Most people are aware that the federal tax law changed at the beginning of 2018 due to the passage of the Tax Cuts & Jobs Act. Some of the significant changes included reducing the capital gain rates and lowering tax rates on corporations. Among other things the Act eliminated personal property from the tax deferral provisions of IRC §1031, leaving only real estate as an asset eligible for such deferral. This was a significant departure from how §1031 was utilized by taxpayers since its inception in 1921.
Many types of real estate include machinery, equipment and other components that may or may not be considered part of the real estate. Before the change in the law, it was not quite as significant whether those items were so inherently a part of the real estate that they were deemed real estate itself. If they were determined to be personal property and it was likely the trade would include like kind replacement personal property, then the character would not matter much; the real estate portion would be deferred as would the personal property portion.
In order to add clarity to these determinations as to what constituted real estate in this context, in June of 2020, the IRS put out proposed regulations on the subject. Essentially, each component had to be analyzed separately to determine whether it was land, an inherently permanent structure, or a structural component of an inherently permanent structure. Land was rather clear but some of the other determinations were difficult to make. For instance, in regard to a component of a structure, the determination was largely based upon function. An example in the regulations referenced different treatment for a gas line that serviced the property generally for heating purposes, compared to a gas line that was used for cooking food that was served by the business. The former was considered part of the real estate for exchange purposes and the latter being used towards the “production of income” and therefore not so. Furthermore, the proposed regulations suggested that reference to local law characterization would not be taken into consideration. This was a departure from prior analyses where local law was a significant part of the determination.
In any event, the IRS took into consideration the significant amount of feedback received and changed the final regulations in favorable ways. Under the final regulations, the asset is considered real estate if (i) it is specifically listed as such in the regulations or (ii) if it is real estate under state or local law and last (iii) if it is “considered real property based on all the facts and circumstances under the various factors provided in the final regulations.”
It should be worth noting that the classification of an asset for exchange purposes is not determinative of its classification for other purposes such as taking of depreciation. The asset can be considered real estate for one purpose and personal property for another.
The final regulations introduced another favorable rule. After personal property exchanges were disallowed, if exchange funds were directed to a closing for the purchase of replacement property whose purchase price included a personal property component, the exchange could be put at risk. This was seen as an unpermitted use of exchange funds on the part of the taxpayer which, in turn, violated the entire exchange. To provide a solution to this dilemma, the service borrowed on a provision from the original exchange regulations regarding the identification of personal property that was typically incidental to the real property. Examples are office furnishings in the purchase of an office building or hotel furnishings with the purchase of the hotel. This rule, known as the “incidental property rule” states that the personal property did not have to be separately identified from the real property but must be incidental to the real replacement property, having an aggregate fair market value not greater than 15% of the fair market value of the real estate, and must typically be transferred with the real property in a standard commercial transaction. Under the final regulations should part of the purchase price of the real estate include the value of personal property fitting this definition, it will not be considered “actual or constructive” receipt of the funds by the taxpayer otherwise compromising the exchange.
Again, it should be noted that this rule pertains to avoiding a taxpayer getting boxed in when a real estate purchase includes some customary personal property that is not being paid for separately. However, that is not to say that it is disregarded nor considered part of the real estate for gain purposes. It still retains its character as non like-kind property compared to the original sale of real estate.
If you have questions about an exchange that includes property as described above, please get in touch with one of our subject matter experts to discuss your situation specifically.