On June 11, 2020, the IRS and Treasury issued highly anticipated proposed regulations addressing changes made in 2017 under the Tax Cuts and Jobs Act (TCJA) governing like-kind exchanges under Section 1031 of the tax code. Before the TCJA, Section 1031 provided that no gain or loss is recognized on an exchange of like-kind real property or certain personal property held for productive use in a trade or business or for investment. Under the TCJA, Section 1031 now applies only to exchanges of real property. As a result of this change, it became crucial to define real property for purposes of Section 1031. Moreover, it is not uncommon for an exchange of real property to include personal property (e.g., a furnished office building). The proposed regulations provide a detailed definition of real property and a safe harbor for personal property transferred with real property.

Taxpayers generally can rely on the proposed regulations (provided that they apply them in their entirety) for exchanges after 2017.

Definition of Real Property for Section 1031 Purposes

The proposed regulations define real property for purposes of Section 1031 as (i) land, (ii) improvements to land, (iii) unsevered natural products of land, and (iv) water and air space superjacent to land. The guidance emphasizes that real property that was eligible for like-kind exchange treatment under pre-TCJA law continues to be eligible in tax years beginning after 2017.

The proposed regulations provide the following definitions:

• Improvements to land. Inherently permanent structures and the structural components of inherently permanent structures.
• Inherently permanent structures. Any building or other structure that is permanently affixed to real property and that will ordinarily remain affixed for an indefinite period of time. The proposed regulations provide a list of items that are properly identified as inherently permanent structures, including (i) in-ground swimming pools, (ii) roads, (iii) bridges, (iv) tunnels, and (v) parking facilities.
• Structural components of inherently permanent structures. 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 instance, structures that provide a building with electricity or heat), the assets are analyzed collectively as one distinct asset that may be a structural component. The proposed regulations include a list of items that are specifically identified as structural components, including (i) permanent coverings of walls, floors, and ceilings, (ii) elevators and escalators, (iii) insulation, and (iv) chimneys.
• Unsevered natural products of land. 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 or removed from the land.

Each asset must be analyzed separately from related assets to ascertain whether the asset is land, an inherently permanent structure, or a structural component of an inherently permanent structure. Items categorically listed in the proposed regulations as buildings and other inherently permanent structures, as well as structural components, are distinct assets for purposes of Section 1031. Other distinct assets are identified using a multi-factored approach.

Incidental Personal Property Safe Harbor

The proposed regulations add a taxpayer-favorable provision whereby personal property is deemed to be “incidental to real property” acquired in an exchange, and thus disregarded, if (i) in standard commercial transactions, personal property is typically transferred with the real property, and (ii) the aggregate fair market value of transferred incidental property does not exceed 15% of the aggregate fair market value of the replacement real property. However, a taxpayer must recognize gain on the receipt of incidental personal property, as it is non-like-kind exchange property. Examples of incidental personal property include office furniture typically acquired in the sale of an office building, a refrigerator transferred along with an apartment, or a laundry machine transferred along with a house. However, the 15% threshold could prove burdensome as appraisals would require a careful breakdown of all assets included in the exchange to ensure that the threshold is not breached.