Like-kind exchange basics
Sec. 1031(a)(1) provides that no gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind, which is held either for productive use in a trade or business or investment. Taxpayers may sell business or investment property (relinquished property) and defer tax on the gain if the taxpayers reinvest in similar property (replacement property).
Personal property and property held primarily for sale do not qualify
Sec. 1031 is very form-driven, and taxpayers must satisfy a number of requirements and timing elements or the deal fails. One particularly important requirement addressed by the new regulations requires that the deal must be structured as an exchange; taxpayers cannot sell, get the proceeds, and then buy. Rather, they must either trade the property directly or use a qualified intermediary (QI) to buy and sell such that it looks like an exchange from the taxpayer’s perspective.
How the TCJA changed the landscape
Following the TCJA, Sec. 1031 only applies to real property. Any personal property transferred in a like-kind exchange is considered separately bought and sold, with undeferrable gain on the sale. Qualifying relinquished and replacement property now must satisfy two core requirements: (1) The property must be real property, and (2) the two types of property must be of like kind to one another.
Determining what counts as real property
New Regs. Sec. 1.1031(a)-3 provides a unifying definition of real property for Sec. 1031. The starting point under Regs. Sec. 1.1031(a)-3(a)(1) holds that real property includes “land and improvements to land, unsevered natural products of land, and water and air space superjacent to land.” From there, taxpayers have a facts-and-circumstances analysis to determine whether their assets qualify in one of those categories. Importantly, new Regs. Sec. 1.1031(a)-3(a)(4) provides that each distinct asset must be analyzed separately from any other assets to determine whether it counts as real property.
New Regs. Sec. 1.1031(a)-3(a)(2)defines “improvements to land” as inherently permanent structures and the structural components of inherently permanent structures. It then provides more detailed definitions of “inherently permanent” and “structural components” with examples of each. This section helps address one question that loomed in the minds of many taxpayers: How should taxpayers treat different types of assets that make up one system?
Under new Regs. Sec. 1.1031(a)-3(a)(2)(iii), if interconnected assets work together to serve an inherently permanent structure (e.g., systems that provide a building with electricity, heat, or water), the assets should be analyzed together as one distinct asset that may qualify as a structural component of real property. T
Intangible assets related to land often challenge taxpayers, and new Regs. Sec. 1.1031(a)-3(a)(5) lists examples of intangible assets that count as real property, while specifically excluding others. The regulations specifically include leaseholds, options, easements, and land development rights. Note that the duration of an easement or leasehold interest may determine whether it is of like kind to a permanent interest. For example, in GCM 39182, the IRS Chief Counsel’s Office analyzed a temporary easement and cited Regs. Sec. 1.1031(a)-1(c), which establishes that leases of 30 years or more are of like kind to a fee interest in real property. Shorter interests may not be. Some taxpayers hoped the final regulations would provide more detail on easements and other limited interests in real property, but the IRS and Treasury declined to address them further.
Notably, the final regulations state in new Regs. Sec. 1.1031(a)-3(a)(1) that any property that is considered real property under the law of the relevant state or local jurisdiction counts as real property for purposes of Sec. 1031. In the conference report for the TCJA, Congress stated its intent that any property qualifying for like-kind exchanges before the TCJA should continue to qualify after its enactment (H.R. Conf. Rep’t 115-466, at 396, fn. 726 (2017)). Thus, the new regulations reemphasize state law classifications and now arguably affirm state law as the final voice on the matter.
The final regulations address one more personal property-related concern by allowing taxpayers to receive some personal property without violating exchange requirements. Existing Regs. Sec. 1.1031(k)-1(c)(5) permits taxpayers to identify a large unit of real property for a like-kind exchange that includes incidental personal property constituting up to 15% of the aggregate fair market value. For example, a taxpayer may identify a hotel it will acquire for $1,000,000 as replacement property, even if the purchase involves $850,000 of real property and $150,000 of furniture and fixtures incidental to the real property. This rule only applies to the identification of the replacement property; thus, the taxpayer in this example is still acquiring $850,000 of real property for purposes of the exchange and separately purchasing $150,000 of personal property.