There’s Lots To Like In The Like-Kind Exchange Tax Regs
The long-absent definition of real property for like-kind exchanges is finally available in regulations (T.D. 9935), with several other helpful amendments to the regime for taxpayers. Questions remain, particularly regarding intangible property, but the final rules provide assurances and some increased flexibility compared with the proposed rules.
The limitation of deferral under section 1031 to exchanges of real property in the Tax Cuts and Jobs Act heightened the stakes for the definition of real property, prompting the new regulations. The distinction between real property and everything else has always been important in section 1031 transactions, but it was previously a secondary question about what taxpayers could trade for, not a threshold question, said Lou Weller of Weller Partners LLP.
Many commentators criticized the emphasis in the proposed regulation’s purpose or use test on the function of property as inconsistent with Congress’s intent to leave items that had been characterized as real property before 2017 as real property. The result in the final rules is that machinery is no longer automatically excluded but must either be on the regulation’s list of included structures or be determined inherently permanent under a five-factor test.
Also notable in the final rules is the inclusion of intangible assets in the definition of real property. Outstanding issues in this area may require further IRS intervention or eventually wind up in the courts. The final rules satisfactorily address many of the problems that commentators identified. Overall, the final regulations provide helpful clarification, said Bradley T. Borden of Brooklyn Law School.
Finally Defining Real Property
In the preamble to the proposed regulations, the government explained that a definition of real property under section 1031 became necessary post-2017 so that taxpayers can determine whether any part of replacement property received in an exchange is non-like-kind property subject to the gain recognition rules. The proposed regulations took a narrow view of how much state law controlled whether an asset was real property under section 1031, and the IRS and Treasury changed course dramatically in the final rules.
The conference report for the TCJA (H.R. Rep. No. 115-466) explains that “Congress intended real property that was eligible for like-kind exchange treatment prior to the enactment of the TCJA to continue to be eligible for like-kind exchange treatment after its enactment.” The report included an example in which an exchange of shares in a mutual ditch, reservoir, or irrigation company is a like-kind exchange because state law recognizes the shares as “constituting or representing real property or an interest in real property” at the time of the exchange. Based on this example, the proposed regulations said state law controlled whether shares in a mutual ditch, reservoir, or irrigation company are real property under section 1031, but that whether other types of assets were real property wasn’t controlled by state law. Comment letters disagreed with this limited scope of state law applicability.
The final regulations provide that tangible and intangible property is real property under section 1031 if it’s classified as real property under the law of the state or local jurisdiction where it’s located at the time of the transfer in an exchange. Property is real property if it meets the following requirement: It’s real property under state and local law, is listed as real property in the final regulations, or is considered real property based on a facts and circumstances test in the final rules.
Weller characterized the final rules as “state law plus,” because they provide that if property is real property under state law, it’s real property under section 1031, but they also account for the limitations inherent in the reliance on state law. He said the “plus” piece of the new rule is a recognition that state and local laws don’t always give a clear answer and that it should be clear what’s in or out of the like-kind exchange regime.
The new rules therefore include a list of assets that are always real property under section 1031 and a facts and circumstances test for assets not on the list. “I think what they did was something we all can live with and go forward not worrying too much about things that should be qualified as real property being qualified,” Weller said. He added that everything that was previously qualified as real property for section 1031 still is real property and that the regulations now include several administrative fixes used to solve problems over the years.
As in the proposed regulations, the IRS and Treasury continue to maintain in reg. section 1.1031(a)-3(a)(7) that the real property definition applies only for section 1031 and that these rules shouldn’t be used for classification or characterization of property under other code sections. Weller said that is an important aspect of the final rules because it answers a long-standing question about whether the classification of property as eligible for faster depreciation in a cost segregation study matters for section 1031.
The rules are now clear that real property under section 1031 is still real property even if a taxpayer did a cost segregation study and took bonus depreciation, Weller said. “But don’t forget that this does not turn off section 1245 or 1250 recapture,” he said. The final regulations explain that if a taxpayer transfers relinquished section 1245 property in a section 1031 exchange, the taxpayer is still subject to the section 1245 gain recognition rules.
Inherently Permanent
In accordance with the comments on the proposed regulations, the final regulations eliminate the “purpose or use test,” which means that there’s no longer any consideration whether the property contributes to the production of income unrelated to the use or occupancy of the space. Under the final rules, if tangible property is permanently affixed to real property and will remain so indefinitely, it’s an inherently permanent structure and real property under section 1031.
Reg. section 1.1031(a)-3(a)(2)(ii)(C) includes an extensive laundry list of structures that qualify as inherently permanent. But the IRS and Treasury declined to automatically include installed appliances such as refrigerators, stoves, and dishwashers; sheds and carports; Wi-Fi systems; and trade fixtures that support functions like manufacturing, cooking, or lighting that are semi-permanently affixed to real property as real property. Taxpayers that want to characterize these types of property as real property must use the facts and circumstances test.
The factors for the inherently permanent structure facts and circumstances test are how the assets are affixed to real property, whether the asset is designed to be removed, the damage that removal would cause to the item or to the real property, any circumstances that suggest the expected period of affixation is finite, and the time and expense required to move the asset. The facts and circumstances test is new to section 1031, so it remains to be determined when and how easy it is to apply.
Borden said the broad application of the test in the final regulations is an improvement over the production-of-income test that the proposed regulations applied to machinery. Under that test, some types of property would have been difficult to classify as real property or machinery. For example, an automated car wash is used to produce income from washing cars, but is also permanently affixed to the land, is not designed to be removed or easily removed, likely has an indefinite period of affixation, and if removed, could cause damage to the structure and equipment. Under the final regulations, the analysis focuses solely on the nature of the property and doesn’t require determining whether the item generates income from the car wash business or the ownership of real property, Borden said. That type of analysis is familiar to section 1031 practitioners, and since it treats all property similarly, it’s an improvement over the proposed regulations.
Application of the facts and circumstances test may occasionally cause headaches, but it eliminates one of the larger problems in the proposed regulations for small businesses that the Federation of Exchange Accommodators identified in its comment letter. Under the proposed rules, taxpayers would need a cost segregation study to determine the value of the machinery-like components. The trade group pointed out that “this would be an extraordinary financial burden for a taxpayer of modest means who operates a small business or who leases a building to an operating business.”
Weller said the final regulations were an example of the system of notice and comment working as designed. “They got it wrong and made it right based on comments. I really do applaud the government for rethinking and listening to commenters and coming up with a reasonable approach that will serve taxpayers and the administration well,” he said.
Intangible Assets
One of the open questions following the final rules’ inclusion of specific types of intangibles in the definition of real property is the scope of the items on the “in” list. Under the final rules, options to acquire real property are now within the definition, along with more obvious interests like fee ownership, co-ownership, leases, and easements. The regulations include a catchall for “similar interests,” as long as the “intangible derives its value from real property and is inseparable from that real property or interest in real property.” Some types of stock, securities or other evidence of debt or interest, interests in a partnership, certificates of trust, and choses in action are excluded from the definition.
The final rules partially address the long-standing question whether and how gain can be deferred under section 1031 on an in-the-money option to buy real estate. Including options on the list of intangible real property in the final regulations is helpful, but “we don’t know what like-kind assets you can acquire if you sell an option,” Weller noted. The range of possibilities of what is like-kind to an option is wide, and future guidance might be needed if the IRS decides to narrow it.
On the broader end of the spectrum is allowing options to be exchanged for fee interests. However, if it’s possible only to exchange an option for another option, the term of the options might matter. Weller said the question of how equivalent the terms of leases must be could provide an analogy, but that no authority speaks to whether leases must have the same term lengths or whether they can be bifurcated. He said guidance in the form of a revenue ruling would be helpful to avoid taxpayers taking inconsistent positions.
The catchall category of intangible real property both is welcome and leaves some uncertainty, although on balance it should be helpful to taxpayers. The list of intangibles that are real property is helpful, but observers may question whether a contract to buy real property is similar to an option and should come within the definition of real property, Borden said. He noted that case law distinguishes between an option and a contract outside the section 1031 context, but because a contract to purchase property derives its value from the real property and is inseparable from real property, it appears to come within the definition of real property under the final regulations for section 1031 purposes.
The $25,000 Error and Future Guidance
A “scrivener’s error” has persisted in the examples in reg. section 1.1031(k)-1(d)(2) for the past 29 years, and at long last the final regs rectify the computational discrepancy. Example 3 explained that a barn on two acres of land has “a fair market value of $250,000 ($187,500 for the barn and underlying land and $87,500 for the remaining land).” The incorrect numbers were repeated several times. This error never really tripped up any taxpayers or advisers because the rest of the example makes clear that the total value of the replacement property is $250,000, not $275,000, but it’s been a small thorn in the side of the drafters of the section 1031 rules for nearly three decades. So although that example has nothing to do with the rest of the proposed regulations that were finalized, the IRS took the opportunity to change “$87,500” to “$62,500” and save future readers of the examples from pausing to contemplate the addition.
The preamble to the final regs says guidance on the interaction between the bonus depreciation rules in section 168 and the section 1031 rules is beyond the scope of these regs. But it promises that the IRS and Treasury will consider how those rules work together.