Tax Deferred Exchanges of ONLY Real Estate; But, What is Real Estate?
The law under the Internal Revenue Code, Section 1031, is clear that if one can qualify for a Tax Deferred Exchange under this Code Section, the property that is to be exchanged must be “real estate.” That is the subject property being exchanged cannot be personal property. (Historically, a taxpayer could possibly be permitted to defer income tax when exchanging qualified trade or business property that was either real estate or personal property. However, a taxpayer can no longer employ this defer rule under Code Section 1031, if the property being exchanged is not real estate. Hence, the issue of what is real estate as opposed to non-real estate has been an important issue ever since 2017, when the law was changed and Code Section 1031 was restricted to deferrals that only involve real estate. (See Tax Cuts and Jobs Act of 2017, PL 115-97.)
Recently, the Internal Revenue Service (IRS) issued Proposed Regulations (Prop Regs) to clarify what is “realty” and what is not “realty” for purposes of Section 1031. (See Prop Reg REG-117589-18)
Under these Prop Regs, for purposes of Code Section 1031, the Prop Regs state that “The term ‘real property’ for purposes of Code Sec. 1031 and its Regs means land and improvement to land, unsevered natural products of land, and water and air space superjacent to land. (Prop Reg Section 1.1031(a)-3(a)(1)).”
This stated definition might seem somewhat obvious. However, the Prop Regs state:
“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 section 1031.”
The Prop Regs further state:
“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. Items that are specifically listed in these proposed regulations as buildings and other inherently permanent structures are distinct assets. Assets and systems specifically listed in these proposed regulations as types of structural components also are treated as distinct assets. Other distinct assets are identified using factors provided by these proposed regulations. All listed factors must be considered, and no one factor is determinative.”
Other assets related to the land or building may also qualify as realty. The Prop Regs state:
“The proposed regulations provide that unsevered natural products of land generally are treated as real property under section 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.”
What other property might also be considered real estate for this Code Section 1031 rule, even though one might normally think of it as personal property? The Prop Regs commented as to intangible property:
“The proposed regulations also address instances in which intangible property is considered real property under section 1031. An intangible asset is real property or an interest in real property for purposes of section 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 section 1031.”
The above statements give rise to more questions. For example, what are “inherently permanent structures?” The Prop Regs state that such terms include distinct assets, if permanently affixed, such as-ground swimming pools, roads, bridges, tunnels, paved parking areas, docks, fences, and much more.
If the given property is not part of those items listed by the Prop Regs as “inherently permanently structures,” then there are factors listed to help determine if the item fits this characterization.
The Prop Regs also provide that machinery and related equipment is “generally not an inherently permanent structure” and thus is not real estate for this 1031 purpose.
What are structural components are also examined in the Prop Regs to see if the item will be considered realty.
Other issues, such as whether tenant improvements are realty, are covered in the Prop Regs. Many other special types of properties and settings are covered in the Prop Regs.
Personal property incidental to real property: One of the most critical issues addressed by the Prop Regs in determining if an asset will be considered realty relates to whether “personal property is incidental to real property.” A very important conclusion is provided in the Prop Regs to allow “personal property transferred with the real property” to be considered as “incidental to real property” in certain cases. To fall within this exception, one of the limitations is that the aggregate of the fair market value of the personal property that is deemed “incidental personal property” must not be in excess of 15% of the aggregate fair market value of the real property. (Such personal property must also normally be part of the commercial property.) Such determination that personal property is incidental to the realty being exchanged does NOT mean the gain on the personal property is not currently taxed. Rather, such gain on the personal property is subject to current tax on the exchange.
Final Regulations were issued 11/23/2020. The above rules were not changed in the Final Regulations.
Dr. Mark Lee Levine,
Professor, University of Denver