The enactment of the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, amended Sec. 1031 to apply only to exchanges of real property. Because of this change, the exchange of personal property for other personal property of like kind is now a taxable event. In response to this change, questions arose on what was defined as "real property" and whether a like-kind exchange would fail if incidental personal property was received.
On June 11, 2020, these questions were answered by Treasury through its release of proposed regulations (REG-117589-18). The proposed regulations provided a definition of real property just for Sec. 1031 exchanges and clarification for transactions where a taxpayer receives incidental personal property as part of the exchange.
DEFINITION OF REAL PROPERTY
The definition of "real property" determines whether gain is deferred versus taxable in a Sec. 1031 exchange. Under the proposed regulations, real property includes land and land improvements, unsevered crops and other natural products of land, and water and air space superjacent to land. The definition of real property includes an inherently permanent structure (i.e., buildings, roads, and bridges) or a structural component of an inherently permanent structure (i.e., walls, doors, and wiring). The proposed regulations provide a list of structures that qualify as real property as well as factors that must be used to determine if the property is considered an inherently permanent structure. Even if a property is not listed in the proposed regulations, it can still be considered real property, based on a consideration of all the facts and circumstances.
Certain fixed assets, such as machinery or equipment, often accompany real property and must be analyzed to determine whether they are part of the real property. Generally, machinery or equipment is not an inherently permanent structure and therefore is not real property, unless it serves an inherently permanent structure and does not produce or contribute to the production of income other than for the use or occupancy of space, the proposed regulations' preamble states. Likewise, some structural components may be personal property rather than real property for the same reason. Taxpayers may perform a functional test for structural components to determine whether they serve an inherently permanent structure. For example, the preamble states, a natural gas line to a furnace may be real property, but a similar gas line to a fryer and ovens is not. Treasury and the IRS requested comments on this functional-test method.
INCIDENTAL PERSONAL PROPERTY
Under a Sec. 1031 exchange, gain or loss may be recognized if money or property is received that is not of like kind to the relinquished property. Because of the change under the TCJA, the effect of the receipt of personal property incidental to the taxpayer's replacement real property in an intended Sec. 1031 exchange has become an issue. For example, if the taxpayer receives office furniture in addition to an office building, would the Sec. 1031 transaction fail and be considered a taxable sale?
The proposed regulations address this question by stating that personal property will be considered incidental to the real property acquired if:
- The personal property is customarily transferred together with the acquired real property, and
- The fair market value (FMV) of the personal property does not exceed 15% of the FMV of the real property.
If this is the case, the like-kind exchange of the real property will be maintained and valid; however, gain will need to be recognized equal to the lesser of the realized gain on the relinquished property or the FMV of the acquired personal property.
PURCHASE PRICE ALLOCATION PLANNING
Since there is a potential for gain recognition or for the like-kind exchange of real property to fail based on the FMV allocated to personal property, taxpayers contemplating or undertaking a like-kind exchange should appropriately determine the purchase price allocation. Normally, a qualified appraisal is performed to allocate the purchase price among the categories of land, building, land improvement, and personal property. If a qualified appraisal is not obtained, then the values reported on the real estate tax bill can be used. Unlike a sale of a business, the purchase price allocation for the purchase of real estate does not need to be agreed upon with the seller at the time of sale. Most often, the purchase price is not allocated to personal property, since the intent of the buyer is to purchase the real property. (For more on the allocation of sales proceeds to personal property and other Sec. 1031 issues, see "Tax Practice Corner: Like-Kind Exchanges and Personal Property," JofA, Nov. 2019.)
If the purchase price is allocated to personal property and the amount is less than 15% of FMV of the real property, the proposed regulations indicate that even though the exchange will not fail to be treated as of like-kind property, there will be gain recognition for the FMV of the personal property. However, in this situation, taxpayers may be able to take 100% additional first-year depreciation, known as "bonus depreciation," on the personal property. Under the TCJA, bonus depreciation increased to 100% from 50% for qualifying property acquired with a recovery period of 20 years or less and placed in service after Sept. 27, 2017, and before Jan. 1, 2023. Therefore, although there may be gain recognition based on the incidental acquisition of personal property, a portion of the replacement property is allocated to the personal property. Thus, the gain can be reduced by taking accelerated depreciation on the personal property.
CLARIFICATION AND RELIANCE
Due to the change under the TCJA and the limitation of like-kind exchanges only to real property, some questions were raised. In response, the proposed regulations provide clarification needed on the definition of "real property." In addition, they provide guidance on the impact of incidental personal property tied in with the real property like-kind exchange. While the proposed regulations had not been finalized as of August, taxpayers can rely on them for exchanges of real property beginning after Dec. 31, 2017, if followed consistently and in their entirety.
Brenda Graat, CPA, MBA, is a senior tax manager with Baker Tilly US LLP in Milwaukee. To comment on this article or to suggest an idea for another article, contact Paul Bonner, a JofA senior editor, at Paul.Bonner@aicpa-cima.com or 919-402-4434.