By: Juliya L. Ismailov
At the end of 2017, the Tax Cuts and Jobs Act ("TCJA") restricted like-kind exchanges under Sec. 1031 of the Tax Code to exchanges of real property. Prior to this change in the law, like-kind exchanges were available to personal property as well.
Sec. 1031(a) provides that no gain or loss is recognized on the exchange of real property held for productive use in a trade or business or for investment if such "relinquished" property is exchanged solely for "replacement" real property of like kind, which is to be held for productive use in a trade or business or for investment. Application of Sec. 1031 results in tax deferral on the subject exchange.
Below we discuss some of the specific aspects of the final regulations issued recently in furtherance of the TCJA changes to Sec. 1031.
However, as a preliminary matter, we note that President-Elect Joe Biden has proposed to eliminate the tax deferral benefits under Sec. 1031 altogether as a way to generate revenue. Further, under current rules, a taxpayer with built-in capital gain (whether or not involved in a Sec. 1031 exchange) can completely eliminate such gain by holding on to real property until death. Biden has proposed to eliminate such step-up in basis at death.
Given the Biden proposal to repeal Sec. 1031, which would not affect like-kind exchanges completed before the effective date of the repeal, and the uncertainty as to the timing of such repeal, taxpayers currently considering a Sec. 1031 exchange, or those who may not have considered it yet, are encouraged to take action sooner rather than later.
Keeping in mind the current political context, below we discuss the details of the regulations that were recently issued on November 23, pursuant to TCJA, limiting 1031 like-kind exchanges to only "real property” (T.D. 9935, https://www.irs.gov/pub/irs-drop/td_9935.pdf).
One issue addressed by the regulations is what constitutes "real property." The definition in the regulations includes the following categories:
property generally classified as real property under state and local law;
property specifically identified in the regulations, such as:
o co-op stock, land development rights, licenses and permits
OR
property that can be considered real property based on a facts-and-circumstances set forth in the regulations.
There are 3 types of tangible property incidental to real property that do qualify for 1031 treatment because they are considered to be a type of real property. These are fixtures that form an "inherently permanent structure," a "structural component," or are otherwise considered real property under state and local law.
To the extent the transaction involves non-fixtured personal property, gain or loss on such non-qualifying personal property will be recognized. However, such incidental personal property can be disregarded under the rules, when conducting the transaction through a qualified intermediary, for determining whether the taxpayer's rights to benefits from non-like kind property are expressly limited under Reg. 1.1031(k)-1(g)(6). Personal property that can be disregarded for this purpose is defined as: (i) the type customarily transferred together with real property, and (ii) whose value represents up to 15% of the aggregate fair market value of the replacement real property.
Commentators have noted that the Treasury and the IRS left some 1031-related issues unaddressed. These include applicability of Sec. 168 bonus depreciation rules, and Sec. 453 installment method to incidental personal property. In addition, with personal property no longer qualifying for Sec. 1031 treatment and being treated as "boot" received in exchange for cash, there is no guidance on the impact of liabilities related to such "boot" on cost basis and gain allocation.
The effective date of the new regulations is December 2, 2020, the date of the publication of the final regulations in the Federal Register. However, a taxpayer may rely on the previously issued proposed regulations for like-kind exchanges entered into between the Dec. 31, 2017 TCJA enactment date and Dec. 2, 2020 final regulations' publication date.
In conclusion, we note again that, given the Biden tax proposals, it behooves a taxpayer to consider entering into a like-kind exchange before Sec. 1031 may be repealed. This would allow one to defer built-in gain on a real property holding, even if the proposed repeal of the basis step-up would remove the further possibility of completely eliminating the tax, along with the incentive to hold on to capital until death.