Effective December 2, 2020, the IRS released its final rule (the “Final Rule”) clarifying what constitutes real estate under Section 1031 of the Internal Revenue Code. The IRS issued these regulations to provide guidance in response to legislative changes to the Tax Cuts and Jobs Act, which provided that personal property no longer qualifies for Section 1031 treatment. Here are some highlights of the final settlement, including some major changes from the June 2020 proposed settlement (the “proposed settlement”).
- Improvements are real property. No surprise here. Basically, inherently permanent structures (like buildings) and their structural components (like electrical wiring) are real property. The final settlement dropped the proposed settlement’s use or purpose test, which means that taxpayers do not have to consider whether the gas lines that a restaurant tenant installed exclusively to heat his fryers are real property or not – under the final settlement, the gas lines are real property.
- If it is real property under state or local law, it is likely real property for purposes of Section 1031. The final settlement departs from the proposed settlement on this point as well. The final regulations defer more broadly to state and local laws to determine what constitutes real property. The state and local law test applies to tangible and intangible property and controls, unless: (a) federal law specifically classifies the type of property as personal property; (b) the Final Settlements specifically classify the property type as real estate; or (c) upon analysis of the various applicable factors provided by the Final Settlement, it is deemed to be real property.
- Intangible property is real property if it derives its value from real property or an interest in real property and is inseparable from the real property or interest in real property.. Think of co-ownership interests in real estate, leases, options to purchase real estate, easements and land development rights. The IRS Commentary on the Final Regs noted that leases and easements may need to be long-term to be similar, but the Final Regs only deals with what is considered real estate. The Final Settlements expressly exclude certain securities, including interests in partnerships, from being classified as real property. The Proposed Settlements and Final Settlements are generally consistent regarding the classification of intangibles.
- Incidental personal property will not disqualify your 1031 exchange if it is worth 15% or less of the transaction. It should be the type of personal property typically transferred with real estate (such as washing machines that came with the building you purchased). You will still recognize any gain on that personal property, but you will not lose your 1031 tax treatment on the rest of the transaction. The Proposed Settlements and Final Settlements are also consistent on this rule.
Fortunately, the final regulations clarify what real estate is for 1031 purposes and do so in a taxpayer-friendly way. Hopefully 1031 sticks around long enough to make this blog post worth reading!