IRS Releases Proposed Regulations to Clarify Rules
On Thursday, June 11, 2020, the IRS released proposed rules to clarify the 2017 Tax Act’s limit on the kinds of property that can be traded for other property with no immediate income tax consequences under section 1031 of the Internal Revenue Code, a transaction commonly referred to as a like-kind exchange.
The 2017 Tax Act limited these tax-advantaged exchanges to “real property,” and directed the IRS to define what property qualifies. The proposed regulations define real property based on the 2017 Tax Act’s conference report and existing income tax regulations.
Prior to the amendment of section 1031 by the 2017 Tax Act, certain exchanges of personal, intangible, or real property held for use in a trade or business or for investment qualified for non-recognition of taxable gain under section 1031.
The 2017 Tax Act amendments to section 1031 generally limit the application of like-kind exchange treatment to exchanges of real property after December 31, 2017. Specifically, section 1031 provides for the nonrecognition of any gain or loss on the exchange of real property held for productive use in a trade or business or for investment if that property is exchanged solely for real property of a like-kind that is to be held either for productive use in a trade or business or for investment.
The Proposed Definition of Real Property
The proposed rules define real property to distinguish it from personal property. The legislative history of the 2017 Tax Act allows real property eligible for like-kind exchange treatment prior to the 2017 Tax Act to remain eligible.
Under the proposed regulations, the IRS applies the definition of real property from various existing income tax regulations that are consistent with the legislative history underlying the 2017 Tax Act to section 1031. Consistent with these existing regulations, the proposed regulations define real property to include “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 permanent structures and the structural components of permanent structures.
The Proposed Rule on Incidental Personal Property
The proposed regulations also include a separate rule relating to personal property in an exchange that is incidental to the real property exchanged. Under this rule, personal property is incidental to real property acquired in an exchange if, in standard commercial transactions, the personal property is typically transferred together with the real property. Furthermore, the aggregate fair market value of the incidental personal property transferred with the real property must not exceed 15 percent of the aggregate fair market value of the replacement real property.
This incidental property rule in the proposed regulations is based on an existing rule in the regulations under 1031, which allows certain incidental property to be ignored when determining whether a taxpayer has properly identified replacement property.
Further Developments on Like-King Exchanges
The proposed regulations are extensive and contain a number of examples to show what the IRS will consider as qualifying property. The proposal is now subject to a comments period before being reviewed for issuance as final regulations.
Planning for a tax-qualified exchange of like-kind real property is a complex undertaking. These proposed regulations bring some clarity to planning exchange opportunities. The Tax group at Woods Rogers will continue to monitor the developments concerning the like-kind exchange rules.