New Proposed Regulations on Like-Kind Exchange Limitations

July 01, 2020

By Ling You

On June 12, 2020, the IRS released proposed regulations (REG-117589-18) that amend the existing regulations to add a definition of real property that reflects statutory changes limiting Internal Revenue Code (“IRC” or “the Code”) Sec. 1031 to exchanges of real 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.

Background

The Tax Cuts and Jobs Act (“TCJA”) amended IRC Sec. 1031 to limit its application to exchanges of real property for exchanges completed after December 31, 2017, subject to a transition rule for certain exchanges in which property had been transferred before January 1, 2018.

Although the 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 after the changes to IRC Sec. 1031 made by the TCJA. 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 IRC Sec. 1031. The Treasury Department and the IRS have determined that regulations providing guidance on whether property is real property under IRC Sec. 1031 are necessary 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 IRC Sec. 1031(b).

Definition of Real Property

Various income tax regulations provide definitions of real property for purposes of applying Code sections other than IRC Sec. 1031, such as §1.263(a)-3(b) in the UNICAP regulations, §1.263A-8(c) in the interest expense capitalization regulations and §1.1250-1(e)(3) for purposes of determining depreciation or amortization recapture upon the disposition of certain property.

Although there are many similarities in the definition of “real property” in these Code sections and regulations, there are also differences that reflect the different purposes underlying those provisions. The legislative history to the TCJA provides that real property eligible for like-kind exchange treatment prior to the TCJA should continue to be eligible for like-kind exchange treatment.

Therefore, the Treasury Department and the IRS propose to extract certain portions of the definition of real property from various existing regulations that are consistent with the legislative history underlying the TCJA amendment to IRC Sec. 1031.

Under the proposed regulations, real property includes land and improvements to land, unsevered crops and other natural products of land, and water and air space superjacent to land. Improvements to land include “inherently permanent structures” and the “structural components of inherently permanent structures.” The proposed regulations also provide that local law definitions generally are not controlling in determining the meaning of the term “real property” for purposes of IRC Sec. 1031.

These proposed regulations provide 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. 

  • Inherently permanent structure.
    The proposed regulations provide that inherently permanent structures include any building or other structure that is permanently affixed to real property and that will ordinarily remain affixed for an indefinite period of time
    • Building. The proposed regulations define a “building” as any structure or edifice enclosing a space within its walls, and usually 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. “Buildings” also include the following distinct assets if permanently affixed: houses, apartments, hotels, motels, enclosed stadiums and arenas, enclosed shopping malls, factory and office buildings, warehouses, barns, enclosed garages, enclosed transportation stations and terminals, and stores.
    • Other inherently permanent structures. The proposed regulations provide a list of structures that qualify as inherently permanent structures. Examples include: 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 IRC Sec. 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.

      If property is not included in the list of inherently permanent structures, the proposed regulations provide the following factors that should be used to determine whether the property is an inherently permanent structure for purposes of IRC Sec. 1031:
      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.
    • Machinery. Property that is in the nature of machinery or is essentially an item of machinery or equipment is generally not an inherently permanent structure and not real property for purposes of this section. However, in the case 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.
  • Structural components.
    The term structural component means any distinct asset that is a constituent part of, and integrated into, an inherently permanent structure. If 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. A structural component may qualify as real property only if the taxpayer holds its interest in the structural component together with a real property interest in the space in the inherently permanent structure served by the structural component. 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 under the proposed regulations. However, 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, as defined in IRC Sec. 1031(f)(3), but that may be incorporated into real property by an unrelated buyer, is not treated as real property by the producing taxpayer.

    If a component of a building or inherently permanent structure is a distinct asset and is not listed as a structural component, the determination of whether the component is a structural component 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
    The proposed regulations provide that unsevered natural products of land generally are treated as real property under IRC Sec. 1031. This includes growing crops, plants, and timber; mines; wells; and other natural deposits. Natural 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.
  • Intangible property
    The proposed regulations also address instances in which intangible property is considered real property under IRC Sec. 1031. An intangible asset is real property or an interest in real property for purposes of IRC Sec. 1031 to the extent it 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. For instance, 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, easement, or fee ownership, generally is an interest in real property for purposes of IRC Sec. 1031.

    Under the proposed regulations, a license or permit to engage in or operate a business on real property is not real property or an interest in real property for purposes of IRC Sec. 1031 if the license or permit produces or contributes to the production of income other than consideration for the use and occupancy of space.
  • No inference outside of IRC Sec. 1031
    The rules provided in the proposed regulations concerning the definition of real property apply only for purposes of IRC Sec. 1031. No inference is intended with respect to the classification or characterization of property for other purposes of the Code, such as depreciation and IRC Secs. 1245 and 1250 recapture. For example, a structure or a portion of a structure may be IRC Sec. 1245 property for depreciation purposes and for determining gain under IRC Sec. 1245, but considered real property under IRC Sec. 1031. Also, in determining the amount and character of the gain for relinquished property, the rules of IRC Secs. 1245 and 1250 and the underlying regulations should be followed, notwithstanding that the relinquished property or replacement property is real property under IRC Sec. 1031.

Incidental Personal Property

The proposed regulations also include a separate rule relating to personal property received in an exchange that is incidental to the real property exchanged. Under this rule, two tests need to be met for a personal property to be considered “incidental:”(1) if in standard commercial transactions, the personal property is typically transferred together with the real property; and (2) 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 an existing rule in the regulations under IRC Sec. 1031, which provides that certain incidental property is ignored in determining whether a taxpayer has properly identified replacement property. It should be pointed out that under IRC Sec. 1031(b), a taxpayer must recognize gain on the receipt of the incidental personal property, which is non-like-kind property.

About Ling You

Ling You is a Tax Director in the Real Estate and Financial Services Groups, with nearly 20 years in public accounting.