Depending on the outcome of the upcoming presidential election, real property investors may lose the valuable benefit of capital gains deferral permitted under IRS Code Section 1031. This article explores how Section 1031 is utilized today, and what may happen to eliminate its benefits.
The Basics of Section 1031
IRS Code Section 1031 allows investors to defer paying capital gains taxes upon the exchange of an investment property as long as another “like kind” investment property is acquired with the proceeds from the sale. The Tax Cuts and Jobs Act (TCJA, adopted December 2017) changed deductions, depreciation, tax credits and other tax items that affect businesses, but it also permanently removed personal property as qualified like-kind property under Section 1031. Almost three years later, the IRS is adopting regulations that further limit the types of real property that can qualify for like-kind exchange treatment.
In order to qualify for the deferral of capital gain, the basic Section 1031 transaction involves the exchange of real property held for investment or business purposes (Relinquished Property) followed by the acquisition of like-kind real property held for investment or business purposes (Replacement Property). Seems simple enough, so why do we need new IRS regulations? Because, as the IRS acknowledges in the new regulations, “neither the Code nor the Income Tax Regulations provided a definition of the term “real property” for purposes of Section 1031.” In other words, you need to understand and meet the new definitions of “real property” in order to qualify for the deferral of capital gains taxes in a real property exchange.
Defining Real Property
So, let’s dig in to discover what constitutes a real property exchange. The regulations define real property as:
- Land and improvements to land;
- Unsevered natural products of land; and
- Water and air space overlying land.
The regulations provide much needed guidance on what types of property qualify under the foregoing categories:
- Land includes, for example, ownership, co-ownership, an option to purchase, a leasehold and an easement. Improvements to land is defined as “inherently permanent structures” (such as hotels, apartments and office buildings that are distinct assets and are permanently affixed to the real property) and the “structured components of inherently permanent structures” (such as HVAC system and associated duct work, plumbing and wiring) serving the inherently permanent structure, and not contributing to the production of income other than for the use and occupancy of the space;
- Unsevered natural products of land are treated as real property for purposes of Section 1031, and include growing crops, plants, standing timber, mines and wells. The implication here is that, once severed or extracted, they no longer constitute real property;
- The regulations offer no guidance on what constitutes “water and air space superjacent to land,” but it is in keeping with use of the phrase in other sections of the TCJA.
Incidental Personal Property
Personal property that is considered Incidental Personal Property is considered part of the Replacement Property and can be included in a tax-deferred 1031 exchange. According to the regulations, personal property is considered incidental to the Replacement Property if, (i) in a typical commercial transaction, such personal property is typically transferred with the Replacement Property, and (ii) the aggregate fair market value of the incidental personal property transferred with the Replacement Property does not exceed 15% of the aggregate fair market value of the Replacement Property.
Conclusions
You are now armed with a roadmap to ensure that your travels from the Relinquished Property to the Replacement Property are safe and rewarding. But be forewarned, Democratic presidential candidate Joe Biden’s proposed tax plan would eliminate the 1031 exchange. That change could take effect as early as Jan. 1, 2021. Can you get your like-kind exchange completed before the exchange right is eliminated?
If you have questions or would like to discuss further, please reach out to Steve Marrer (sam@kjk.com or 216.736.7267) or Kevin O’Connor (kto@kjk.com or 216.736.7213).
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