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 November 23, 2020, the IRS issued final regulations (irs.gov/pub/irs-drop/td_9935.pdf) defining what constitutes “real property” for purposes of the Section 1031 like-kind exchange rules.
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.
Proposed regulations (REG-117589-18) issued earlier this year adopted a definition of real property that was substantially similar to the definition contained in the regulations defining real property under the REIT rules. (Click here for our client update on the proposed regulations). The proposed regulations further indicated that state and local law definitions of real property generally were not relevant to the determination of real property characterization for purposes of Section 1031. Although the final regulations retain the basic approach and structure of the proposed regulations, the final regulations contain a few key revisions that are generally taxpayer-favorable. The most material of these are that the final regulations (i) provide that property that is treated as real property under state or local law will be treated as real property for purposes of Section 1031 and (ii) eliminate exceptions to real property treatment for machinery or equipment and intangible property that contribute to the production of income unrelated to the use or occupancy of space.
Summary of Regulations
General. The final regulations indicate that real property under Section 1031 generally includes (i) property that, as of the date of its transfer, is classified as real property under the law of the state or local jurisdiction in which that property is located and (ii) property (regardless of its classification under state or local law) that is specifically listed as real property in the final regulations or is considered real property based on the various factors provided in the final regulations.
The final regulations (like the proposed regulations) indicate that real property 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 final 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, an easement or similar right generally is an interest in real property.
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. Affixation is considered permanent if it is reasonably expected to last indefinitely based on all the facts and circumstances.
The final regulations (like 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 platforms, (xviii) derricks, (xix) oil and gas storage tanks and (xx) grain storage bins and silos.
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:
- The manner in which the distinct asset is affixed to real property;
- Whether the distinct asset is designed to be removed or to remain in place;
- The damage that removal of the distinct asset would cause to the item itself or to the real property to which it is affixed;
- Any circumstances that suggest the expected period of affixation is not indefinite; and
- The time and expense required to move the distinct asset.
The regulations contain an example applying the foregoing factors to conclude that a pre-fabricated bus shelter that is readily moved, without significant time or expense, when bus routes change is not an inherently permanent structure and, thus, is not real property.A similar conclusion may be reached for other prefabricated structures 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 final regulations (like 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:
- The manner, time, and expense of installing and removing the component;
- Whether the component is designed to be moved;
- 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
- Whether the component is installed during construction of the inherently permanent structure
The final 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 final 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), (ii) isolation valves and vents and pressure relief valves and vents that are part of the pipeline system qualify as structural components and (iii) meters and compressors that are part of the pipeline system do not qualify as structural components. The last conclusion was reached due to the fact that, under the facts of the example, the meters and compressors were not time consuming and expensive to install and remove from the pipelines, the meters and compressors were not designed specifically for the particular pipelines for which they are a part and their removal would not cause damage to the asset or the pipelines if removed.
Machinery and Equipment. As discussed above, the final regulations eliminate exceptions (which were contained in the proposed regulations) to real property treatment for property that is an item of machinery or equipment or intangible property that contributes to the production of income unrelated to the use or occupancy of space. Instead, items of machinery or equipment are characterized as real property if they comprise an inherently permanent structure or structural component or are real property under state or local law (e.g. fixtures). The final regulations include an example concluding that a 12-ton 3D printer of aircraft wings and an electrical generator serving the building and 3D printer in a backup capacity each qualify as structural components and, thus, as real property, due to the fact that each one is costly to remove from the building in which it is located, is not designed to be moved, was installed during construction of the building and, in the case of the 3D printer, would cause damage to the building if removed. The final regulations also include an example concluding that a large steam turbine attached as a fixture to a building and which is used for the commercial production of electricity for sale to customers (as well as to generate electricity for the building) qualifies as a structural component and, thus, as real property, because the steam turbine is costly to remove from the building in which it is located, is not designed to be moved, would cause damage to the building if removed and was installed during construction of the building.
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, an easement or a similar right is an interest in real property.The final regulations also specifically list land development rights and options to acquire real property as intangible assets that qualify as real property.On the other hand, a license or permit to engage in or operate a business on real property is not real property or an interest in real property, regardless of its classification under state or local law.Examples of this would include gambling licenses and liquor licenses.
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