The U.S. Treasury Department and IRS today released for publication in the Federal Register a notice of proposed rulemaking (REG-117589-18) as guidance to implement the 2017 tax law changes made to the like-kind exchange rules of section 1031.
The proposed regulations [PDF 481 KB] (48 pages) amend existing regulations under section 1031 to:
Comments on these proposed regulations and requests for a public hearing must be received by a date that is 60 days after June 12, 2020 (the date when the proposed regulations will appear in the Federal Register). The preamble includes requests for comments regarding certain specific topics (some of these are noted in the following discussion).
These proposed regulations apply to exchanges beginning on or after the date the regulations are published as final regulations in the Federal Register. However, a taxpayer may rely on these proposed regulations, if followed consistently and in their entirety, for exchanges of real property beginning after December 31, 2017, and before the final regulations are published.
The 2017 tax law (Pub. L. No. 115-97)—the law that is often referred to as the “Tax Cuts and Jobs Act” (TCJA)—amended section 1031 to limit its application to exchanges of real property. Deferral under section 1031, however, is not allowed for an exchange of real property held primarily for sale.
The changes to the section 1031 rules made by the TCJA apply to exchanges completed after December 31, 2017. A transition rule provided the amended section 1031 rules do not apply to any exchange in which the taxpayer disposed of relinquished property, or received replacement property, on or before December 31, 2017.
Definition of real property
Today’s release includes a proposed definition of real property for purposes of section 1031. The definition is “very similar” to how the term is used in other regulatory provisions, including regulations under section 48, section 263(a), section 263A and section 856; however, there are differences “necessary for the proper application of section 1031.”
As explained in the preamble to the proposed regulations, real property includes land and improvements to land (defined as inherently permanent structures and structural components of inherently permanent structures), unsevered crops and other natural products of land, and water and air space superjacent to land. Real property also includes certain interests in real property, including leaseholds, easements, co-ownerships, and options to acquire real property. Finally, except in the case of a mutual ditch, reservoir, or irrigation company, local law definitions are not controlling for purposes of determining whether an item of property is real property under section 1031.
In determining whether property is land or an improvement to land, each “distinct asset” as described by the proposed regulations must be analyzed separately. The proposed regulations provides certain items of property (e.g., a building) that are considered to be distinct assets. For property that is not specifically listed as a distinct asset, the proposed regulations provide that a list of factors that must be considered, and no one factor is determinative. These rules are similar to the rules concerning distinct assets in Reg. section 1.856-10(e).
Inherently permanent structures
The preamble explains that inherently permanent structures include any building or other structure that is permanently affixed to real property and that will ordinarily remain affixed for an indefinite period of time. For this purpose, a “building” is defined as any structure or edifice enclosing a space within its walls, and usually covered by a roof, the purpose of which is, for example, to provide shelter or housing, or to provide working, office, parking, display or sales space.
“Buildings” also include the following distinct assets if permanently affixed—houses, apartments, hotels, motels, enclosed stadiums and arenas, enclosed shopping malls, factory and office buildings, warehouses, barns, enclosed garages, enclosed transportation stations and terminals, and stores. The preamble explains that the definition of buildings and these examples are derived from Reg. sections 1.48-1(e)(1) and 1.856-10(d)(2)(ii)(B).
According to the preamble, a list of structures that qualify as inherently permanent structures is provided. If property is not included in the list of inherently permanent structures, there are factors that must be used to determine whether the property is an inherently permanent structure for purposes of section 1031 (these factors are similar to the factors in Reg. section 1.856-10(d)(2)(iv)).
Structural components of inherently permanent structures
Under the proposed regulations, structural components of inherently permanent structures are also improvements to land and thus real property for purposes of section 1031. A structural component is any distinct asset that is a constituent part of, and integrated into, an inherently permanent structure.
The proposed regulations also contain a list of properties that are structural components for purposes of section 1031. For components not included in the list, the proposed regulations provide factors for determining whether the component is a structural component of a building or inherently permanent structure and thus real property for section 1031 purposes.
In addition, the preamble explains that a structural component may qualify as real property only if the taxpayer holds its interest in the structural component together with a real property interest within the physical space of the inherently permanent structure served by the structural component.
If interconnected assets work together to serve an inherently permanent structure (for example, systems that provide a building with electricity, heat or water), the assets are analyzed together as one distinct asset that may qualify as a structural component. For example, the preamble provides that a gas line that provides fuel to a building’s heating system is part of the structural component that is the heating system and, therefore, qualifies as real property for section 1031 purposes. However, if the purpose of a gas line is to provide fuel to business equipment in a building (such as fryers and ovens in a building used as a restaurant), the gas line is not a constituent part of an inherently permanent structure and therefore not real property for section 1031 purposes.
The IRS and Treasury have requested comments whether the function of a distinct asset that is not machinery is appropriate to use as the basis for determining whether the asset qualifies as real property for section 1031 purposes.
Machinery or equipment
Under the proposed regulations, property that is in the nature of machinery or equipment is generally not an inherently permanent structure and not real property under section 1031. However, in instances of a building or inherently permanent structure that includes property in the nature of machinery as a structural component, the proposed regulations provide that machinery is real property if it serves the inherently permanent structure and does not produce or contribute to the production of income other than for the use or occupancy of space.
Again, these rules regarding machinery are “very similar” to the rules in other regulations, here Reg. sections 1.263A-8(c)(4) and 1.856-10(d)(3).
Natural products of land
The proposed regulations provide that unsevered natural products of land generally are treated as real property under section 1031. This includes growing crops, plants, and timber; mines; wells; and other natural deposits. Natural products and deposits—such as crops, timber, water, ores, and minerals—cease to be real property when they are severed, extracted, or removed from the land, according to the proposed regulations.
The proposed regulations also address instances when intangible property is considered real property under section 1031.
According to the preamble, an intangible asset is real property or an interest in real property for purposes of section 1031 to the extent it: (1) derives its value from real property or an interest in real property; (2) is inseparable from that real property or interest in real property; and (3) does not produce or contribute to the production of income other than consideration for the use or occupancy of space.
For instance, a license, permit, or other similar right that is solely for the use, enjoyment or occupation of land or an inherently permanent structure, and that is in the nature of a leasehold, easement or fee ownership, generally is an interest in real property for purposes of section 1031. A license or permit to engage in or operate a business on real property, however, is not real property or an interest in real property for purposes of section 1031 if the license or permit produces or contributes to the production of income other than consideration for the use and occupancy of space.
As noted in the preamble, the rules in the proposed regulations relating to intangible assets are similar to the rules in Reg. section 1.856-10(f) and are consistent with pre-TCJA law concerning whether an intangible asset is real property for section 1031 purposes.
Qualified intermediary and incidental personal property
The proposed regulations add to the items in Reg. section 1.1031-1(g)(7) that are disregarded in determining whether the agreement between the taxpayer and the qualified intermediary expressly limits the taxpayer’s rights to receive, pledge, borrow or otherwise obtain the benefits of money or other property held by the qualified intermediary.
The proposed regulations provide that personal property that is incidental to replacement real property is disregarded in determining whether a taxpayer's rights to receive, pledge, borrow or otherwise obtain the benefits of money or other property held by a qualified intermediary are expressly limited as provided in Reg. section 1.1031(k)-1(g)(6). 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, and the aggregate fair market value of the incidental personal property transferred with the real property does not exceed 15% of the aggregate fair market value of the replacement real property.
The preamble notes that this incidental property rule is based on the existing rule in Reg. section 1.1031(k)-1(c)(5), which provides that certain incidental property is ignored in determining whether a taxpayer has properly identified replacement property under section 1031(a)(3)(A) and Reg. section 1.1031(k)-1(c).
The IRS and Treasury Department have requested comments regarding the definition of real property set forth in these proposed regulations.
Comments are specifically requested regarding the proposed relevant factors and analysis for determining the qualification of an item as real property.
The IRS and Treasury Department also are requesting comments about the proposed treatment of a taxpayer’s receipt of personal property that is incidental to the taxpayer’s replacement real property in an intended section 1031 exchange, including the appropriateness of the proposed 15% fair market value limit set forth in that test for personal property transferred with real property.
Lastly, today’s release requests comments on the removal of “outdated” regulations, and specifically concerning existing regulations under section 1031 that apply to tax years before the TCJA amendments to section 1031 limiting its application to exchanges of real property.
For more information, contact a tax professional with KPMG’s Washington National Tax:
Holly Belanger | +1 (407) 734-5564 | email@example.com
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