Definitions of Real and Incidental Property in New Like-Kind Exchange Regulations

Like-kind exchanges have been a vehicle for tax gain deferral since §1031 was added to the Internal Revenue Code in 1921. Put simply, §1031 allows a taxpayer to defer the gain realized in the disposition of certain property if that taxpayer receives property of the same kind in exchange (as opposed to cash or other non like-kind property). The rationale being that the taxpayer is continuing an investment by exchanging one property for another of the same kind and should not recognize gain until such investment is actually disposed of. While §1031 has seen many changes since its inception, the most recent came in 2017 with the enactment of the Tax Cuts and Jobs Act (TCJA). Specifically, §1031, as amended by the TCJA, no longer allows a taxpayer to defer gain on personal and certain intangible property and now only permits gain deferral on exchanges of real property not held primarily for sale.

In June, the IRS issued new proposed regulations that provide taxpayers with a definition as to what constitutes "real property." Per the proposed regulations, real property includes “land and improvements to land, unsevered crops and other natural products of land, and water and air space superadjacent to land.” Improvements to land include, “inherently permanent structures and structural components of inherently permanent structures."[1] The regulations also provide that an inherently permanent structure is "any structure that is permanently affixed to real property and that will ordinarily remain affixed for an indefinite period of time."

Taxpayers can look to the regulations for definitions and listed examples of the types of structures that would qualify for §1031 treatment. The lists provided are not exhaustive and, if an asset is not one specifically listed, whether the asset qualifies for §1031 treatment is determined by applying a multifactor facts and circumstances test, which is also provided in the proposed regulations.

Finally, the regulations provide that taxpayers should not rely on other provisions or laws to define property for the purposes of applying §1031.

While providing definitions of the types of property that qualify for §1031 treatment is an important addition to the regulations, it’s not the only one the IRS made in the new proposed regulations. The agency also added provisions to clarify the definition of incidental property, which is what can be received by a taxpayer, in addition to a larger piece of real property, without disqualifying the larger transaction from §1031. Personal property is considered incidental if, "in a standard commercial transaction, the personal property is typically transferred together with the real property, and the aggregate FMV of the incidental personal property transferred with the real property does not exceed 15 percent of the aggregate FMV of the replacement real property received."[2]

It was determined that this 15 percent threshold was high enough to encompass the amount of property typically transferred in a sale of real property without creating the opportunity for taxpayers to transfer, and subsequently defer gain on, assets that would not on their own qualify for like-kind exchange treatment.

The new definitions, and accompanying examples, provide taxpayers with a much clearer picture as to what qualifies for like-kind exchange treatment and, in turn, a great opportunity for reinvestment and planning for the future. If you’re someone looking to reinvest and would like to discuss whether a §1031 transaction could work for you, a Schneider Downs real estate tax advisor would love to hear from you!

[1] Prop. Treas. Reg. § 1.1031(a)-3(a).

[2] Prop. Treas. Reg. § 1.1031(k)-1(g)(7)(iii).

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Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.

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