register.
Here is a short synopsis of the Final Regulations:
Before January 1, 2018, taxpayers could exchange business or investment property for “like-kind” business or investment property (including real estate, as well as art, equipment, trademarks, and collectables) to defer their capital gain tax liability. With the passage of the TCJA, effective January 1, 2018, Section 1031(a)(1) was amended so that the term “property” was replaced with “real property.” Prior to the issuance of these regulations, Section 1031 did not contain a definition of “Real Property.”
Prior to the limits placed by the TCJA, investors were often concerned that the receipt of “non-like kind property” in an exchange could trigger severe tax consequences. Therefore, taxpayers had to carefully consider exactly what they were selling and buying. Under the previous definitions of “like-kind” which differed for real and personal property, many sales would involve an exchange of real estate for real estate and several smaller exchanges of personal property for replacement personal property in order to properly structure tax deferral through exchanges.
Post TCJA, investors and their advisors have had reason to be more concerned than ever regarding what is “real property” and what is “personal property” due to the TCJA limitation of exchanges to “real property” only. Many commercial property exchanges often include personal property (non-real estate) as part of what is being sold. For example, if an investor sells an office building, sometimes office furniture and removable or semi-permanent cubicle partitions or similar equipment are included in the transfer. Another example may be the furniture and other non-real estate in a hotel or a vacation rental. Investors and their tax advisors are often concerned about these incidental transfers of non-qualifying property during an exchange. To help alleviate such concerns, the new regulations (1.1031(k)-1) would disregard these incidental transfers of non-like kind property for up to 15% of the value of the real property being sold or acquired in the exchange for the purpose of determining whether the taxpayer had in fact spent their exchange funds on real estate. The Final Regulations (1.1031(a)-3) have lists and several tests to help determine if an “inherently permanent structure” or a structural component is considered real property.[i]
The regulations provide several lists of the common items that may be considered “real property” including:
· “Improvements to land” [1.1031(a)-3(a)(2)] “Improvements” is defined as “inherently permanent structures and their structural components.” The regulations provide a list of improvements that qualify, but there are also tests for making determinations regarding improvements and their structural components, which are a little complex and not for the scope of this article. The good news is that the Final Regulations provide examples and analysis for applying these tests. The listed items include, if permanently affixed: in-ground swimming pools; roads; bridges; tunnels; paved parking areas, parking facilities, and other pavements; special foundations; stationary wharves and docks; fences; microwave transmission, cell, broadcasting, and electric transmission towers; oil and gas pipelines; offshore drilling platforms, derricks, oil and gas storage tanks; grain storage bins and silos.
· “Natural products of land” [1.1031(a)-3(a)(3)] This includes unsevered growing crops and plants, mines, wells, and other natural deposits. “Natural products and deposits, such as crops, timber, water, ores, and minerals, cease to be real property when they are severed, extracted, or removed from the land.” The regulations give an example of how once a crop is removed and stored, even if on the same property, it is no longer part of the real property.
· “Water and air space” “super adjacent” to the land is real property [1.1031(a)-3(a)(1)] – meaning water and airspace touching (lying, above, upon, or below) the land.
Intent: The intent of the Final Regulations is to provide some leeway and reassurance to taxpayers completing transactions where some of the components of the property acquired in the exchange may be personal property and not “real property” for purposes of Section 1031 or where there is a variance due to state law. The IRS believes that these changes will alleviate some due diligence required by taxpayers conducting an exchange and streamline the administrative process on the IRS’ side. While up to 15% of property that is not considered “real property” will be disregarded for purposes of assessing the validity of the exchange, it is important to note that the taxpayer could potentially still have a taxable gain from receiving non-like kind property (often referred to as “boot”). This important aspect was clarified in the Final Regulations after the IRS received comments and concerns.
Scope: The Final Regulations will only apply to “real property” for the purposes of 1031 Exchanges and not for other sections of the tax code. Other sections of the tax code, for example, depreciation (§168, §1245, and §1250) and expensing provisions (§179) will continue to have their own definitions of “real property”, as well as personal or tangible property.[ii]
Q: How would the Final Regulations provide breathing room for taxpayers? What about intermediaries, lawyers, and brokers?
For taxpayers: The Final Regulations enhance an existing safe-harbor for incidental items paid with exchange funds [(g)(7)]. For the acquisition of replacement property in an exchange, Exchangers would be able to include incidental personal property, up to a value equal to 15% of the aggregate purchase price of the real estate, without the exchange being subject to scrutiny. Incidental personal property acquired along with the real estate in an exchange is still not considered real estate for like kind purposes (its boot), it is just disregarded/incidental for (g)(6)/(g)(7) purposes. Under the current Final Regulations, if exchange funds are used to pay for personal property in excess of 15% the aggregate fair market value of the real property, then the exchange would be outside of the safe harbor and subject to scrutiny. However, the IRS did specify that the 15% incidental rule is not a “bright line” test that would automatically invalidate an exchange. According to the IRS, the taxpayer may be able to use deductions such as bonus depreciation or expensing to offset the gain from the non-real property received if it used in a trade or business.
The Final Regulations also help taxpayers determine what components and systems the IRS views as part of the real estate as opposed to personal property to make a determination regarding the percentage of real and personal property reflected in the purchase/sale price.
For intermediaries, advisors, and brokers: Qualified intermediaries can rest assured that they can distribute exchange proceeds for the purchase of real property that may include incidental personal property without running afoul of the tax code’s restrictions on the use of their 1031 exchange funds, which could impact the taxpayer’s exchange. As a result of the specificity of these regulations, the burden of compliance with the like-kind rules is now, even more so, in the hands of the taxpayer and their advisors.
Tax and legal advisors have the reassurance that they can rely on the regulations to determine if part of the sale qualifies as real property and advise their clients how to best structure the purchase and sale agreements of relinquished and replacement property in an exchange. The IRS noted that the Final Regulations do not address some concerns raised by industry experts, for example, how the timing of an exchange involving personal property plays out with regards to the bonus depreciation rules, and issues related to accounting for gain recognition when the exchange straddles two tax years. The IRS commented that these Regulations are “limited to the definition of real property under section 1031 and to incidental property received in a section 1031 exchange.” Additional regulations may be necessary to address these concerns.
Lastly, brokers will likely be less concerned about accounting for personal property when negotiating a contract of sale that may involve some incidental business or personal property.
Conclusion: While the Final Regulations have some issues to be ironed out, they are a good step in the right direction. They will help provide taxpayers with concrete and uniform guidance on how to categorize property sold and acquired through a 1031 exchange.
[i] In the Final Regulations, the IRS and Treasury wisely departed from a “purpose and use” test that considered whether the mechanical component of a building produced income unrelated to the use of the real estate. The original criteria was confusing and would potentially automatically eliminate some mechanical structures from qualifying as Real Property, even if they met all other criteria. An example in the proposed regulations demonstrated how a steam turbine that produced income was automatically eliminated from being part of the real property acquired. The final regulations were amended to include this item as real property when income was not taken into account.
[ii] Another example is §865(d)(9)(D)(ii) which provides that at least 75% of a REIT’s assets must be real estate, cash, or government securities. This “real property” analysis under the Final Regulations is only specific to Section 1031 and would not affect REIT compliance.
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