IRS Issues Final Regulations Defining Real Property
The Tax Cuts and Jobs Act passed in 2017 modified IRC Section 1031 to eliminate personal property and limit exchange treatment to real property. Earlier this summer, the IRS issued proposed regulations to provide guidance on implementing these changes. The Federation of Exchange Accommodators and several other parties submitted comments* in response to these proposed regulations and on November 23, 2020, the IRS issued the final regulations defining real property for Section 1031 purposes.
The final regulations included responses to the various comments and ultimately these regulations expand the definition of real property particularly with respect to structural components and machinery and they clarify the treatment of exchange funds used to purchase personal property that is “incidental” to replacement real property.
The final regulations do not change pre-existing law on the determination of what is real property, and they will not impact the typical 1031 exchange transactions. However, some assets have both real and personal property characteristics; for example, cell towers, oil and gas pipelines, and offshore platforms. These types of assets must be classified as real property or personal property in order to determine if they are exchangeable under Section 1031. The final regulations provide several alternative tests to determine if a property is real property for Section 1031 purposes.
Assets still must be like kind, as determined under federal law, and the taxpayer must have an exchangeable interest in the real property asset, which the final regulations refer to as an “intangible interest”. These intangible interests include the common forms of real property ownership such as fee ownership; co-ownership; leasehold; easement; as well as certain types of shares in a mutual ditch, reservoir, or irrigation company; stock in a cooperative housing corporation; and land development rights.
Finally, the regulations clarify that if exchange funds are used to acquire personal property that is incidental to replacement property, it will not violate the (g)(6) limitations of the QI safe harbor. Personal property is “incidental” to real property if: (1) the personal property is typically transferred together with real property, and (2) the aggregate fair market value of the incidental property is not greater than 15% of the aggregate fair market value of the replacement property.
This is helpful for taxpayers who may be acquiring a hotel or restaurant and there is a small portion of the purchase price allocated to personal property items. As long as those items are “incidental” per the definition above, the taxpayer can use exchange funds for that portion of the purchase price without a constructive receipt risk. It is important to note that the exchange funds used would still be considered taxable boot because the funds are being used to purchase personal property rather than “like kind” to real property.
A Note to define “Like-Kind”
Contrary to what many people believe, "like-kind" does not mean that an investor must, for example, exchange land for land, or a duplex for a duplex. In the context of real estate, like-kind exchanges are valid between and among several different types of investment property, including bare land, commercial property, industrial buildings, retail stores, apartments, duplexes-even leasehold interests exceeding 30 years and certain oil and gas interests.