The Tax Cuts and Jobs Act limited like-kind exchanges under §1031 to exchanges of real property effective January 1, 2018.  The IRS has issued proposed regulations, [1] upon which taxpayers may rely,[2] to implement these revisions in §1031.

Real Property Definition Needed Specifically for §1031

The most significant item covered in these regulations is the definition of what is considered real property for like-kind exchanges under §1031.  The preamble notes:

The determination of whether property is real property has taken on additional significance as a result of the TCJA amendments limiting like-kind exchange treatment under section 1031 to exchanges of real property. Prior to enactment of the TCJA, neither the Code nor the Income Tax Regulations provided a definition of the term “real property” for purposes of section 1031. The Treasury Department and the IRS have determined that regulations providing guidance on whether property is real property under section 1031 are needed because taxpayers need certainty regarding whether any part of the replacement property received in an exchange is non-like-kind property subject to the gain recognition rules of section 1031(b).[3]

The preamble notes that there are many different definitions of real property in the IRC, but these existing individual definitions have various differences due to the specific issues each section deals with.  Thus, the IRS concludes that a §1031 specific definition of real property is necessary to determine whether an asset is real property for a like-kind exchange:

…[I]nstead of a wholesale adoption of an existing real property definition used in another Code or regulations section, these proposed regulations incorporate certain aspects from existing regulatory definitions of real property that are consistent with the legislative history underlying the TCJA amendment to section 1031 indicating that real property eligible for like-kind exchange treatment under pre-TCJA law should continue to be eligible for like-kind exchange treatment after the enactment of the TCJA. See, for example, §§1.263(a)-3(b)(3) and 1.856-10 defining the term “real property” to mean land and improvements to land such as buildings and other inherently permanent structures, and their structural components, and providing that local law is not controlling for purposes of determining whether property is real property under that section; §1.263A-8(c) providing that real property includes unsevered natural products of land such as growing crops and plants, mines wells and other natural deposits; and §1.856-10(c) providing, in relevant part, that the term “land” includes “water and air space superjacent to land.[4]

Definition of Real Property for §1031

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

The regulation begins by defining real property as:

• Land;

• Improvements to land;

• Unsevered natural products of land; and

• Water and airspace adjacent to land.[5]

This includes interests in real property such as:

• Fee ownership;

• Co-ownership;

• A leasehold;

• An option to acquire real property;

• An easement; or

• A similar interest.[6]

However, the regulation points out that local law definitions are not controlling for purposes of §1031—this is a federal tax law definition specific to §1031.[7]

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.[8]

Proposed 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:

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.[9]

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.[10]

Improvements to Land

Improvements to land include:

• Inherently permanent structures and

• Structural components of inherently permanent structures.[11]

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.”[12]

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.[13]

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.[14]

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 drilling platforms, derricks, oil and gas storage tanks; grain storage bins and silos; and enclosed transportation stations and terminals.[15]

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 this paragraph (a)(2)(ii)(C), the determination of whether the property is an inherently permanent structure under this paragraph (a)(2)(ii) 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.[16]

Machinery is generally not considered part of real property, as it is not normally an inherently permanent structure.[17]  However, the regulation does provide an exception:

In the case, however, of a building or inherently permanent structure that includes property in the nature of machinery as a structural component, the machinery is real property provided it serves the inherently permanent structure and does not produce or contribute to the production of income other than for the use or occupancy of space.[18]

Structural Components

A structural component is a distinct asset “that is a constituent part of, and integrated into, an inherently permanent structure.”[19]  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.”[20]

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.[21]

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.[22]

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.

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.[23]

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.”[24]

Intangible Assets

In certain cases, an intangible asset can be treated as real property for §1031 purposes.  The regulation provides:

To the extent an intangible asset derives its value from real property or an interest in real property, is inseparable from that real property or interest in real property, and does not produce or contribute to the production of income other than consideration for the use or occupancy of space, the intangible asset is real property or an interest in real property. Real property includes shares in a mutual ditch, reservoir, or irrigation company described in section 501(c)(12)(A) if, at the time of the exchange, the 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.[25]

The regulation devotes a more detailed discussion to the issue of when licenses and permits will be deemed to be real property for §1031 purposes, with the following qualifying as real property:

A license, permit, or other similar right that is solely for the use, enjoyment, or occupation of land or an inherently permanent structure and that is in the nature of a leasehold or easement generally is an interest in real property under this section.[26]

But the guidance finds the following licenses and permits are not real property for §1031 purposes:

However, a license or permit to engage in or operate a business on real property is not real property or an interest in real property if the license or permit produces or contributes to the production of income other than consideration for the use and occupancy of space.[27]

Examples

The regulation provides a series of twelve examples of applying these rules, found at Proposed 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 (in this case the example illustrates how the 3D printer in question, despite being impractical to move, does not qualify as real property but a generator supplying electricity to the entire building does)

• Example 6: Generator for Industrial 3D Printer (changes the facts in Example 5 so that the generator solely supports the 3D printer and thus ceases to be real property)

• Example 7: 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 8: Steam Turbine (again the item is found to be part of machinery and not real property, even though it has certain attributes, including being permanently affixed, that might lead an adviser to believe it would qualify as real property)

• Example 9: Partitions (while a conventional partition system is found to be real property, a modular partition system is found not to be real property)

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

• 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 describes the issue in the preamble:

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.[28]

The preamble goes on to describe the solution proposed 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).[29]

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

(iii) Personal property 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 incidental personal property transferred with the real property does not exceed 15 percent of the aggregate fair market value of the replacement real property.[30]

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

Example (Proposed 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 other 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] REG-117589-18, SUPPLEMENTARY INFORMATION, Proposed Applicability Date

[3] REG-117589-18, SUPPLEMENTARY INFORMATION, Explanation of Provisions, Section I.A.

[4] REG-117589-18, SUPPLEMENTARY INFORMATION, Explanation of Provisions, Section I.A.

[5] Proposed Reg. §1.1031(a)-3(a)(1)

[6] Proposed Reg. §1.1031(a)-3(a)(1)

[7] Proposed Reg. §1.1031(a)-3(a)(1)

[8] Proposed Reg. §1.1031(a)-3(a)(6)

[9] Proposed Reg. §1.1031(a)-3(a)(4)(i)

[10] Proposed Reg. §1.1031(a)-3(a)(4)(ii)

[11] Proposed Reg. §1.1031(a)-3(a)(2)(i)

[12] Proposed Reg. §1.1031(a)-3(a)(2)(ii)(A)

[13] Proposed Reg. §1.1031(a)-3(a)(2)(ii)(B)

[14] Proposed Reg. §1.1031(a)-3(a)(2)(ii)(B)

[15] Proposed Reg. §1.1031(a)-3(a)(2)(ii)(C)

[16] Proposed Reg. §1.1031(a)-3(a)(2)(ii)(C)

[17] Proposed Reg. §1.1031(a)-3(a)(2)(ii)(D)

[18] Proposed Reg. §1.1031(a)-3(a)(2)(ii)(D)

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

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

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

[22] Proposed Reg. §1.1031(a)-3(a)(2)(iii)(B)

[23] Proposed Reg. §1.1031(a)-3(a)(3)

[24] Proposed Reg. §1.1031(a)-3(a)(3)

[25] Proposed Reg. §1.1031(a)-3(a)(5)(i)

[26] Proposed Reg. §1.1031(a)-3(a)(5)(ii)

[27] Proposed Reg. §1.1031(a)-3(a)(5)(ii)

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

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

[30] Proposed Reg. §1.1031(k)-1(g)(7)(iii)