The Tax Cuts and Jobs Act (TCJA) limited the ability of taxpayers to engage in a tax-deferred exchange (1031 exchange) in property held for investment or business use. The TCJA removed the ability to engage in a 1031 exchange for any property other than real property. Gone are the days of a tax-deferred trade of equipment, vehicles, or other tangible personal property used in a trade or business. But now we need a better definition of what constitutes real estate for this purpose.
Prior regulations mainly focused on the determination of whether property was of “like-kind” instead of whether it was actually “real estate.” Local law was also considered as a determining factor. The authors of the TCJA made it clear that the ability of real estate to be exchanged in a 1031 exchange should be unchanged, so a clear definition of what constitutes “real estate” for this purpose is needed.
Recently released proposed regulations define land as “land and improvements to land, unsevered crops and natural products of land, water and air space superjacent to the land.” Land improvements are defined as improvements that are inherently permanent structures, i.e., roads, bridges, and paved parking areas. Each asset should be analyzed separately in the determination. Some specific assets are provided for in the regulations, but other assets should be identified using the following factors:
- The way the asset is affixed to real property
- Whether the distinct asset is designed to be removed or remain in place
- The damage that removal would cause to the item or to the real property
- Other circumstances that suggest the expected period of affixation is not indefinite
- The time and expense that would be required to remove the distinct asset
All factors must be considered, and any one factor alone should not be a deciding factor.
These factors are important because any property that is not considered real property, or an inherently permanent addition to real property that serves and contributes to the use of real property, does not qualify for like-kind exchange treatment. Some items we think are personal property are actually considered a structural component to real property and will be treated as part of that real property in an exchange.
A structural component is any distinct asset that is integrated into the permanent structure and serves the purpose of the permanent structure, as long as the ownership is in coordination with the ownership of the permanent structure it serves. Examples of structural components are provided in the regulations. If an asset is not listed, then a list of factors like those listed above should be considered. Items held for sale by a dealer, developer, or maker of the asset will not be eligible for like-kind exchange treatment.
Unsevered natural products of land, such as crops, timber, water, etc., are treated as real property. Intangible assets, such as long-term leaseholds or easements, continue to qualify as real property if they are inseparable from real property. The value must be derived from the value of the real property, and the interest in the property must not be income producing other than consideration for the use or occupancy of space.
The rules from other sections of tax guidance should not be considered for purposes of a 1031 exchange. For example, the owner of a commercial building may be eligible to depreciate certain structural components of the building over a shorter life because they are treated as personal property. This treatment does not prevent those components from being treated as real property for purposes of a 1031 exchange.
What happens if you have personal property that is included in a sale that is part of an exchange? If the personal property is typically transferred with real property and the value of the personal property received does not exceed 15 percent of the aggregate value of the replacement property, the transaction will still qualify for 1031 exchange treatment. However, the receipt of personal property in an exchange could be considered boot and be taxable.
While the TCJA eliminated the tax-deferred benefits of a 1031 exchange for owners of personal property, there was a clear intention that the owners of real property should not be negatively affected. The proposed regulations provide the guidance and definitions needed to help ensure that real property owners can continue to benefit from Internal Revenue Code Section 1031 and tax-deferred like-kind exchanges.
Michael Hill, CPA, is a Managing Director for BKD CPAs & Advisors’ Jackson office. He serves as the office’s construction & real estate industry leader. He can be reached at firstname.lastname@example.org.
This article is for general information purposes only and is not to be considered as legal advice. This information was written by qualified, experienced BKD professionals, but applying this information to your particular situation requires careful consideration of your specific facts and circumstances. Consult your BKD advisor or legal counsel before acting on any matter covered in this update.