The Tax Cuts and Jobs Act limited like-kind exchanges under §1031 to exchanges of real property effective January 1, 2018.  The IRS issued proposed regulations in June 2020 [1] to implement these revisions in §1031.  In November 2020 the IRS finalized these regulations after making certain changes.[2]

Summary of Changes from the Proposed Regulations

The preamble to the final regulations contains the following overview of the key changes found in the final regulations as compared to the proposed regulations issued five months earlier.  First, it notes that the final regulations modify the definition of real property to now refer to the appropriate state and local law definition of real property:

The final regulations retain the basic approach and structure of the proposed regulations, with certain revisions. In particular, the final regulations revise the definition of “real property” in the proposed regulations to provide that property is classified as real property for section 1031 purposes if, on the date it is transferred in an exchange, the property is real property under the law of the State or local jurisdiction in which that property is located.[3]

The final regulations also remove the “purpose or use test” that was found in the proposed regulations from the definition of real property:

The final regulations also revise the proposed definition of real property to eliminate, with regard to both tangible and intangible properties, any consideration of whether the particular property contributes to the production of income unrelated to the use or occupancy of space (referred to as the “purpose or use test,” as defined in part II.B.1 of this Summary of Comments and Explanation of Revisions).[4]

The final regulations continue to contain a warning that these rules apply solely for purposes of §1031, and do not impact other provisions of the IRC:

Finally, in §1.1031(a)-3(a)(7), the final regulations retain the language of the proposed regulations clarifying that the rules of these final regulations apply only for purposes of section 1031 and that no inference is intended with respect to the classification or characterization of property for other purposes of the Code.[5]

Key Revisions to Real Property Definitions for §1031

The proposed regulations in most cases ignored whether state and local law considered something to be real property, aiming for a standard federal definition to be applied in most cases.  However, this attracted a number of comments arguing against this approach:

Commenters generally critiqued the apparent scope of the application of State and local law in the proposed regulations for purposes of defining real property. These commenters contended that, prior to enactment of the TCJA, State and local law classification of a property often was the determining factor in characterizing property as real or personal under section 1031. With regard to the Conference Report Example, the commenters asserted that the reference to “shares in a mutual ditch, reservoir, or irrigation company” merely constituted a set of examples that Congress provided to broadly indicate that real property eligible for like-kind treatment under law prior to enactment of the TCJA will continue to be eligible following the TCJA’s amendment to section 1031. Consequently, the commenters recommended that the final regulations conform to that intent by expanding the rules to rely significantly, or wholly, on State-law classifications for all assets, rather than limiting such reliance to shares in a mutual ditch, reservoir, or irrigation company. Additionally, commenters suggested that the final regulations should include multiple examples of instances in which taxpayers may rely on State or local law for purposes of classifying property as real or personal.[6]

Thus, the IRS describes the following changes found in the final regulations:

…[T]he final regulations provide generally that property is real property for purposes of section 1031 if, on the date it is transferred in an exchange, that property is classified as real property under the law of the State or local jurisdiction in which that property is located (State and local law test). The State and local law test applies to both tangible and intangible property classifications.[7]

While this is true in most cases, the IRS did exclude some property from the definition to be consistent with prior law:

However, consistent with Congressional intent that “real property eligible for like-kind exchange treatment” under the law in effect prior to enactment of the TCJA will continue to be eligible for like-kind exchange treatment after enactment of the TCJA, property ineligible for like-kind exchange treatment prior to enactment of the TCJA remains ineligible, including real property that was excluded from the application of section 1031. See Conference Report at 396, fn. 726. Prior to amendment by the TCJA, former section 1031(a)(2) explicitly excluded certain assets from the application of section 1031. Accordingly, the final regulations exclude from the definition of real property the intangible assets listed in section 1031(a)(2) prior to its amendment by the TCJA, regardless of the classification of the property under State or local law, because such property never was “real property eligible for like-kind exchange treatment” prior to enactment of the TCJA. Conference Report at 396, fn. 726 (emphasis added).

In summary, under the final regulations, property is classified as real property for purposes of section 1031 if the property is (i) so classified under the State and local law test, subject to certain exceptions, (ii) specifically listed as real property in the final regulations, or (iii) considered real property based on all the facts and circumstances under the various factors provided in the final regulations. A determination that property is personal property under State or local law does not preclude the conclusion that property is real property as specifically listed in §1.1031(a)-3(a)(2)(ii) or (a)(2)(iii)(B) or as real property under the factors listed in §1.1031(a)-3(a)(2)(ii)(C) or (a)(2)(iii)(B).[8]

Definition of Real Property for §1031

The regulations add new Reg. §1.1031-3, Definition of Real Property.

The new regulation begins by defining real property as:

• Land;

• Improvements to land;

• Unsevered natural products of land; and

• Water and airspace adjacent to land.[9]

Property that is real property under state or local law where the property is located is real property for purposes of §1031[10] except for certain intangible assets described in Reg. §1.1031(a)-3(a)(5).

Such intangible assets that are not real property are:

• Stock (other than stock in a cooperative housing corporation and shares in a mutual ditch, reservoir or irrigation company), bonds or notes;

• Other securities or evidence of indebtedness;

• Interests in a partnership (other than those with a valid election under IRC §761(a) to be excluded from subchapter K);

• Certificates of trust or beneficial interests; and

• Choses in action.[11]

Conversely, the regulation holds that the following intangible interests will qualify as real property:

Intangible assets that are real property for purposes of section 1031 and this section include the following items: fee ownership; co-ownership; a leasehold; an option to acquire real property; an easement; stock in a cooperative housing corporation; shares in a mutual ditch, reservoir, or irrigation company described in section 501(c)(12)(A) of the Code if, at the time of the exchange, such shares have been recognized by the highest court of the State in which the company was organized, or by a State statute, as constituting or representing real property or an interest in real property; and land development rights. Similar interests are real property for purposes of section 1031 and this section if the intangible asset derives its value from real property or an interest in real property and is inseparable from that real property or interest in real property.[12]

The regulation also makes clear that these definitions are solely for the purposes of §1031 and do not apply to other provisions in the IRC:

The rules provided in this section concerning the definition of real property apply only for purposes of section 1031. No inference is intended with respect to the classification or characterization of property for other purposes of the Code, such as depreciation and sections 1245 and 1250. For example, a structure or a portion of a structure may be section 1245 property for depreciation purposes and for determining gain under section 1245, notwithstanding that the structure or the portion of the structure is real property under this section. Also, a taxpayer transferring relinquished property that is section 1245 property in a section 1031 exchange is subject to the gain recognition rules under section 1245 and the regulations under section 1245, notwithstanding that the relinquished property or replacement property is real property under this section. In addition, the taxpayer must follow the rules of section 1245 and the regulations under section 1245, and section 1250 and the regulations under section 1250, based on the determination of the relinquished property and replacement property being, in whole or in part, section 1245 property or section 1250 property under those Code sections and not under this section.[13]

Reg. §1.1031-3(a) continues by providing detailed definitions of various classes of assets.

Distinct Asset

Several of the definitions reference a distinct asset, a term defined in the regulations.  The regulations provide:

For this section, a distinct asset is analyzed separately from any other assets to which the asset relates to determine if the asset is real property, whether as land, an inherently permanent structure, or a structural component of an inherently permanent structure. Buildings and other inherently permanent structures are distinct assets. Assets and systems listed as a structural component in paragraph (a)(2)(iii)(B) of this section are treated as distinct assets.[14]

The regulation provides the following test to determine if an item is a distinct asset for the purposes of these regulations:

The determination of whether a particular separately identifiable item of property is a distinct asset is based on all the facts and circumstances. In particular, the following factors must be taken into account--

(A) Whether the item is customarily sold or acquired as a single unit rather than as a component part of a larger asset;

(B) Whether the item can be separated from a larger asset, and if so, the cost of separating the item from the larger asset;

(C) Whether the item is commonly viewed as serving a useful function independent of a larger asset of which it is a part; and

(D) Whether separating the item from a larger asset of which it is a part impairs the functionality of the larger asset.[15]

Improvements to Land

Improvements to land include:

• Inherently permanent structures and

• Structural components of inherently permanent structures.[16]

Inherently Permanent Structures

The regulation defines inherently permanent structures as “any building or other structure that is a distinct asset” that is permanently affixed to real property and “will ordinarily remain affixed for an indefinite period of time.”[17]

A building is defined as:

…any structure or edifice enclosing a space within its walls, and covered by a roof, the purpose of which is, for example, to provide shelter or housing, or to provide working, office, parking, display, or sales space.[18]

The regulations provide that buildings include the following distinct assets if permanently affixed:

• Houses

• Apartments

• Hotels and motels:

• Enclosed stadiums and arenas

• Enclosed shopping malls

• Factories and office buildings

• Warehouses

• Barns

• Enclosed garages

• Enclosed transportation stations and terminals and

• Stores.[19]

Other inherently permanent structures include the following items if permanently affixed:

… in-ground swimming pools; roads; bridges; tunnels; paved parking areas, parking facilities, and other pavements; special foundations; stationary wharves and docks; fences; inherently permanent advertising displays for which an election under section 1033(g)(3) is in effect; inherently permanent outdoor lighting facilities; railroad tracks and signals; telephone poles; power generation and transmission facilities; permanently installed telecommunications cables; microwave transmission, cell, broadcasting, and electric transmission towers; oil and gas pipelines; offshore platforms, derricks, oil and gas storage tanks; and grain storage bins and silos.[20]

The regulation provides the following guidance to determine if an asset is permanently affixed:

Affixation to real property may be accomplished by weight alone. If property is not listed as an inherently permanent structure in paragraph (a)(2)(ii)(B) or (C) of this section, the determination of whether the property is an inherently permanent structure under paragraph (a)(2)(ii) of this section is based on the following factors--

(1) The manner in which the distinct asset is affixed to real property;

(2) Whether the distinct asset is designed to be removed or to remain in place;

(3) The damage that removal of the distinct asset would cause to the item itself or to the real property to which it is affixed;

(4) Any circumstances that suggest the expected period of affixation is not indefinite; and

(5) The time and expense required to move the distinct asset.[21]

Structural Components

A structural component is a distinct asset “that is a constituent part of, and integrated into, an inherently permanent structure.”[22]  The regulation notes that “[i]f interconnected assets work together to serve an inherently permanent structure (for example, systems that provide a building with electricity, heat, or water), the assets are analyzed together as one distinct asset that may be a structural component.”[23]

The regulation provides the following additional detailed rules for structural components:

• If a distinct asset is customized, the customization does not affect whether the distinct asset is a structural component.

• Tenant improvements to a building that are inherently permanent or otherwise classified as real property are real property.

• Property produced for sale, such as bricks, nails, paint, and windowpanes, that is not real property in the hands of the producing taxpayer or a related person, but that may be incorporated into real property by an unrelated buyer, is not treated as real property by the producing taxpayer.[24]

So long as the following items are a constituent part of and integrated into a inherently permanent item, they are treated as structural components for purposes of §1031:

• Walls;

• Partitions;

• Doors;

• Wiring;

• Plumbing systems;

• Central air conditioning and heating systems;

• Pipes and ducts;

• Elevators and escalators;

• Floors;

• Ceilings;

• Permanent coverings of walls, floors, and ceilings;

• Insulation;

• Chimneys;

• Fire suppression systems, including sprinkler systems and fire alarms;

• Fire escapes;

• Security systems;

• Humidity control systems; and

• Other similar property.[25]

For other items not included in the list, the regulation provides the following test to be used to determine if the item is a structural component:

If a component of a building or inherently permanent structure is a distinct asset and is not listed as a structural component in this paragraph (a)(2)(iii)(B), the determination of whether the component is a structural component under this paragraph (a)(2)(iii) is based on the following factors--

(1) The manner, time, and expense of installing and removing the component;

(2) Whether the component is designed to be moved;

(3) The damage that removal of the component would cause to the item itself or to the inherently permanent structure to which it is affixed; and

(4) Whether the component is installed during construction of the inherently permanent structure.[26]

Unsevered Natural Products of Land

Real property for §1031 purposes includes unsevered products of land which is defined to include:

• Growing crops plants, and timber;

• Mines;

• Wells; and

• Other natural deposits.[27]

The regulation goes on to note that “[n]atural products and deposits, such as crops, timber, water, ores, and minerals, cease to be real property when they are severed, extracted, or removed from the land.”[28]

Examples

The regulation provides a series of twelve examples of applying these rules, found at Reg. §1.031-3(b). Advisers should look at these examples to become comfortable with how the IRS sees these rules being applied in specific situations. As is always true, pay special attention to the facts in each example that the IRS references in making the determination of whether the item is or is not real property.

The topics covered by the examples are:

• Example 1: Natural products of land

• Example 2: Water space superjacent to land

• Example 3: Indoor sculpture (an interesting example as it shows how an item not attached to other real property can nevertheless become real property due to its weight and the impracticality of moving the object)

• Example 4: Bus shelters (an illustration of the opposite conclusion to Example 3, the shelters in this case are found not to be real property)

• Example 5: Industrial 3D Printer (this example now arrives at a different result than it did in the proposed regulations.  The final regulations no longer remove machinery from the category of real property so long as it meets the other requirements for property not specifically listed as a structural component.  Also, now old example 6 is deleted, as it no longer matters if a generator supplies power to the entire building or just the 3D printer)

• Example 6 (previously 7 in the proposed regulations): Raised flooring for Industrial 3D Printer (continuing with the 3D printer issue, this example finds the raised flooring for the 3D printer is not real property given the facts of the example)

• Example 7 (previously 8 in the proposed regulations): Steam Turbine (another reversal of position vs. the same example in the proposed regulations, this time the IRS finding the turbine is real property.)

• Example 8 (previously 9 in the proposed regulations): Partitions (while a conventional partition system is found to be real property, a modular partition system is found not to be real property)

• Example 9 (previously 10 in the proposed regulations): Pipeline transmission system (the pipeline and isolation valves are found to be real property, but meters are not)

• Example 10 (new with the final regulations): State or local law determination of property.  Illustrates that if an item is listed in the regulations as real property (cell towers in this case), it is not relevant if state law provides they are not real property.

• Example 11: Land use permit. (a right to use land owned by the Federal government to put up a cell tower is found to be real property)

• Example 12: License to operate a business. (even though limited to a particular location, this license is not real property).

Incidental Personal Property Safe Harbor

In addition to the definition of real property, the IRS addressed concerns about the receipt of incidental amounts of personal property by a qualified intermediary destroying a like-kind exchange based on existing rules.  As the IRS described the issue in the preamble to the proposed regulations:

The Treasury Department and the IRS are aware that taxpayers have questioned the effect of the receipt of personal property that is incidental to the taxpayer’s replacement real property in an intended section 1031 exchange. For example, taxpayers have asked whether an exchange fails to meet the requirements of §1.1031(k)-1(g)(6)(i) if funds from the transfer of relinquished property held by the qualified intermediary are used to acquire an office building, including the personal property in the office building. Taxpayers and qualified intermediaries are concerned that a taxpayer would be considered to be in constructive receipt of all of the exchange funds held by the qualified intermediary if the taxpayer is able to direct the qualified intermediary to use those funds to acquire property that is not of a like kind to the taxpayer’s relinquished property. Under §1.1031(k)-1(a), if a taxpayer actually or constructively receives the funds held by a qualified intermediary before receiving the replacement property, the transaction is a sale and not a section 1031 like-kind exchange.[29]

The preamble goes on to describe the solution provided for this issue, creating a special rule allowing the receipt of such property to be disregarded if the receipt of personal property is incidental to the overall exchange of real property:

In response to these inquiries, the proposed regulations add to the items in §1.1031-1(g)(7) that are disregarded in determining whether the agreement between the taxpayer and the qualified intermediary expressly limits the taxpayer’s rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by the qualified intermediary. The proposed regulations provide that personal property that is incidental to replacement real property is disregarded in determining whether a taxpayer's rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by a qualified intermediary are expressly limited as provided in §1.1031(k)-1(g)(6). Personal property is incidental to real property acquired in an exchange if, in standard commercial transactions, the personal property is typically transferred together with the real property, and the aggregate fair market value of the incidental personal property transferred with the real property does not exceed 15 percent of the aggregate fair market value of the replacement real property. This incidental property rule in the proposed regulations is based on the existing rule in §1.1031(k)-1(c)(5), which provides that certain incidental property is ignored in determining whether a taxpayer has properly identified replacement property under section 1031(a)(3)(A) and §1.1031(k)-1(c).[30]

The proposed regulations would insert the following into existing Reg. §1.1031(k)-1(g)(7):

(iii) Personal property generally resulting in gain recognition under section 1031(b) that is incidental to real property acquired in an exchange. For purposes of this paragraph (g)(7), personal property is incidental to real property acquired in an exchange if--

(A) In standard commercial transactions, the personal property is typically transferred together with the real property; and

(B) The aggregate fair market value of the property described in paragraph (g)(7)(iii)(A) of this section transferred with the real property does not exceed 15 percent of the aggregate fair market value of the replacement real property or properties received in the exchange.[31]

The IRS provided the following example of the application of this provision:

Example (Reg. §1.1031(k)-1(g)(8)(vii))

Example 6. ((A) In 2020, B transfers to C real property with a fair market value of $1,100,000 and an adjusted basis of $400,000. B’s replacement property is an office building and, as a part of the exchange, B also will acquire certain office furniture in the building that is not real property, which is industry practice in a transaction of this type. The fair market value of the real property B will acquire is $1,000,000 and the fair market value of the personal property is $100,000..

(B) In a standard commercial transaction, the buyer of an office building typically also acquires some or all of the office furniture in the building. The fair market value of the personal property B will acquire does not exceed 15 percent of the fair market value of the office building B will acquire. Accordingly, under paragraph (g)(7)(iii) of this section, the personal property is incidental to the real property in the exchange and is disregarded in determining whether the taxpayer’s rights to receive, pledge, borrow or otherwise obtain the benefits of money or non-like-kind property are expressly limited as provided in paragraph (g)(6) of this section. Upon the receipt of the personal property, B recognizes gain of $100,000 under section 1031(b), the lesser of the realized gain on the disposition of the relinquished property, $700,000, and the fair market value of the non-like-kind property B acquired in the exchange, $100,000.

[1] REG-117589-18, June 11, 2020, https://s3.amazonaws.com/public-inspection.federalregister.gov/2020-11530.pdf (retrieved June 12, 2020)

[2] TD 9935, November 24, 2020 (Pre-release version posted on IRS website), https://www.irs.gov/pub/irs-drop/td_9935.pdf (retrieved November 24, 2020)

[3] TD 9935, November 24, 2020, Summary of Comments and Explanation of Revisions, I. Overview

[4] TD 9935, November 24, 2020, Summary of Comments and Explanation of Revisions, I. Overview

[5] TD 9935, November 24, 2020, Summary of Comments and Explanation of Revisions, I. Overview

[6] TD 9935, November 24, 2020, Summary of Comments and Explanation of Revisions, II. Definition of Real Property, A. State or local law definitions of real property, 2. Consideration of Comments and Revision of "Real Property" Definition

[7] TD 9935, November 24, 2020, Summary of Comments and Explanation of Revisions, II. Definition of Real Property, A. State or local law definitions of real property, 2. Consideration of Comments and Revision of "Real Property" Definition

[8] TD 9935, November 24, 2020, Summary of Comments and Explanation of Revisions, II. Definition of Real Property, A. State or local law definitions of real property, 2. Consideration of Comments and Revision of "Real Property" Definition

[9] Reg. §1.1031(a)-3(a)(1)

[10] Reg. §1.1031(a)-3(a)(1), (a)(6)

[11] Reg. §1.1031(a)-3(a)(5)

[12] Reg. §1.1031(a)-3(a)(5)

[13] Reg. §1.1031(a)-3(a)(7)

[14] Reg. §1.1031(a)-3(a)(4)(i)

[15] Reg. §1.1031(a)-3(a)(4)(ii)

[16] Reg. §1.1031(a)-3(a)(2)(i)

[17] Reg. §1.1031(a)-3(a)(2)(ii)(A)

[18] Reg. §1.1031(a)-3(a)(2)(ii)(B)

[19] Reg. §1.1031(a)-3(a)(2)(ii)(B)

[20] Reg. §1.1031(a)-3(a)(2)(ii)(C)

[21] Reg. §1.1031(a)-3(a)(2)(ii)(C)

[22] Reg. §1.1031(a)-3(a)(2)(iii)(A)

[23] Reg. §1.1031(a)-3(a)(2)(iii)(A)

[24] Proposed Reg. §1.1031(a)-3(a)(2)(iii)(A)

[25] Reg. §1.1031(a)-3(a)(2)(iii)(B)

[26] Reg. §1.1031(a)-3(a)(2)(iii)(B)

[27] Reg. §1.1031(a)-3(a)(3)

[28] Reg. §1.1031(a)-3(a)(3)

[29] REG-117589-18, SUPPLEMENTARY INFORMATION, Explanation of Provisions, Section II

[30] REG-117589-18, SUPPLEMENTARY INFORMATION, Explanation of Provisions, Section II

[31] Reg. §1.1031(k)-1(g)(7)(iii)