US Department of Treasury Proposes Regulations Under Code Section 1031 That Provide Taxpayer-Friendly Guidance on Like-Kind Exchanges

Seyfarth Synopsis:  On June 12, 2020, the US Department of Treasury (the “Treasury”) promulgated proposed treasury regulations (the “Proposed Regulations”) under section 1031 (“Section 1031”) of the Internal Revenue Code of 1986, as amended (the “Code”) that (1) abandons prior reliance on piecemeal local law definitions of “real property” in favor of unified, broad, and taxpayer-friendly definition for purposes of Code Section 1031, and (2) provides that incidental personal property received with replacement property will not cause the taxpayer to be considered to be in constructive receipt of the funds held by a qualified intermediary during the exchange period.

Section 13303(c) of the Tax Cuts and Jobs Act of 2017, P.L. 115-97 (the “TCJA”), amended Code Section 1031 to limit its application to exchanges of “real property” (“Section 1031 Exchanges”) after December 31, 2017, subject to certain transition rules.  The Proposed Regulations amend the existing Treasury regulations (the “Current Regulations”) in response to the changes made to Code Section 1031 by the TCJA.  The Proposed Regulations apply to Section 1031 Exchanges beginning on or after the date the Proposed Regulations are published as final regulations in the Federal Register.  Pending issuance of the final regulations, a taxpayer may rely on the Proposed Regulations, if followed consistently and in their entirety, for Section 1031 Exchanges of real property beginning after December 31, 2017 and before the final regulations are published.

Definition of “Real Property”

The determination of whether property is real property has taken on additional significance as a result of the TCJA amendment limiting Section 1031 Exchange treatment to real property.  The Proposed Regulations depart from the Current Regulations, which defined “real property” by reference to local law, and include a standalone definition that is consistent with pre-TCJA law, thereby providing taxpayers with more certainty whether the property in question is of like-kind, independent of its location.  The Treasury Department and IRS decided against adopting a pre-existing definition of real property found in other areas of the Code and the Treasury regulations given the particular purposes of Code Section 1031 and the body of laws developed to date in this context.  Consequently, while this change is superficially significant, it is understandable and even welcome.

Thus, the Proposed Regulations define “real property” to include (1) land and improvements to land, (2) unsevered crops and other natural products of land, and (3) water and air space superjacent to land.  The Proposed Regulations also state that an interest in real property includes fee ownership, co-ownership, a leasehold of 30 years or more (including extensions), an option to acquire real property, an easement, or a similar interest.  It would appropriate for Treasury to state explicitly that “co-ownership” includes not only tenancy-in-common interests but also other co-ownership arrangements such as condominium and cooperative interests, as it presumably does.

The bulk of the text of the Proposed Regulations is spent defining what constitutes an “improvement to land”.  Improvements to land are generally divided into (1) inherently permanent structures and (2) structural components of inherently permanent structures.  We summarize these subcategories below.

The Proposed Regulations define “inherently permanent structures” to 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.  A “building” includes (1) any structure or edifice that (a) encloses space within its walls and, usually, a roof, and (b) has a purpose such as (i) providing shelter or housing, or (ii) providing working, office, parking, display, or sales space, and (2) the following distinct assets if permanently affixed: (I) houses, (II) apartments, (III) hotels, (IV) motels, (V) enclosed stadiums and arenas, (VI) enclosed shopping malls, (VII) factory and office buildings, (VIII) warehouses, (IX) barns, (X) enclosed garages, (XI) enclosed transportation stations and terminals, and (XII) stores.  Similarly, the Proposed Regulations provide a list of other structures that qualify as “inherently permanent structures”, such as in-ground swimming pools, roads, bridges, tunnels, and parking facilities, fences, certain permanent advertising displays, telephone poles, and cell, broadcasting, and electric transmission towers.  Finally, the Proposed Regulations provide a list of factors that must be used to determine whether property that is not included in the list of inherently permanent structures qualifies as such.  Machinery and equipment is generally not an inherently permanent structure unless a building or inherently permanent structure includes the machinery or equipment as a structural component so long as it does not produce or contribute to the production of income other than for the use or occupancy of space.

The Proposed Regulations define “structural components of inherently permanent structures” to include any distinct asset that is a constituent part of, and integrated into, an inherently permanent structure.  The Proposed Regulations provide both a list of structural components and a list of factors that must be used to determine whether other distinct assets constitute a structural component of a building or inherently permanent structure.  When assets are interconnected and work together to serve an inherently permanent structure (for example, electricity, heat, or water systems), such assets are grouped as a single distinct asset to determine whether they are a structural component.  The Proposed Regulations demonstrate this analysis using a gas line as an example.  If a gas line provides fuel to a building’s heating system, then the gas line is part of the heating system, which may be a structural component. However, if the gas line provides fuel to business equipment in the building, such as fryers and ovens in a restaurant, then the gas line is not a part of a structural component of an inherently permanent structure.  The owner of the structural component must also own a real property interest in the inherently permanent structure for the structural component to qualify. If a distinct asset is customized for a tenant, then the customization does not affect whether the distinct asset is a structural component.  The Proposed Regulations also address (1) tenant improvements to a building that are inherently permanent or otherwise classified as real property and (2) property produced for sale that is not real property in the hands of the producing taxpayer or a related person.

Finally, the definition of “real property” includes certain types of intangible property. An intangible asset is real property or an interest in real property if it (1) derives its value from real property or an interest in real property, (2) is inseparable from that real property or interest in real property, and (3) does not produce or contribute to the production of income other than consideration for the use or occupancy of space.  Examples include 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. However, a license or permit to engage in or operate a business on real property is not real property or an interest in real property if the license or permit produces or contributes to the production of income other than consideration for the use and occupancy of space.

Personal Property Incidental to a Section 1031 Exchange

The Proposed Regulations also provide a rule addressing the concern that a taxpayer’s receipt of personal property in a Section 1031 Exchange could cause the taxpayer to be in constructive receipt of the funds held by a qualified intermediary.  The rule, which appears framed as a clarification of the qualified intermediary safe harbors for deferred Section 1031 Exchanges, provides that personal property that is incidental to replacement real property is disregarded in determining whether a taxpayer's rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by a qualified intermediary are expressly limited as provided in Current Regulations Section 1.1031(k)-1(g)(6). Personal property is incidental to real property acquired in an exchange if, in standard commercial transactions, the personal property is typically transferred together with the real property, and 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. The reason this incidental property rule in the Proposed Regulations may sound familiar to long-time advisors and practitioners of Section 1031 Exchanges is because it is based on the existing rule in Current Regulations Section 1.1031(k)-1(c)(5), which provides that certain incidental property is ignored in determining whether a taxpayer has properly identified replacement property under Code Section 1031(a)(3)(A) and Current Regulations Section 1.1031(k)-1(c).

Treasury is requesting that interested parties submit electronic submissions via the Federal eRulemaking Portal at https://www.regulations.gov.  You can read the Proposed Regulations here.