Tax Cuts and Jobs Act and Section 1031 Like Kind Exchanges Revisited
Following the passage of Public Law Number 115-97, commonly known as the Tax Cuts and Jobs Act (TCJA), many tax professionals have questioned how the revisions to §1031 affect cost segregation studies; or more importantly, does cost segregation’s identification of tangible personal property negatively affect Like Kind Exchanges (LKEs). Under §13303 of the TCJA, §1031 now restricts like kind exchanges to real property, i.e. personal property may no longer be exchanged. Most tax professionals have taken one of two competing approaches to interpreting how this impacts cost segregation studies.
- First, many tax professionals have taken the position that state law alone determines whether property is considered real or personal under §1031.
- Second, many others have taken the position that all §1245 tangible personal property is personal property under §1031.
In light of the Service’s position in CCA 201238027 (Sep. 21, 2012), neither common position tells the entire story. Since these determinations affect whether an exchange results in taxable boot, this story is quite important to sophisticated real estate owners and their tax advisors.
In 2012, the Service issued CCA 201238027 to address complicated issues in interstate LKEs. The traditional state law tools to identify like kind property produced indeterminate answers when one state considered an asset to be real property while another considered the same asset to be personal property. Building on prior case law, the Service announced a position that also draws on Federal income tax determinations under Code §263A and §1245 to identify real or personal property under §1031. The key takeaway, however, is that the Service held that state law alone does not determine the characterization of property as like kind under §1031.So how does this work?
Defining Personal Property for LKEs
At the risk of oversimplifying the issue, a building component will be classified as §1245 tangible personal property or §1250 real property depending on two tests: (1) whether it is not inherently permanent;1or (2) whether it is an accessory to the business.2 Plumbing and electrical lines dedicated to particular items of machinery and equipment are a representative example of the latter. The former includes assets such as carpeting or appliances like a refrigerator. Though these assets are all enumerated as structural components in the former Investment Tax Credit regulations, they do not meet the test to be a structural component, which is that they no more than incidentally relate to the operation or maintenance of the building.3 When it comes to defining real property, §263A uses a slightly different scheme. The UNICAP interest capitalization regulations adopt the inherent permanency standard, but also enumerate a list of structural components. Unlike the former ITC, §263A(f) bases structural components on the enumeration in the regs.4 How did the Service implement these competing standards?
They did not provide clear guidance.
In the four examples in the 2012 CCA, the Service followed a multi-step process.
- They first looked at whether each asset is a fixture under state law, which generally leads to a classification as real property under state law.
- They then looked to whether the assets are structural components or machinery or equipment, but did not say whether they used §1245 or §263A(f), (which generally would not have made a difference for the assets discussed in the CCA).
- Finally, they looked to whether the assets were inherently permanent and would be conveyed with the property.
Based on these considerations, they determined whether the assets were of like kind. The problem is that, as discussed in CCA 200648026, some inherently permanent §1245 assets are considered real property under §263A! Nonetheless, given the prominence they assigned the inherent permanency test, it appears appropriate to favor the standards of §263A to determine whether an asset is like kind, real property.
Turning back to the cost segregation study; plumbing, electrical, and land improvements often make up the majority of assets that are reclassified to tangible personal property for Federal depreciation purposes. These asset types are usually inherently permanent and conveyed with the building property. This suggests that the facts and circumstances would usually dictate that they are like kind real property for §1031 despite their treatment as personal property for Federal depreciation. Other types of assets that are not inherently permanent may create taxable boot, though even this could offset by the related 100% bonus depreciation available.
- 1 Whiteco Indus., Inc. v. Comm’r, 65 T.C. 664 (1975)
- 2 Scott Paper Co. v. Comm’r, 74 T.C. 137 (1980).
- See Treas. Reg. § 1.48-1(e)(2.
- See CCA 200648026 (Dec. 1, 2006)/
- John Downes & Jordan Elliot Goodman, eds.
Dictionary of Finance and investment Terms.
6th Edition. New York: Barron’s, 2003.