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IRS Issues Proposed Rules Defining “Real Property” for Purposes of Tax-Free Section 1031 Like-Kind Exchanges

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Section 1031 of the Internal Revenue Code (the Code) provides for tax-free treatment in the case of exchanges of real property held for productive use in a trade or business or for investment for other real property of a like kind.  As a result of changes made to Section 1031 in 2017 by the Tax Cuts and Jobs Act (TCJA), only exchanges of “real property” qualify for tax-free treatment and exchanges of personal property, such as vehicles, boats or artwork, no longer qualify.  On June 11, 2020, the IRS issued proposed regulations (REG-117589-18) providing much-needed guidance as to what constitutes “real property” for purposes of the Section 1031 like-kind exchange rules.

The proposed regulations draw from a variety of other federal income tax rules defining “real property,” but are intended to craft a definition that is unique to the policies of Section 1031 and expressly state that no inference is intended regarding the status of property as “real property” for other purposes of the Code.

Background

The determination of what constitutes “real property” under the Section 1031 like-kind exchange rules has long been uncertain, largely due to the fact that neither the Code nor the regulations provided a definition of the term “real property” for purposes of Section 1031.  As a result, case law and IRS guidance have in many cases looked to federal tax rules under other provisions, such as Section 48 (the investment tax credit rules), Section 263A (the uniform capitalization rules), Section 856 (the REIT rules) and/or Section 897 (the FIRPTA rules), for guidance in determining what constitutes real property under Section 1031.  Yet other cases and IRS guidance have looked to state and local law to determine what constitutes real property under Section 1031.  This has led to uncertainty in situations in which assets located in a state whose laws classify such assets as real property are exchanged for similar assets located in another state whose laws classify such assets as personal property. The TCJA exacerbated the need for a Section 1031-specific definition of real property by limiting the application of Section 1031 to exchanges of real property.

Summary of Proposed Rules

General.  The proposed regulations indicate that real property under Section 1031 generally includes (i) land, (ii) improvements to land, which include inherently permanent structures and the structural components of inherently permanent structures, (iii) unsevered natural products of land, including growing crops, plants, and timber, mines, wells, and other natural deposits, and (iv) water and air space superjacent to land.  The proposed regulations further indicate that 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 or easement generally is an interest in real property.  The preamble to the proposed regulations confirms that mineral rights and the interest of a lessee in a producing oil lease constitute interests in real property for these purposes.  The proposed regulations specifically (and helpfully) provide that state and local law definitions generally are not controlling in determining the meaning of the term “real property” for purposes of Section 1031.

Inherently permanent structures.  Inherently permanent structures include any building or other structure that is a distinct asset and is permanently affixed to real property and that will ordinarily remain affixed for an indefinite period of time.

The proposed regulations include a list of items that are specifically identified as inherently permanent structures.  That list includes permanently affixed (i) in-ground swimming pools, (ii) roads, (iii) bridges, (iv) tunnels, (v) paved parking areas, parking facilities and other pavements, (vi) special foundations, (vii) stationary wharves and docks, (viii) fences, (ix) inherently permanent advertising displays for which an election under Section 1033(g)(3) is in effect, (x) inherently permanent outdoor lighting facilities, (xi) railroad tracks and signals, (xii) telephone poles, (xiii) power generation and transmission facilities, (xiv) permanently installed telecommunications cables, (xv) microwave transmission, cell, broadcasting, and electric transmission towers, (xvi) oil and gas pipelines, (xvii) offshore drilling platforms, (xviii) derricks, (xix) oil and gas storage tanks, (xx) grain storage bins and silos and (xxi) enclosed transportation stations and terminals.

In the case of property not specifically identified as an inherently permanent structure, the determination of whether the property is an inherently permanent structure is based on the following factors:

  1. The manner in which the distinct asset is affixed to real property;
  2. Whether the distinct asset is designed to be removed or to remain in place;
  3. The damage that removal of the distinct asset would cause to the item itself or to the real property to which it is affixed;
  4. Any circumstances that suggest the expected period of affixation is not indefinite; and
  5. The time and expense required to move the distinct asset.

The proposed regulations contain an example applying the foregoing factors to conclude that a pre-fabricated bus shelter that is readily moved, without damage or significant time or expense, when bus routes change is not an inherently permanent structure and, thus, is not real property.  A similar conclusion would be reached for other prefabricated buildings that can be readily moved without damage or significant time or expense.

Structural components.  Structural components of inherently permanent structures include any distinct asset that is a constituent part of, and integrated into, an inherently permanent structure. 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 be a structural component.

The proposed regulations include a list of items that are specifically identified as structural components.  That list includes the following items, provided the item is a constituent part of, and integrated into, an inherently permanent structure: (i) walls, floors, doors and ceilings, (ii) permanent coverings of walls, floors, and ceilings, (iii) partitions, (iv) wiring, pipes and ducts, (v) plumbing systems, (vi) central air conditioning and heating systems, (vii) elevators and escalators, (viii) insulation, (ix) chimneys, (x) fire suppression systems, including sprinkler systems and fire alarms, (xi) fire escapes, (xii) security systems, (xiii) humidity control systems and (xiv) other similar property.

In the case of components of a building or inherently permanent structure not specifically identified as a structural component, the determination of whether the component is a structural component is based on the following factors:

  1. The manner, time, and expense of installing and removing the component;
  2. Whether the component is designed to be moved;
  3. The damage that removal of the component would cause to the item itself or to the inherently permanent structure to which it is affixed; and
  4. Whether the component is installed during construction of the inherently permanent structure.

The proposed regulations apply the foregoing factors to conclude that modular wall partitions in an office, and raised flooring designed to support certain machinery, which in each case are readily removable, without damage or material time or expense, are not structural components and, thus, are not real property.  The proposed regulations also contain an example concluding that, in the case of a gas pipeline, (i) the determination of structural component status is made separately for the distinct assets that are part of the pipeline (i.e., the inherently permanent structure) and (ii) isolation valves and vents and pressure relief valves and vents that are part of the pipeline system qualify as structural components, while meters and compressors that are part of the pipeline system do not.

Machinery and equipment.  The proposed regulations indicate that items of machinery and equipment generally are not real property for Section 1031 purposes (regardless of how permanently affixed the machinery or equipment is), unless the machinery or equipment 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.  The proposed regulations include examples concluding that an electrical generator that provides electricity for an entire building may qualify as real property, but an electrical generator that supplies electricity solely to the manufacturing equipment within a facility would not qualify.  The proposed regulations also include an example concluding that a steam turbine used for the commercial production of electricity for sale to customers constitutes machinery that does not qualify as real property.

Licenses and permits.  As discussed above, 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 or easement generally is an interest in real property.  On the other hand, a license or permit to engage in or operate a business on real property is not real property if the license or permit produces or contributes to the production of income other than consideration for the use and occupancy of space.  Examples of this would include gambling licenses and liquor licenses.  

Effective Date. The proposed regulations generally will apply to exchanges beginning on or after the date the regulations are published as final regulations in the Federal Register. The preamble to the proposed regulations indicates that, pending issuance of the final regulations, a taxpayer may rely on the 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.

 

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