On June 11, 2020, the Treasury and IRS released proposed regulations under IRC Section 1031 (REG-117-589-18) (the Proposed Regulations), which define "real property" and clarify that the receipt of certain incidental personal property in an exchange will not violate the qualified intermediary safe harbor in Treas. Reg. Section 1.1031(k)-1(g)(4).

The Proposed Regulations would apply to exchanges beginning on or after the date the Proposed Regulations are published as final regulations. Taxpayers may, however, rely on the Proposed Regulations if they are followed consistently and in their entirety for exchanges of real property beginning after December 31, 2017, and before final regulations are published.

Background

As most recently amended under the Tax Cuts and Jobs Act (TCJA), IRC Section 1031(a) states the general rule that no gain or loss is recognized on the exchange of "real property" held for productive use in a trade or business or held for investment. If money or other non-like-kind property (e.g., personal property) is received in the exchange, IRC Section 1031(b) clarifies that gain is recognized to the extent of the money and the fair market value of the non-like kind property received, up to the realized gain from the transfer of the real property.

Prior to amendment by the TCJA, IRC Section 1031 also applied to exchanges of tangible personal property and certain intangible personal property. TCJA modified IRC Section 1031 by limiting its application solely to exchanges of real property, effective for exchanges completed after December 31, 2017 (with a transition rule). As a result of the amendment, the determination of whether property constitutes real property, as contrasted with personal or intangible property, has taken on greater importance. Previously, neither IRC Section 1031 nor the existing regulations defined real property for IRC Section 1031 purposes.

Real property defined

The Proposed Regulations provide a comprehensive definition of "real property" for IRC Section 1031 purposes. Highlights include the following:

• Real property includes land and improvements to land, such as buildings and other inherently permanent structures, and their structural components.
• Buildings include the following items (if permanently affixed to real property): 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 include the following items (if permanently affixed to real property): in-ground swimming pools; roads; bridges; tunnels; paved parking areas, parking facilities and other pavements; special foundations; stationary wharves and docks; fences; inherently permanent advertising displays for which an election under IRC Section 1033(g)(3) is in effect; inherently 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 drilling platforms, derricks, oil and gas storage tanks; grain storage bins and silos; enclosed transportation stations and terminals. Property not included in this safe harbor list may qualify as an "other inherently permanent structure" based on an analysis of five factors in Prop. Treas. Reg. Section 1.1031(a)-3(a)(2)(ii)(C).
• Property that "is in the nature of machinery or is essentially an item of machinery or equipment" is not an inherently permanent structure and thus, not real property, unless it qualifies as a structural component of an inherently permanent structure. For example, the proposed regulations consider a steam turbine that is permanently affixed to a building and used by an electric utility primarily to produce electricity for sale to customers as an item of "machinery"; and, therefore, not real property.
• Structural components (i.e., the item is "a constituent part of, and integrated into, an inherently permanent structure" that is owned by the taxpayer) include the following: 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. A component not included in this safe harbor list may qualify as a "structural component" based on an analysis of the four factors in Prop. Treas. Reg. Section 1.1031(a)-3(a)(2)(iii)(B).
• Real property also includes improvements to the taxpayer's land and "unsevered natural products" of the land (e.g., growing crops, plants and timber; mines; wells; and other natural deposits until they are severed, extracted or removed from the land) and water and air space superjacent to the land.
• Local law definitions are not controlling for purposes of determining whether an item constitutes real property, except for determining whether shares in a mutual ditch, reservoir or irrigation company qualify as real property.
• The determination of whether a property constitutes real property is based on a building-block approach requiring identification of each "distinct asset" comprising a property and then analyzing each distinct asset under the Proposed Regulations.
• An intangible asset qualifies as real property if it "derives its value from real property or an interest in real property, is inseparable from that real property or interest in real property, and does not produce or contribute to the production of income other than consideration for the use or occupancy of space." The proposed regulations cite a special use permit from the government to place a cell tower on government land as an example of real property, while rejecting a license from a state to operate a casino in the building as an example of real property.

Incidental personal property

Most exchanges of real property involve deferred exchanges that are facilitated through the assistance of a qualified intermediary (QI) and structured to satisfy the QI safe harbor of Treas. Reg. Section 1.1031(k)-1(g)(4). If an exchange satisfies the QI safe harbor, the QI is not treated as an agent of the taxpayer and the taxpayer is not considered in constructive receipt of the exchange funds (i.e., the proceeds from the disposition of the relinquished property) held by the QI — events that would otherwise result in the exchange being treated as a taxable sale.

The QI safe harbor requires that the taxpayer's exchange agreement with the QI expressly "limit the taxpayer's rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by the QI" as provided in Treas. Reg. Section 1.1031(k)-1(g)(6), which generally restricts such taxpayer's rights until the end of the 180-day exchange period (with certain exceptions). Treas. Reg. Section 1.1031(k)-1(g)(7) disregards the receipt of certain described items (e.g., prorated rents and property taxes) in determining whether an exchange satisfies Treas. Reg. Section 1.1031(k)-1(g)(6).

The Preamble to the Proposed Regulations indicates that taxpayers have expressed concern that the receipt of incidental personal property in connection with the receipt of real property in an exchange (e.g., the receipt of personal property in an acquired office building) could potentially be treated as the receipt of "other property," causing the taxpayer to fail to qualify for the QI safe harbor. The Proposed Regulations clarify that the receipt of certain incidental personal property will not violate the QI safe harbor. Specifically, the Proposed Regulations would revise Treas. Reg. Section 1.1031(k)-1(g)(7) to add "personal property that is incidental to real property" to the list of items that are disregarded in determining whether an exchange satisfies Treas. Reg. Section 1.1031(k)-1(g)(6). This proposed revision would also protect a taxpayer from potentially violating the qualified escrow account and qualified trust safe harbors of Treas. Reg. Section 1.1031(k)-1(g)(3).

For these purposes, personal property would be treated as incidental if: (1) the personal property is typically transferred with the real property in standard commercial transactions; and (2) the aggregate fair market value of the incidental personal property transferred with the real property does not exceed 15% of the aggregate fair market value of the replacement real property.

Implications

The Proposed Regulations are important because they provide a framework for determining whether a particular property (or component thereof) constitutes real property for purposes of IRC Section 1031, and thus would reduce uncertainties under existing law concerning the definition of real property for purposes of IRC Section 1031. The Proposed Regulations would make it clear that local law is not controlling in determining whether property is real property, with one minor exception (i.e., local law controls a state's characterization of shares in a mutual ditch reservoir or irrigation company described in IRC Section 501(c)(12)(A) if, at the time of the exchange, state law or the state's highest court recognized the shares as real property or an interest in real property).

Taxpayers should not find any surprises regarding the classification of traditional types of real property (e.g., an office building or apartment building) as real property. However, the evaluation of certain infrastructure-type property (not otherwise included in a safe harbor list) will require a building-block type of analysis. For example, the Proposed Regulations evaluate a "pipeline transmission system" (comprised of underground pipelines, isolation valves and vents, pressure control and relief valves, meters, and compressors) that is used to transport natural gas from third-party producers and gathering facilities to third-party distributors and end users, and conclude that the meters and compressors do not constitute real property, while the remainder of the pipeline transmission system does constitute real property.

The Proposed Regulations also clarify that property in the nature of "machinery" is not real property, unless it qualifies as a structural component of real property. The proposed regulations give the examples of a steam turbine permanently affixed to a building used by a utility to produce electricity for sale to customers and a 12-ton 3D printer permanently affixed to a factory building used to manufacture airplane parts as not qualifying as real property.

The definition of real property is very similar (but not identical) to the definition of real property applicable to real estate investment trusts (REITs) in Treas. Reg. Section 1.856-10, which was published in August 2016 after a multi-year development period by the IRS and Treasury.

Finally, the clarification that receiving certain incidental personal property in an exchange will not violate the QI safe harbor in Treas. Reg. Section 1.1031(k)-1(g)(4) is welcome news for taxpayers. Taxpayers should recall, however, that the receipt of such personal property will result in taxable "boot" treatment in the exchange and thus, depending on the circumstances, will either trigger taxable gain dollar-for-dollar in regards to the relinquished real property, up to the realized gain, or will be treated as taxable consideration received for other non-like-kind property disposed of in the exchange.

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