Section 1031 like-kind exchange limitations: Final regulations released on ‘real property’ definition
The IRS recently issued Final Regulations providing guidance in connection with the definition of “real property” under Section 1031 of the Internal Revenue Code (IRC). The Final Regulations change the definition that was contained in the June 2020 Proposed Regulations.
Prior to the Tax Cuts and Jobs Act (TCJA), Section 1031 allowed like-kind exchange treatment for exchanges of real property and/or personal property. The TCJA amended 1031(a) so that Section 1031 only defers gain on exchanges of real property. Accordingly, the definition of real property under Section 1031 has become very important.
The following are highlights of changes made in the Final Regulations, which were published in the Federal Register on Dec. 2, 2020:
1. State and local law treatment of the assets: Under the Proposed Regulations, the state and local law treatment of property as real or personal property would not control how that property would be treated under Section 1031. Commenters pointed out that Congress intended that real property that was eligible for like-kind treatment prior to the TCJA would continue to be eligible under the TCJA. The IRS and Treasury Department have changed this rule. Under the Final Regulations, a taxpayer may treat property as real property if it is so classified under state or local law. If it is not, it may nonetheless be treated as real property under Section 1031 if the type of property either is specifically listed and classified as real property or meets the facts and circumstances test in the Final Regulations.
2. Purpose or use test: The Proposed Regulations considered the function of property in determining whether it was real property under Section 1031. Specifically, property would not be real property – under the Proposed Regulations – if it contributed to the production of income unrelated to the use or occupancy of space. “Commenters uniformly disagreed with the purpose or use test,” according to the IRS and Treasury, because it narrows the scope of the definition of real property under Section 1031 and, if adopted in the Final Regulations, “would treat certain types of property that have historically been treated as real property for Section 1031 purposes as personal property.” The Treasury and IRS wrote that they agree with the commenters and revised the Final Regulations to eliminate the test.
3. Incidental personal property: Under the Proposed Regulations, personal property that is incidental to the replacement of real property is disregarded in determining whether a taxpayer has the rights to receive or otherwise obtain the benefits of money or non-like-kind property, although the “incidental personal property” generally results in gain recognition under Section 1031(b). In other words, the receipt of incidental personal property does not invalidate the Section 1031 transaction. However, the Final Regulations add language in Treas. Reg. Section 1.1031(k)-1(g)(7)(iii) that makes it clear that receipt of incidental personal property in an otherwise valid Section 1031 exchange results in taxable gain to the taxpayer. Personal property is incidental to real property if:
1. “In standard commercial transactions, the personal property is typically transferred together with the real property, and”
2. “The aggregate fair market value of the incidental personal property transferred with the real property does not exceed 15% of the aggregate fair market value of the replacement real property.”
The Final Regulations provide a road map for determining whether property will be treated as real property for purposes of Section 1031. Generally, in order to determine if property is real property, taxpayers will need to consider whether the property is:
- Classified as real property under the state and local law test (with certain exceptions);
- Specifically listed as real property in the Final Regulations; and
- Considered real property based on the facts and circumstances under various factors outlined in the Final Regulations.
Taxpayers engaging in Section 1031 exchanges should consider these rules to determine whether they might be selling or receiving personal property in a Section 1031 and whether that might result in current revenue recognition.
The Final Regulations should be considered and applied in instances of Section 1031 exchanges beginning after Dec. 2, 2020. Taxpayers may rely on the Proposed Regulations, if followed consistently and in their entirety, for exchanges of real property beginning after Dec. 31, 2017, and before Dec. 2, 2020.
Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.
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