Proposed regulations issued for like-kind exchanges

| 6/25/2020
Proposed regulations issued for like-kind exchanges

Proposed regulations published on June 12 provide guidance for like-kind exchanges under IRC Section 1031 as a result of changes enacted by the Tax Cuts and Jobs Act of 2017 (TCJA). Under pre-TCJA law, an income deferral under Section 1031 generally was available for any exchange of property provided the property received was of similar nature. The TCJA significantly limited transactions eligible for like-kind exchange treatment. Under the TCJA, income deferral provided under Section 1031 applies only in the case of an exchange of real property for transactions occurring after Dec. 31, 2017.

The proposed regulations focus on defining what constitutes real property solely for purposes of determining whether the property qualifies for like-kind exchange treatment under Section 1031. They also provide relief for incidental personal property received in a like-kind exchange, which otherwise could have made the entire transaction ineligible for income deferral.

Under the proposed regulations, the determination of whether a distinct asset is real property is based on an analysis of whether it customarily is sold as a single unit, whether it is separable, and whether it is interdependent.

Qualifying as real property

In general, real property is defined in the proposed regulations as one of the following:

  • Land
  • Inherently permanent structures affixed to real property, including buildings of various types and improvements such as paved parking areas or fences
  • Structural components that constitute a part of and are integrated into an inherently permanent structure, such as walls, plumbing systems, or elevators
  • Natural products of land, such as crops, timber, or natural deposits, provided they have not yet been severed, extracted, or removed from the land
  • Other intangible assets, to the extent they are related solely to an interest in real property and don’t themselves contribute to the production of income aside from the use of space, such as a license for the use of land or an option to acquire land

The proposed regulations identify specific assets that meet the definition of an inherently permanent structure. In addition, the rules provide that taxpayers should assess if a property is real property based on how the asset is affixed, how permanent its placement is intended to be, whether it is designed to be removed, and the expense and damage caused by removing it.

Machinery and equipment generally are not considered real property. However, in certain cases these types of assets can be considered real property provided they are part of and serve an inherently permanent structure and do not otherwise contribute to the production of income. Tenant improvements may be considered real property as well to the extent they are inherently permanent or structural components of an inherently permanent asset.

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Incidental personal property

The proposed regulations also address whether receipt of nonqualifying personal property as part of an exchange of real property, such as an office building that includes the furniture and fixtures within it, makes the entire exchange ineligible for like-kind exchange treatment when relying upon a qualified intermediary (QI). A QI facilitates like-kind exchanges by allowing taxpayers to acquire qualifying property from a party different from the party that receives the taxpayer’s property under the exchange.

Under the proposed regulations, if personal property acquired customarily is included with real property and the personal property does not exceed 15% of the aggregate fair market value of the acquired real property, the personal property is treated as incident to the receipt of real property. As such, the personal property is disregarded for purposes of determining whether the property received in exchange through a QI qualifies the transaction under the QI safe harbor rules. This provision mirrors a similar 15% test in the existing Section 1031 regulations for identifying and matching assets received in the exchange.

Looking ahead

The scope of like-kind exchanges has decreased significantly under the TCJA. The proposed regulations provide much needed clarifications and relief that will avoid narrowing availability of these rules going forward. Generally, the proposed regulations will be effective when published as final regulations, but they may be relied upon if applied consistently and in their entirety.

Like-kind exchanges remain an important tax deferral mechanism, though it is now limited to the sale of real property. The like-kind exchange rules are complex, and taxpayers should consult their tax advisers if they are considering a sale or exchange of real property to determine if their exchange qualifies.

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