IRS Defines Real Property for Section 1031 Like-Kind Exchanges
The Tax Cuts and Jobs Act (TCJA) tossed an unwanted rule into Section 1031 by forbidding exchanges of personal property.
But before we move on, let’s clarify one thing: Section 1031 is not an “exchange,” which is defined by Merriam-Webster as a trade. In a tax code 1031 exchange, you generally would:
- Engage an intermediary to handle the money and the tax paperwork;
- Sell your real property; and
- Buy the replacement property
So you are buying and selling, but when you do this under the Section 1031 tax rules, you don’t pay taxes on the sale. Pretty sweet, huh?
You are not off the hook. You can look at it this way: with the exchange, you push the tax you’ve avoided to the replacement property instead.
You can keep doing this until you die, and then with the estate tax exemption, you may avoid paying any taxes—and your heirs inherit the property on its stepped-up basis. (That’s the way the death part has been for some time, except for in 2010, and the way it is at the moment.)
Now that you have the big picture, let’s see how you can put this tax-favored law to work for you.
When you meet the requirements for a Section 1031 exchange, you carry over your basis in the property you sell (surrendered property) to the property you buy (replacement property).
The tax code defers your gain until you sell the replacement property (without Section 1031). Then your total gain is taxed.
Example: John owns a rental home with an adjusted basis of $150,000 and a fair market value of $300,000. If he sold his property, he’d have to pay a 20 percent capital gains tax on the $150,000 gain, or $30,000.
Instead, he hires an intermediary who helps him exchange the rental house for a $300,00 rental duplex. The basis of John’s new property is the same as the basis of the old ($150,000). John recognizes no taxable gain on the transaction.
Now let’s say that 11 years later, John sells the duplex for $500,000. His total gain on the sale is $350,000 ($500,000 – $150,000).
You can do as many like-kind exchanges as you want. So long as you exchange for replacement property of equal or greater value, you’ll owe no tax.
But if you exchange for property of lesser value and keep some cash, you’ll have to pay tax on some or all of the cash you keep.
In practice, it’s rare for two people to swap their properties with each other in a simultaneous direct exchange.
Instead, the majority of exchanges are delayed three-party exchanges done with a qualified intermediary— ordinarily a professional who specializes in Section 1031 exchanges.
In the delayed exchange, the tax code binds you and the intermediary to strict time limits for the transactions. Your first step in this process is to hire an intermediary.
What Property Can You Exchange?
From 1921 through 2017, Section 1031 exchanges could be used for both real and personal property. For example, you could use an intermediary to sell an office building and buy a restaurant. You could trade in a business automobile on a replacement and pay no taxes on the trade-in.
But beginning in 2018, the TCJA permanently eliminated Section 1031 exchanges for personal property. Under the TCJA, you may not do a Section 1031 exchange with vehicles, equipment, machinery, artwork, collectibles, or patents and other intellectual property. Today, Section 1031 exchanges may involve only like-kind real property.
The IRS regulations broadly construe like-kind real property to include all business and investment real property in the United States, whether improved or unimproved. For example, you can exchange an office building for a farm, or exchange a ranch for a strip mall.
You may exchange foreign real property, but only with other foreign property.
What Is Real Property?
All well and good. But what exactly is “real property” in the first place? Real property often contains personal property. For example, an office building may contain office furniture and equipment. How does this impact a 1031 exchange?
Section 1031 doesn’t define “real property.” The IRS permits property owners to rely on state law to define it. State law definitions are not the same as the definitions the IRS uses for depreciation purposes.
After a three-year wait, the IRS gave us its answers in new final regulations, effective December 2, 2020.
The new regs are good news for all owners of business and investment real property. The IRS adopts a broad definition that includes virtually everything you’d view as real property and some things you likely never thought of as qualifying.
The IRS regs also make it clear that Section 1031 does not get in the way of cost segregation—a tax strategy used to speed up depreciation on real property.
Under the new regs, three categories of property qualify as real property for Section 1031:
- Property specifically listed as real property in the IRS regulations
- Property classified as real property under state or local law
- Property that satisfies an IRS facts-and-circumstances test
You need to make a determination regarding whether a property is real property for each “distinct asset” included in a Section 1031 exchange. This includes all the specific types of property listed below and other distinct assets.
Property Listed in the IRS Regulations
All the following properties are real property for Section 1031 exchange purposes.
Land: Land used in business or held for investment is always real property for Section 1031 purposes.7 Land held for sale doesn’t qualify for Section 1031 treatment.
Buildings: Buildings are permanently affixed structures with four walls and a roof. Buildings include houses, apartments, hotels, motels, enclosed stadiums and arenas, enclosed shopping malls, factories, and office buildings, warehouses, barns, enclosed garages, enclosed transportation stations and terminals, and stores.
Other Inherently Permanent Structures: These include in-ground swimming pools; roads; bridges; tunnels; paved parking areas, parking facilities, and other pavements; special foundations; stationary wharves and docks; fences; permanent advertising displays; permanent outdoor lighting facilities; railroad tracks and signals; telephone poles; power generation and transmission facilities; permanently installed telecommunications cables; microwave transmission, cell, broadcasting, and electric transmission towers; oil and gas pipelines; offshore platforms, derricks, and oil and gas storage tanks; and grain storage bins and silos.
Structural Components: The following structural components of real property are also Section 1031 real property: walls; partitions; doors; wiring; plumbing systems; central air conditioning and heating systems; pipes and ducts; elevators and escalators; floors; ceilings; permanent coverings of walls, floors, and ceilings; insulation; chimneys; fire suppression systems, including sprinkler systems and fire alarms; fire escapes; security systems; humidity control systems; and other similar property.
Real Property Under State or Local Law
All property classified as real property under state or local laws that apply where the property is located is real property for Section 1031 purposes. This is so even if it is classified as personal property under the IRS regulations.
For example, a movable mobile home not attached to land would likely not be classified as real property under the IRS regulations. It is not one of the listed types of real property, and it likely wouldn’t pass the facts-and-circumstances test described below.
But Rhode Island and New Hampshire both classify all mobile homes as real property, whether or not the home is permanently attached to land. In these states, movable mobile homes are real property for Section 1031 purposes.
IRS Facts-and-Circumstance Test
You can treat property that is not listed in the IRS regulations and is not classified as real property under state law as Section 1031 real property if it satisfies an IRS facts-and-circumstances test.
Permanent Structures: Permanent structures not listed as an inherently permanent structure above are real property if they satisfy a five-part test that looks at the following:
- The manner in which the asset is affixed to real property
- Whether the asset is designed to be removed or remain in place
- The damage that removal of the asset would cause to the item itself or to the real property
- Any circumstances that suggest the expected period of affixation is not indefinite
- The time and expense required to move the asset
Examples: A massive 30-foot-tall, 12-ton sculpture installed in a building atrium and permanently affixed to the building’s foundation is real property under this test. But a prefabricated bus shelter that you can disassemble and move with relative ease is not real property.
Unlisted Structural Components: Structural components not included in the above list can still be Section 1031 real property if they are a part of, and integrated into, an inherently permanent structure. The IRS has created a four-factor test that considers the following:
- Whether the item is customarily sold or acquired as a single unit rather than as a component part of a larger asset
- Whether the item can be separated from a larger asset, and if so, the cost of separating the item from the larger asset
- Whether the item is commonly viewed as serving a useful function independent of a larger asset of which it is a part
- Whether separating the item from a larger asset of which it is a part impairs the functionality of the larger asset.
Examples: A 12-ton 3D printer installed during a building’s construction and designed to remain in place indefinitely would be real property under this test. But a modular office partition system that you can easily move is not real property.
Other Section 1031 Real Property
Section 1031 real property also includes:
- Unsevered crops, timber, natural deposits, and other natural products of land;
- Water and air space superjacent to land;
- Licenses or permits to use real property;
- Leasehold interests in land;
- An option to buy or sell real property;
- A real property easement; and
- A co-ownership interest in real property
Incidental Personal Property
Movable items, such as furniture, are personal property for Section 1031 purposes. What if you want to acquire replacement property that contains personal property? For example, what if you wish to acquire an apartment building that contains personal property furniture and appliances?
In this event, your exchange qualifies for Section 1031 tax-free treatment provided that:
- 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.
Where the personal property contained within the replacement property does not exceed 15 percent of the total value of the combined real and personal property, no separate identification of the personal property is required.
But since it’s personal property, it’s non-like-kind real property. That makes it boot, which generally results in a taxable gain in a Section 1031 exchange.16 In Section 1031, you recognize gain to the extent of cash, reduction in debt, and fair market value of the personal property you receive in an exchange.
Example: You have an adjusted basis of $435,000 in a rental duplex that you sell for $1 million and exchange into an apartment building worth $1 million. The apartment building includes furniture, laundry machines, and other personal property with a fair market value of $100,000. Since $100,000 is less than 15 percent of $1 million, the exchange qualifies for Section 1031 tax-free treatment.
Although the apartment building, furniture, laundry machines, and other personal property are treated as one property for Section 1031, you must recognize gain of $100,000 on the fair market value of the personal property boot that you acquired in the exchange.
On the personal property, you likely have to pay some or all of the taxes on the gain at ordinary income tax rates because of Section 1245 depreciation recapture.
Cost Segregation and Section 1031
You can greatly speed up your depreciation deductions for business or investment real property if you do a cost segregation study to separately identify the personal property and land improvements.
Under regular depreciation rules, you can then depreciate certain segregated parts of the property over five, seven, or 15 years, instead of over 27.5 or 39 years for residential and commercial real property, respectively. Such segregation can create property that’s eligible for 100 percent bonus depreciation in the year of purchase.
Because the TCJA made personal property no longer eligible for Section 1031 exchanges, many tax pros had feared that any five- and seven-year property identified through cost segregation would not be included in a Section 1031 exchange.
Not so. The IRS regulations make it clear that you can define property as real property for Section 1031 and as personal property for depreciation.
Thus, you can exchange real property in a like-kind exchange even if you depreciated a portion of the relinquished property as personal property. Likewise, you can depreciate a portion of the replacement property as personal property. But you must figure the depreciation deductions using the replacement property’s carryover basis from the relinquished property.
Here are six things to remember from this article:
- Because of the TCJA, you now may use Section 1031 tax-deferred exchanges for real property only. (You have to love the “tax-deferred” part—and remember, if you keep doing this until you die, your tax-deferred part could become tax-free.)
- Real property for Section 1031 purposes includes all property defined as real property by the state or local law where the property is located.
- Real property for Section 1031 purposes includes land, buildings, inherently permanent structures, and structural components.
- You can qualify for a Section 1031 exchange so long as no more than 15 percent of the replacement property’s fair market value consists of personal property.
- You can use cost segregation on real property to speed up your deductions without damaging your Section 1031 tax advantages.
- The word “exchange” is a misnomer because in a Section 1031 exchange you don’t generally swap properties with someone else. Instead, you generally use an intermediary to help you sell your existing property and buy the replacement property.<.li>
If you want to retain more of what you make and multiply your net worth while remaining tax compliant, and discuss the possible use of a Section 1031 transaction to upgrade your rental or business property portfolio contact us at Morris + D’Angelo. This is our Expertise!
Parts of this article are published with permission from Bradford Tax Institute, © 2021 Daniel Morris, Morris + D’Angelo
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