Proposed regulations define “real property” for like-kind exchanges
New proposed regulations, for the first time, supply a definition of “real property” for §1031 purposes.
The Treasury Department and IRS have released proposed regulations that for the first time define “real property” only for purposes of §1031 like-kind exchanges. No inference is intended for classification or characterization of property for other purposes, such as for depreciation and determining gain from the sale or disposition of depreciable or real property.
In addition to the examples cited below, the proposed regulations include many examples illustrating the various concepts pertaining to like-kind exchanges of real property.
Pending issuance of final regulations, taxpayers may rely on the rules in the proposed regulations, if followed consistently and in their entirety, for exchanges of real property beginning on or after December 31, 2017.
Background on like-kind exchanges and the TCJA
The §1031 like-kind exchange rules provide that no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment. Prior to the TCJA, exchanges of personal, intangible, or real property could potentially qualify for like-kind exchange treatment. For exchanges completed after December 31, 2017, the TCJA limits like-kind exchange treatment to real property.
As noted in the proposed regulations though, §1031 and related regulations until now do not define real property. While real property is defined elsewhere throughout the IRC and income tax regulations, other definitions are for a specific purpose, such as the capitalization rules for amounts paid to improve tangible property. Accordingly, as taxpayers need certainty regarding like-kind exchanges in view of the TCJA, the proposed regulations provide a definition of real property specifically for like-kind exchange purposes.
Definition of real property: land and improvements
Real property means land and improvements to land, unsevered natural products of land, and water and air space adjacent to land. Certain interests in real property may be considered real property. Aside from certain intangible assets described later, local law definitions of real property are not controlling in determining the meaning of real property for like-kind exchange purposes.
Improvements to land means inherently permanent structures and the structural components of inherently permanent structures. Throughout the discussion, the proposed regulations stress that analysis as to whether an item is real property must be analyzed separately for each “distinct asset.”
Facts and circumstances determine whether an item is a distinct asset, including whether the item:
- Is customarily sold or acquired separately or as a component of a larger asset.
- Can be separated from a larger asset and the cost of doing so.
- Serves a useful function independent of the larger asset.
- If separated would impair the functionality of the larger asset.
Inherently permanent structures. An inherently permanent structure is a building or any distinct asset that is permanently affixed to real property and will ordinarily remain affixed for an indefinite period of time. Buildings may include houses, apartments, hotels and motels, enclosed stadiums and arenas, shopping malls, factories, office buildings, warehouses, barns, enclosed garages, enclosed transportation stations, and stores.
Other inherently permanent structures include many diverse kinds of permanently affixed assets such as parking facilities, in-ground swimming pools, cell transmission towers, offshore drilling platforms, bridges and tunnels, grain storage bins and silos, and more. See §1.1031-3(a)(ii)(C) for the full list of inherently permanent structures.
Factors to determine if a structure not mentioned in the regulations is an inherently permanent structure are:
- The manner in which the distinct asset is affixed to real property.
- Whether the asset is designed to be removed or remain in place.
- The damage that removal would cause to the item itself or the real property.
- Any circumstances that suggest the expected period of affixation is not indefinite.
- The time and expense required to remove the item.
Structural components. A structural component is a distinct asset that is a constituent part of and integrated into an inherently permanent asset. Examples include walls and doors, central air conditioning and heating systems, permanent floor coverings, elevators and escalators, fire suppression and security systems, and similar property. See §1.1031-3(a)(iii)(B) for the full list of structural components.
Factors to determine if an item is a structural component are similar to those for determining if an item is an inherently permanent structure:
- The manner, time, and expense of installing and removing the component.
- Whether the component is designed to be moved.
- The damage removal would cause to the item or to the structure to which it is affixed.
- Whether the component is installed during construction of the structure or afterwards.
If interconnected assets work together to serve the structure (systems that provide electricity, heat, and water, for example), the assets are analyzed together to determine if they are a structural component. In any case, the taxpayer must hold an interest in the structural component together with an interest in the space in the inherently permanent structure served by the structural component.
Example: The Green office building has two types of interior, floor-to-ceiling, non-load bearing drywall partition systems, both of which are distinct assets that were installed after the building was constructed. Green’s conventional partition system is designed and constructed to be integrated into the building and remain in place.
It is composed of materials that can be removed only by demolition and cannot be reused. In contrast, Green’s modular partition system is designed to be removed and reassembled without damage to accommodate new owners’ or tenants’ interior space needs.
The conventional drywall system is a listed structural component treated as real property because it is comprised of walls that are integrated into the Green building. The modular drywall system is not a listed structural component.
Analyzing the system using the four factors above, it is easily and inexpensively installed and removed, it is designed to be moved, removal causes no damage, and the system was installed after the building was constructed. Green’s modular system is not a structural component and not real property.
Other items that may be real property
Unsevered natural products. Unsevered natural products of land that may be considered real property include growing crops, plants, timber, and natural deposits such as minerals and ores. Once these products have been severed, extracted, or removed from the land they are not real property.
Intangible assets. Although tax-free exchanges of intangible assets are no longer permitted, to the extent an intangible asset derives its value and is inseparable from real property or a real property interest and does not produce income on its own, the intangible asset is considered real property. Examples include shares in a mutual ditch, reservoir, or §501(c)(12)(A) irrigation company, provided such shares are recognized as real property under state law.
Real property interests. A license or permit, such as a leasehold or easement solely for the use, enjoyment, or occupation of land or an inherently permanent structure is an interest in real property. However, a license to operate a business is not a real property interest.
Example: Lost Co. owns a building and receives a license from the state to operate a casino in the building. The building is an inherently permanent structure and therefore real property.
Although Lost’s casino license applies only to the building and is not transferable, it is not a right for the use, enjoyment, or occupation of the building and therefore is not a real property interest.
Machinery. Machinery and equipment are not usually considered inherently permanent structures and thus not treated as real property. However, machinery is a structural component, and thus real property, if it serves the inherently permanent structure and does not produce or contribute to the production of income other than for use or occupancy of space.
Example: Flight Co. owns a building used in its airplane parts manufacturing business. The building includes an industrial 3D printer that prints airplane wings and an electrical generator that serves the building in a backup capacity. Both items were installed during the building’s constructions and are designed to remain in place indefinitely.
Although it is permanently affixed, the 3D printer is not a structural component because it produces income other than for use or occupancy of the space. The electrical generator serves the inherently permanent structure (the entire building) and does not generate income on its own. Thus, the generator is machinery treated as a structural component and therefore is real property.
Incidental property is disregarded
Taxpayers can exchange properties through a process called a deferred exchange, usually via a qualified intermediary. Strict requirements must be adhered to, including methods and time frames for transferring relinquished property, identifying suitable replacement property, and receiving the replacement property. If the taxpayer receives money or other non-like-kind property before receiving the replacement property, the exchange could fail, and the taxpayer may have to recognize gain immediately.
These rules are not changed by the TCJA. The proposed regulations update a rule regarding personal property received in an exchange.
Personal property that is incidental to real property acquired in an exchange is disregarded in determining if deferred like-kind exchange criteria are met.
Property is considered incidental if:
- It is typically transferred together with the real property, and
- The aggregate FMV of the incidental property is not more than 15% of the aggregate FMV of the replacement property.
Example: Abbot exchanges real property with basis of $400,000 and FMV of $1,100,000 for an office building with FMV of $1,000,000. Abbot also acquires the building’s office furniture valued at $100,000, which is standard practice for this type of commercial transaction.
Since the value of the furniture is less than 15% of the value of the replacement property, the furniture is disregarded in determining if deferred exchange criteria are met. Abbot must only recognize gain of $100,000 on receipt of the non-like-kind property.