Sec. 1031 Prop. Regs: Transfer of Incidental Personal Property Doesn't Taint Exchange

(Parker Tax Publishing July 2020)

The IRS issued proposed regulations which amend the existing regulations under Code Sec. 1031 to add a definition of "real property" to reflect changes made to Code Sec. 1031 in the Tax Cuts and Jobs Act of 2017. In the proposed regulations, the IRS provides a more expansive definition of real property than that used for depreciation purposes and provides that a taxpayer's receipt of personal property incidental to real property does not cause the exchange to fail to qualify as a Code Sec. 1031 like-kind exchange. REG-117589-18.

Background

The Tax Cuts and Jobs Act of 2017 (TCJA) amended the like-kind exchange rules in Code Sec. 1031 to limit its application to exchanges of real property completed after December 31, 2017, subject to a transition rule for certain exchanges in which property had been transferred before January 1, 2018. As amended by the TCJA, Code Sec. 1031(a) provides that no gain or loss is recognized on the exchange of real property held for productive use in a trade or business or for investment (relinquished real property) if the relinquished real property is exchanged solely for real property of a like kind that is to be held either for productive use in a trade or business or for investment (replacement real property). However, left unchanged by TCJA, Code Sec. 1031(b) provides that a taxpayer must recognize gain on the receipt of money and non-like-kind property in an exchange.

To implement these changes, the IRS issued proposed regulations in REG-117589-18. In addition to defining the term "real property" for purposes of a Code Sec. 1031 exchange, the proposed regulations adapt an existing incidental property exception to apply to a taxpayer's receipt of personal property that is incidental to real property the taxpayer receives in the exchange.

Observation: Although TCJA removed personal and certain intangible property from eligibility for like-kind exchange treatment, the need to determine whether the relinquished real property and the replacement real property are of a like kind continues to exist. Reg. Sec. 1.1031(a)-1(b), which was not changed by the proposed regulations, provides that ''like kind'' refers to the nature or character of the real property and not to its grade or quality. Real property of one kind or class may not, under Code Sec. 1031, be exchanged for real property of a different kind or class. The fact that any real property involved is improved or unimproved is not material because that fact relates only to the grade or quality of the real property and not to its kind or class. Examples of exchanges of real property of a like kind include an exchange (1) by a non-dealer of city real estate for a farm or ranch; (2) of improved real estate for unimproved real estate; and (3) of a leasehold interest in a fee with 30 years or more to run for real estate.

Definition of Real Property

Under the proposed regulations, real property is defined as land and improvements to land, unsevered natural products of land, and water and air space superjacent to land. Real property includes an interest in real property involving fee ownership, co-ownership, a leasehold, an option to acquire real property, an easement, or a similar interest. Improvements to land include inherently permanent structures and the structural components of inherently permanent structures. Local law definitions generally are not controlling in determining the meaning of the term ''real property'' for purposes of Code Sec. 1031. While the real property definition language is very similar to the language in Code Sec. 48, Code Sec. 263(a), and Code Sec. 263A, the definition under the proposed regulations includes certain differences and provides that each distinct asset must be 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.

Items that are specifically listed in the proposed regulations as buildings and other inherently permanent structures are distinct assets. If property is not listed as an inherently permanent structure, Prop. Reg. Sec. 1.1031-3(a)(2)(ii)(C) provides that the determination of whether the property is an inherently permanent structure 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.

Assets and systems specifically listed in the proposed regulations as types of structural components also are treated as distinct assets. Prop. Reg. Sec. 1.1031-3(a)(4)(ii) provides that other distinct assets are identified using the following factors:

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

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

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

(4) whether separating the item from a larger asset of which it is a part impairs the functionality of the larger asset.

All listed factors must be considered, and no one factor is determinative.

Under the proposed regulations, the definition of real property applies only for purposes of Code Sec. 1031 and no inference is intended with respect to the classification or characterization of property for any other purposes, such as Code Sec. 1245 and Code Sec. 1250. For example, a structure or a portion of a structure may be Code Sec. 1245 property for depreciation purposes and for determining gain under Code Sec. 1245, notwithstanding that the structure or the portion of the structure is considered real property for purposes of Code Sec. 1031 under the proposed regulations.

Exchanges Involving Incidental Personal Property

The proposed regulations also provide a rule addressing a taxpayer's receipt of personal property that is incidental to real property the taxpayer receives in the exchange. Under current Reg. Sec. 1.1031(k)-1(c)(4), the maximum number of properties a taxpayer may identify as replacement real property is three properties, without regard to the fair market value of the properties, or any number of properties as long as the aggregate fair market value of the properties does not exceed 200 percent of the aggregate fair market value of the relinquished real property. Current Reg. Sec. 1.1031(k)-1(c)(5) provides that, for purposes of the identification rules, property that is incidental to a larger item of property is not treated as property separate from the larger item if, in standard commercial transactions, the property is typically transferred with the larger item of property, and the aggregate fair market value of all of the incidental property does not exceed 15 percent of the aggregate fair market value of the larger item of property.

Consistent with longstanding regulations under Code Sec. 1031, in determining whether a taxpayer has actual or constructive receipt of money or other property held by a qualified intermediary, the proposed regulations disregard certain incidental personal property. Specifically, the proposed regulations disregard incidental personal property that (1) in standard commercial transactions is typically transferred together with the real property, and (2) does not exceed 15 percent of the aggregate fair market value of the replacement real property. Nonetheless, under Code Sec. 1031(b), a taxpayer must recognize gain on the receipt of the incidental personal property, which is non-like-kind property.

Observation: According to the IRS, the proposed 15-percent limitation is responsive to ordinary-course exchanges that often commingle personal property and real property as part of the aggregate exchanged property. With regard to a limitation in excess of 15 percent, the IRS determined that a higher limit might induce taxpayers to bundle more personal property with their exchanged property. Such a result would lead to increased amounts of personal property exchanged with real property under Code Sec. 1031 and effectively unlock a class of personal property that would no longer be ''incidental'' to the real property. With regard to a lower limit, the IRS determined that the burden of accurately measuring the separate costs of comingled personal and real property would increase. In addition, the IRS said, the proposed 15 percent incidental personal property limitation would reduce the cost of investing in real property, when compared to no exchanges for incidental personal property. Raising this limit, however, would further increase the tax incentives for investing in such property, although most taxpayers will be indifferent when exchanging incidental property, plants, and equipment with a depreciable life of 20 years or less that is eligible for 100 percent additional first year depreciation (i.e., bonus depreciation). Under 100 percent bonus depreciation, gains from the sale of property can be offset by deductions for investment in other qualifying property.

A Glitch in the Proposed Regulations?

Prop. Reg. Sec. 1.1031(a)-1 provides that a number of regulations under Code Sec. 1031 apply only to qualifying exchanges of real property that is held for productive use in a trade or business, or for investment, and that is not held primarily for sale. Specifically, among other regulations that only apply to real property exchanges, Prop. Reg. Sec. 1.1031(a)-1 cites (1) Reg. Sec. 1.1031(d)-2, which provides that the amount of any liabilities of the taxpayer assumed by the other party to the exchange (or of any liabilities to which the property exchanged by the taxpayer is subject) is to be treated as money received by the taxpayer upon the exchange, whether or not the assumption results in a recognition of gain or loss to the taxpayer under the law applicable to the year in which the exchange was made, and (2) Reg. Sec. 1.1031(j)-1, which provides an exception to the general rule that the application of Code Sec. 1031 requires a property-by-property comparison for computing the gain recognized and basis of property received in a like-kind exchange where multiple properties are exchanged.

Observation: As was noted in a comment submitted to the IRS by tax practitioner, Monte Jackel, if the regulations mentioned in Prop. Reg. Sec. 1.1031(a)-1 only apply to real property exchanges, how do the proposed regulations apply if an exchange involves both qualifying real property and other property (i.e., boot)? How do the proposed regulations apply if a liability encumbers all assets in the exchange? Would the debt be bifurcated? For example, if the taxpayer surrenders real property and non-real property, is the portion of the debt encumbering the other property considered to be boot? If non-real property is also received and encumbered, is that portion of the debt an offset to boot? As Mr. Jackel noted, the proposed regulations appear to have a glitch in them in that the multiple property rules in Reg. Sec. 1.1031(j)-1 must apply in some manner to take into account property that is not part of the tax-free exchange. According to Mr. Jackel, it is much more likely that those rules will now come into play, and in his view, the proposed regulations "turn off" those rules because there would not be an exchange of qualifying real property. Mr. Jackel stated that taxpayers will also need guidance on how to treat an exchange of qualifying and nonqualifying property where there is debt encumbering both types of property.

For a discussion of the requirements for a valid like-kind exchanges, see Parker Tax ¶113,130.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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