The TCJA limited like-kind exchange transactions to real estate, meaning that personal property included in an exchange could trigger current-year tax consequences. Recent IRS guidance clarifies how to qualify for tax deferral. Here’s what you need to know.
The IRS has issued final regulations that attempt to answer questions arising from the Tax Cuts and Jobs Act’s (TCJA’s) limitation of tax-favored like-kind exchanges solely to exchanges of real property. Prior to this modification, like-kind exchanges could include multiple classes of property such as real property and personal property included in the same transaction. With certain classes of property now excluded from the benefits of this type of transaction, taxpayers and the IRS needed a clearer set of definitions for the types of property that still qualified for deferral under the like-kind exchange rules of Internal Revenue Code (IRC) Section 1031 (1031) and the types that would not.
Taxpayers and the IRS needed a clearer set of definitions for the types of property that still qualified for deferral under the like-kind exchange rules.
1031 before the TCJA
Prior to the TCJA, so long as the assets were relatively similar to the exchanged assets, tax authorities didn’t typically challenge that aspect of the exchange. If property was exchanged for some other kind of property, gain could be deferred as long as no cash was exchanged to make up the difference in values. The presence of cash “boot” would make the transaction taxable to some extent, but it still didn’t typically necessitate separate treatment for different classes of property within the exchange.
15% safe harbor for “incidental personal property”
One step that the final regulations took to protect taxpayers from an inadvertent reclassification of an intended tax-deferred exchange into a currently taxable sale transaction was to allow a small percentage of personal property to be included in an exchange without consequence. For instance, in the event that two businesses exchanged office buildings and left significant amounts of office furniture behind, they could still meet “safe harbor” requirements under the new rules as long as the value of the nonreal estate property involved didn’t exceed 15% of the total transaction value.
1031 real property like-kind exchanges after TCJA
As happens so often when a new law modifies a longstanding provision of the tax code, the exclusion of personal property from like-kind treatment under 1031 had the unintended consequence of pointing out that the existing guidance on the topic didn’t really define “real property.” The final regulations state that real property means “land and improvements to land, unsevered natural products of land, and water and air space superjacent to land.” The rules defer substantially to state law in this area, allowing that, “Property that is real property under state or local law…is real property for purposes of section 1031.”
Improvements to land, inherently permanent structures, & structural components
To qualify as real property and avoid triggering treatment of an intended like-kind exchange as a sale, the final regulations allow for the inclusion of “inherently permanent structures” as components of the real property exchanged. These include any building or structure that’s “permanently affixed to real property” and “reasonably expected to last indefinitely based on all of the facts and circumstances.” The rules go on to list numerous assets that will qualify as inherently permanent if they’re permanently affixed to the land, including roads, bridges, parking facilities, wharves, and in-ground swimming pools.
The final regulations allow for the inclusion of “inherently permanent structures” as components of the real property exchanged.
If an asset doesn’t appear on the list of inherently permanent structures, taxpayers can still argue that it be treated as inherently permanent, and thus part of the real estate that qualifies for like-kind treatment, based on the following five criteria in the final regulations:
- The manner in which the asset is affixed to the real property.
- Whether the distinct asset is designed to be removed or to remain in place.
- The damage that removal of the distinct asset would cause to the item itself or to the real property to which it is affixed.
- Any circumstances that suggest the expected period of affixation is indefinite.
- The time and expense required to move the distinct asset.
The final 1031 regulations also delve into assets that may qualify as real estate by virtue of their existence as “structural components” of an inherently permanent structure like a building. Interconnected assets that work together to deliver utilities like water, electricity, heat, and air conditioning into a building can qualify for real estate treatment in a like-kind exchange as structural components. An item or system not specifically listed in the regulations as a structural component can still qualify based on the following factors:
- The manner, time, and expense required to install or remove the equipment.
- Whether the component is designed to be moved.
- The damage that removal of the component would cause to the item itself or to the inherently permanent structure to which it’s affixed.
- Whether the component was installed during the construction of the inherently permanent structure.
“State law plus” test
In effect, what we’ve just described is a new three-part test created by the regulations that has become known as “state law plus.” An asset will qualify as real property for purposes of the like-kind exchange rules if the answer to any one of the following questions is “yes:”
- Is the asset treated as real property under state law?
- If it’s not real property under state law, is the asset among those specifically described in the regulations as an “improvement to land” or a “structural component of an improvement to land?”
- If it doesn’t qualify under 1 or 2, does the asset qualify for treatment as an improvement to land or a structural component of an improvement to land under the facts-and-circumstances tests for those classifications spelled out in the regulations?
Cost segregation & like-kind exchanges
The final regulations appear to alleviate some uncertainty among taxpayers that have had a cost segregation study. Some were concerned that by performing a cost segregation on a building, a taxpayer might create noneligible personal property that could no longer be part of a like-kind exchange. The rules appear to address this concern by continuing to treat the components of the building that meet the above criteria as real property for federal like-kind exchange purposes, even though some of these same assets might be classified as personal property for federal depreciation purposes. It’s still possible that some components of a building might not be considered real property, but this new test will lessen the number and narrow the types of assets that are excluded from like-kind exchange treatment.
New landscape for like-kind exchanges
While the final regulations do bring some clarity to the like-kind exchange world in the wake of the TCJA, the risks to participants are still significant. Taxpayers that rely on like-kind exchanges to defer taxes as their businesses grow should be aware that the rules have changed and transactions that qualified in the past may be subject to different tax treatment as a result of these new rules. One way to reduce the risk is to perform a cost segregation study prior to the exchange to ensure personal property doesn’t exceed the 15% safe harbor.
If you have any questions about how these new rules might affect exchanges that your business might be planning, please contact your Plante Moran advisor.