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Recent Proposed Regulations for 1031 Tax Exchanges

by | Nov 25, 2020 | Real Estate

Section 1031 tax exchanges are a critical tax planning tool used by investors to help defer taxes that would otherwise be incurred on gains from a real estate transaction.

In June, the U.S. Department of the Treasury issued a series of proposed regulations designed to clarify questions regarding 1031 tax exchanges (also known as “like-kind exchanges”) that arose in the wake of tax reform legislation enacted almost three years ago.

The like-kind exchange provisions under the Internal Revenue Code (IRC) allow taxpayers to defer federal income taxes on gains from the sale of real property so long as the sale proceeds are also reinvested in real property, among other, more technical requirements.  In a like-kind exchange, a taxpayer is not permitted to receive exchange proceeds that are intended to be used to acquire replacement property, otherwise, the transaction will be treated as a taxable sale.  As such, many exchanges utilize a qualified intermediary to hold exchange proceeds under a safe harbor afforded under the IRC.

Under the Tax Cuts and Jobs Act passed in December 2017 (or TJCA), 1031 tax exchanges were limited to deferrals of taxable gain on real property, and the TJCA excluded deferrals on taxable gain on personal property.  This limitation triggered a series of questions from taxpayers and their advisors regarding what constituted “real property”, and what the effect of a qualified intermediary receiving personal property as part of a real property exchange would have on the IRC safe harbor. Would, for instance, an exchange of real property stemming from a real estate transaction become a taxable sale if the transaction also included an incidental amount of personal property?

DEFINING “REAL PROPERTY”

Under IRC Section 1031, a taxpayer is permitted to defer taxable gain when real property used for business or held solely as an investment is exchanged for other business or investment property that is the same type, or “like-kind.”  If, as part of the exchange, other types of property or money are exchanged, taxable gain must be recognized to the extent of the other property and money received.  Prior to the proposed regulations, the IRC had not defined “real property.”

Under the proposed regulations, “real property” is defined as: “land and improvements to land, unsevered crops and other natural products of land, and water and air space superjacent to land. Improvements to land include inherently permanent structures and the structural components of inherently permanent structures.” The proposal provides a detailed list of structures that qualify as real property and also states that if a type of property is not listed, it may still be considered depending on the facts and circumstances.

INCIDENTAL PERSONAL PROPERTY AS PART OF A REAL PROPERTY EXCHANGE

The proposed regulations also address questions relating to personal property in an exchange that is incidental to the real property. The Treasury Department and the IRS said they are aware that taxpayers have questioned whether an exchange fails to meet the qualified intermediary safe harbor requirements (and becomes a taxable sale) if funds from the transfer of relinquished property held by a qualified intermediary are used to acquire real property, such as an office building, that also includes personal property, such as furniture in the office building.

Under the proposed rules, the IRS clarified that a qualified intermediary receiving “incidental” personal property in a real property exchange would not violate the qualified intermediary safe harbor. Personal property is “incidental” to real property acquired in an exchange if, in a standard commercial real estate transaction, “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,” the IRS said in its proposal.  While this is welcome relief for taxpayers seeking to complete a Section 1031 exchange through a qualified intermediary, taxpayers should keep in mind that receipt of even incidental personal property is considered boot and can trigger corresponding taxable gain.

MORE CHANGES AHEAD?

The proposed regulations are part of the ongoing efforts by the IRS to implement the TJCA. However, they may not be the final word on 1031 exchanges in the year ahead. Democrats in Congress and the Biden campaign have called for the end of 1031 exchanges for taxpayers who earn more than $400,000 a year.

Whether those changes will take flight remains to be seen. In the meantime, the rules proposed over the summer should help provide guidance to taxpayers and their advisors stemming from the exclusion of personal property exchanges in the TJCA—at least in the short term. For real estate investors, this means they and their advisors must continue to carefully review personal and real property assets during a real estate transaction  to ensure that they preserve 1031 exchange status and its significant tax benefits as much as possible.

Contact us for a consultation to learn more about how we help businesses navigate the complexities of 1031 tax exchange process.