PROPOSED § 1031 REGULATIONS
On June 12th, 2020, the Treasury published REG-117589-18 in the Federal Register. These proposed reliance regulations provide guidance on the definition of “real property” under Code § 1031. The definition in the proposed regulations would permit many assets identified as shorter-life property in a cost segregation study to be treated as real property for purposes of a LikeKind Exchange (LKE). This is welcome news to many taxpayers and practitioners concerned about the interaction between cost segregation and LKEs following the TCJA’s restriction of LKEs to real property only.
The TCJA Changes to Code § 1031
As we have discussed in the past, § 13303 of the Tax Cuts and Jobs Act amended § 1031 of the Internal Revenue Code for exchanges of property after December 31, 2017. Under the new law, only exchanges of real property qualify for the tax benefits of deferring gain recognition via a LKE. These new rules apply to all exchanges started and completed after December 31, 2017. If a taxpayer had already sold the property to be relinquished in the exchange or had received the property to be acquired in the (reverse) exchange, prior to January 1, 2018, the old rules apply. Tax practitioners have taken a variety of approaches to interpreting how this impacts cost segregation studies;
- That state law alone determined whether property is considered real or personal under § 1031; that
- all § 1245 tangible personal property is personal property under § 1031; or
- our position that relied heavily on the Service’s position in Chief Counsel Advice (CCA) 201238027 (Sep. 21, 2012), which was somewhere between the two extremes.
The proposed regulations, though differing substantively from the prior CCA, take a middle approach with similar results to our position.
The Proposed Regulations
The proposed regulations provide that real property means land and improvements to land; unsevered natural products of land; and, water and airspace super adjacent to land.1 An interest in real property will include fee ownership, co-ownership, a leasehold, an option to acquire real property, an easement, or a similar interest.2 Local law will not control the meaning of real property except in the case of shares in a mutual ditch, reservoir, or irrigation company.3 Since this article focuses on the interaction of cost segregation and LKEs, we will focus on the improvements to land. Improvements to land mean inherently permanent structures and the structural components of inherently permanent structures.4 Even though this terminology largely mirrors the terminology used under MACRS to perform cost segregation studies, these proposed regulations provide that the definition of real property applies only to Code § 1031 and no inference outside of LKEs is intended.5 Though no inference is intended, there will be some situations in which the factual determinations underlying both the MACRS and the LKE definitions of real property lead to the same result in identifying personal property. Turning back to the definition of these terms is where the proposed regulations set themselves apart from MACRS.
- Inherently Permanent Structure – An inherently permanent structure is a building or another structure that is a distinct asset and is permanently affixed to real property and will remain so indefinitely.6
- Building – The definition of a building largely mirrors the investment tax credit (ITC) definition, but also requires permanent affixation.7
- Other Inherently Permanent Structures – Similarly, “other inherently permanent structures” seems like a mash-up of the old ITC definition and the definition of asset class 00.3 Land improvements of Rev. Proc. 87-56.8 Both definitions provide lists of structures that, if permanently affixed, are considered real property.
The key difference is that, unlike under the ITC regulations, these proposed regulations do not permit buildings and other inherently structures to be defined as something other than real property based on function or appearance. Inherent permanence is the sole criterion. Unsurprisingly, the factors to determine inherent permanence also largely mirror the case law under Whiteco and its progeny.9
These regulations also take a different approach, similar to the regulations under Code § 856, in defining machinery. Property in the nature of machinery will generally not be considered real property unless it is a structural component that produces, or contributes to the production of income, other than for the use or occupancy of space.10 The regulations then go on to define “structural components” as distinct assets that are a constituent part of, and integrated into, an inherently permanent structure.11
Examples of structural components include: 12
If a distinct asset is not listed as structural component, the regulations use three factors that are similar to some of the Whiteco factors, but adds a fourth factor: whether the component is installed during the construction of the inherently permanent structure.13 If an asset is listed as a structural component in the regulations, it is treated as a distinct asset.14 Whether an unlisted item is a distinct asset depends on all of the facts and circumstances, such as
- whether it is acquired separately or as a component of a larger asset;
- whether the item is separable from a larger asset and, if so, the cost of separation;
- whether item is commonly viewed as serving a useful function independent of the larger asset; and,
- whether separating the item from the larger asset impairs the functionality of the larger asset.15
What Does This Mean for Cost Segregation
The regulations, as proposed, provide that many of the assets identified as shorter life during a cost segregation study will continue to qualify as real property for LKE purposes.
Land improvements, qualified improvement property, inherently permanent electrical, plumbing, and HVAC components that qualify as § 1245 tangible personal property would generally be treated as real property under these new regulations.
As we discussed in a previous technical update, this should have been understood prior to the proposed regulations. There may be problems with § 1245 assets that are not inherently permanent under the Whiteco factors, such as certain demountable partitions or some types of millwork. Example 9 in these proposed regulations uses facts that are very similar to the Metro National Tax Court case.16 in determining that a modular drywall partition system would not be considered real property for LKE purposes.17
These new proposed regulations also provide one additional benefit for cost segregation studies. Personal property incidental to replacement of real property will now be disregarded in determining whether the taxpayer’s rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property are expressly limited.18 Personal property is incidental real property if the personal property is typically transferred along with the real property in standard commercial transactions and its aggregate fair market value is 15% or less of the aggregate fair market value of the replacement real property. In other words, receiving incidental personal property will not blow up the entire LKE, but it may result in gain recognition. Treasury has specifically requested comments on this provision.
The proposed regulations apply to exchanges beginning on or after the date these regulations are finalized in the Federal Register. Taxpayers, however, may rely on these proposed regulations for exchanges of real property beginning after December 31, 2017 and before the final regulations are published
- Prop. Reg. § 1.1031(a)-3(a)(1).
- Prop. Reg. § 1.1031(a)-3(a)(2)(i).
- Prop. Reg. § 1.1031(a)-3(a)(6).
- Prop. Reg. § 1.1031(a)-3(a)(2)(ii)(A).
- Compare Prop. Reg. § 1.1031(a)-3(a)(2)(ii)(B) with Reg. § 1.48-1(e)(1).
- See Prop. Reg. § 1.1031(a)-3(a)(2)(ii)(C).
- Id.; cf. Whiteco Indus. v. Comm’r, 65 T.C. 664 (1975) acq. 1980-1 C.B. 1.
- Prop. Reg. § 1.1031(a)-3(a)(2)(ii)(D).
- Prop. Reg. § 1.1031(a)-3(a)(2)(iii)(A).
- Prop. Reg. § 1.1031(a)-3(a)(2)(iii)(B).
- Prop. Reg. § 1.1031(a)-3(a)(2)(iii)(B)(1) – (4).
- Prop. Reg. § 1.1031(a)-3(a)(4)(i).
- Metro Nat’l v. Comm’r, T.C. Memo 1987-38.
- Prop. Reg. § 1.1031(a)-3(b), Example 9.
- Prop. Reg. § 1.1031(k)-1(g)(7)(iii).