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Proposed Treasury Regulations Offer Guidance to TCJA Section 1031 Changes

Published: September 15th, 2020

By: Amanda L. Govin Christopher R. D'Amico Charles H. Egerton

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On June 11, 2020, the IRS released Proposed Treasury Regulations under Section 1031 of the Internal Revenue Code (the “Code”), offering guidance on the post-TCJA (Tax Cuts and Jobs Act) changes to Section 1031. Section 1031 of the Code was created in 1921 to allow for nonrecognition of gain or loss on the exchange of property held for investment or for productive use in a trade or business, as long as the property received in the exchange is “like-kind” and is similarly held for investment or for productive use in a trade or business. From its creation until 2018, Section 1031 like-kind exchanges applied to both personal and real property.

In 2018, the enactment of the TCJA limited like-kind exchanges to real property, while leaving the “like-kind” standard unchanged, increasing the importance for certainty as to what constitutes “real property” for purposes of Section 1031. The Proposed Regulations main guidance was to clarify the definition of real property for purposes of Section 1031 and to clarify how that definition would be applied in connection with the receipt of personal property that is incidental to real property received as part of a like-kind exchange. The Proposed Regulations provide that state and local law definitions are no longer controlling for purposes of determining what constitutes real property under Section 1031. Prop. Treas. Reg. § 1.1031(a)-3(a)(1).

Specifically, the Proposed Regulations defined “real property” as land, improvements to land, unsevered crops and other natural products of land, and water and air space superjacent to land. Prop. Treas. Reg. § 1.1031(a)-3(a)(1). The Proposed Regulations go on to further define and provide examples for improvements to land, inherently permanent structures, types of intangible assets that qualify as real property, and other relevant terms. Prop. Treas. Reg. § 1.1031(a)-3(a)(2)(5), (b). The Proposed Regulations specifically provide that options to acquire real property are “real property” for purposes of the Section 1031 and that certain intangible assets, such as licenses and permits that are in the nature of an easement or leasehold are “real property” for purposes of the Section 1031, provided they do not produce or contribute to the production of income. Id.

Importantly, the Proposed Regulations clarify that there is to be no inference with respect to the classification of a structure or portion of a structure for other purposes of the Code, including Code Sections 1245 and 1250. Prop. Treas. Reg. § 1.1031(a)-3(a)(6). “For example, a structure or portion of a structure may be section 1245 property for depreciation purposes…, notwithstanding that the structure or the portion of the structure is real property under this section.” Id. These clarifications appear to address a pressing concern for some taxpayers that, pre-TCJA, used a cost segregation study to depreciate certain personal property assets that were components of real property, and whether the use of component depreciation for such portions of the real property results in a disqualification of those component assets from Code Section 1031 like-kind exchanges post-TCJA. Prop. Treas. Reg. § 1.1031(a)-3(a)(6).

Additionally, the Proposed Regulations provide a safe harbor for the receipt of “incidental personal property” as part of a like-kind exchange. Prop. Treas. Reg. § 1.1031(k)-1(g)(7). The safe harbor provides that for personal property included in 1031 like-kind exchanges to be considered “incidental” to the real property acquired it must (i) be of a type that is typically transferred with such real property, in standard commercial transactions; and (ii) the aggregate fair market value of the incidental personal property can’t exceed 15% of the aggregate fair market value of the entire replacement real property. Prop. Treas. Reg. § 1.1031(k)-1(g)(7).

While the Proposed Regulations were mostly welcomed as helpful clarifications, they nevertheless left several issues open that are worth noting: (i) the Proposed Regulations provide separate categories of inherently permanent structures, structural components of inherently permanent structures, and machinery that must be separately analyzed and may give rise to disputes; (ii) it is unclear how the definition of intangible assets, such as licenses and permits that are real property under the Proposed Regulations will be interpreted; and (iii) for taxpayers that used a cost segregation study to depreciate certain components of real property, it is unclear if the definitions of inherently permanent structures and machinery as defined in the Proposed Regulations will result in certain component parts being disqualified from Code Section 1031 like-kind exchanges post-TCJA, irrespective of the fact that the Proposed Regulations clarify that there is to be no inference with respect to the classification of a structure or portion of a structure for other purposes of the Code. The position adopted in the Proposed Regulations that state law definitions of real property will not be deemed controlling for purposes of Section 1031 received a number of adverse comments from several prominent tax practitioners.

For questions about Section 1031 like-kind exchanges and other tax issues, please contact article authors and tax attorneys Charles H. Egerton, Christopher R. D’Amico and Amanda L. Govin.