June 16, 2020 Proposed IRC Section 1031 regulations define "real property" for purposes of like-kind exchange rules 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:
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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