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

The Tax Cuts and Jobs Act of 2017 (TCJA), made changes to IRC Section 1031 of the Tax Code to allow taxpayers to defer gain realized on the exchange of business or investment real property for other business or investment real property. Known as a like-kind exchange, this provision can generate significant tax savings for real estate investments.

On June 12, 2020, the IRS issued long-anticipated Proposed Regulations that clarify some of the changes made by the TCJA.

The Proposed Regulations provide a definition of real property and address the taxpayer’s receipt of personal property that is incidental to the receipt of real property. 

Real Property

The proposed regulations define the term real property as:

• Land and improvements to land;
• Un-severed natural products of land, which generally include growing crops, plants, and timber, mines, wells, and other natural deposits; and
• Water and air space superjacent to land.

This definition also includes interests in real property, including fee ownership, co-ownership, a leasehold, an option to acquire real property, an easement, or a similar interest. 

Improvements to Land

The term “improvements to land” means “inherently permanent structures and the structural components of inherently permanent structures.” The terms “inherently permanent structures” and “structural components” are defined below.

Note that the definition of real property contained in the Proposed Regulations applies for purposes of IRC Section 1031 only. Further, local legal definitions are not controlling for determining the meaning of real property under the section, except for a state’s characterization of shares in a mutual ditch, reservoir, or irrigation company described in IRC Section 501(c)(12)(A). 

Inherently Permanent Structures

An inherently permanent structure is any building or other structure that is a “distinct asset” and is permanently affixed to real property and will ordinarily remain affixed for an indefinite time. The term “distinct asset” is defined below.

A building is any structure or edifice enclosing a space within its walls, and covered by a roof, the purpose of which is to provide shelter, housing, or working, office, parking, display, or sales space. Buildings include the following distinct assets if the assets are permanently affixed: houses; apartments; hotels; motels; enclosed stadiums arenas; enclosed shopping malls; factories and office buildings; warehouses; barns; enclosed garages; enclosed transportation stations and terminals; and stores. 

Other structures listed in the regulations that are inherently permanent structures include the following distinct assets if they are permanently affixed: in-ground swimming pools; roads; bridges; tunnels; paved parking areas, parking facilities, and other pavements; special foundations; stationary wharves and docks; fences; inherently permanent advertising displays for which an IRC Section 1033(g)(3) election is in effect; inherently permanent 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, oil and gas storage tanks; grain storage bins and silos; and enclosed transportation stations and terminals.

If property is not listed in the Proposed Regulations, the determination of whether it is an inherently permanent structure is based on these factors:

• The manner in which the distinct asset is affixed to real property;
• Whether the distinct asset is designed to be removed or to remain in place;
• The damage that removal of the distinct asset would cause to the item itself or to the real property to which it is affixed;
• Any circumstances that suggest the expected period of affixation is not indefinite; and
• The time and expense required to move the distinct asset.

Machinery or equipment generally is not an inherently permanent structure and not real property for purposes of this section. However, if a building or inherently permanent structure includes property in the nature of machinery as a structural component, the machinery is real property provided it serves the inherently permanent structure and does not produce or contribute to the production of income other than for the use or occupancy of space.

Structural Components

A structural component is any distinct asset that is a constituent part of, and integrated into, an inherently permanent structure. Interconnected assets that work together to serve an inherently permanent structure are analyzed together as one distinct asset that may be a structural component. A structural component may qualify as real property only if the taxpayer holds its interest in the structural component together with a real property interest in the inherently permanent structure. Customization of a distinct asset does not affect whether it is a structural component.

In addition:

• Assets and systems listed as a structural components in Proposed Reg. Section 1.1031(a)-3(a)(2)(iii)(B) are treated as distinct assets.
• Tenant improvements to a building that are inherently permanent are real property.
• Property produced for sale, such as bricks, nails, paint, and windowpanes, that is not real property in the hands of the producing taxpayer or a related person is not treated as real property by the producing taxpayer even if an unrelated buyer may incorporate it into real property.

If a component of a building or inherently permanent structure is a distinct asset and is not listed as a structural component in the Proposed Regulations, the determination of whether the component is a structural component is based on 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 item itself or to the inherently permanent structure to which it is affixed; and
• Whether the component is installed during construction of the inherently permanent structure.

Distinct Assets

A distinct asset is analyzed separately from any other assets to which the asset relates to determine if the asset is real property, whether as land, an inherently permanent structure, or a structural component of an inherently permanent structure. Buildings and other inherently permanent structures, as well as systems listed as structural components in the Proposed Regulations, are treated as distinct assets.

The determination of whether a particular separately identifiable item of property is a distinct asset is based on all the facts and circumstances and must take into account whether the item:

• Is customarily sold or acquired as a single unit rather than as a component part of a larger asset;
• Can be separated from a larger asset, and if so, the cost of separating the item from the larger asset;
• Is commonly viewed as serving a useful function independent of a larger asset of which it is a part; and
• If separated from a larger asset of which it is a part, impairs the functionality of the larger asset.

Intangible Assets

An intangible asset is real property or an interest in real property to the extent that it derives its value from real property or an interest in real property, is inseparable from that real property or interest, and does not produce or contribute to the production of income other than consideration for the use or occupancy of space. 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 generally is an interest in real property. However, a license or permit to engage in or operate a business on real property is not real property or an interest in real property if the license or permit produces or contributes to the production of income other than consideration for the use and occupancy of space.

Incidental Personal Property

Most exchanges of real property involve deferred exchanges that are facilitated through the assistance of a qualified intermediary. The Proposed Regulations clarify that the receipt of certain incidental personal property in a like-kind exchange will not violate the qualified intermediary safe harbor of Reg. Section 1.1031(k)-1(g)(4). 

Under Proposed Reg. Section 1.1031-1(g)(7)(iii), personal property that is incidental to real property acquired in an exchange is disregarded under the qualified intermediary safe harbor if it is typically transferred together with the real property in standard commercial transactions, and the aggregate fair market value of the incidental personal property transferred with the real property does not exceed 15 percent of the aggregate fair market value of the replacement real property.

Applicability

These rules will apply to like-kind exchanges beginning on or after the date the final regulations are published in the Federal Register. Taxpayers may rely on the Proposed Regulations before the final regulations are published if they follow them consistently and in their entirety for exchanges of real property beginning after December 31, 2017. 

For more information about like-kind exchanges or the proposed regulations, contact us.

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