Proposed reliance regulations clarify the definitions of “real property” that qualifies for a like-kind exchange, including incidental personal property. Under the Tax Cuts and Jobs Act (TCJA) ( P.L. 115-97), like-kind exchanges occurring after 2017 are limited to real property used in a trade or business or for investment. Comments are requested.
Real Property Defined for Like-Kind Exchanges
Under the proposed regulations, real property includes:
- land and improvements to land,
- unsevered crops and other natural products of land, and
- water and air space superjacent to land.
This real property definition language is very similar to the language in many other regulations, but it also includes necessary differences. As under pre-TCJA law, local law definitions are not controlling.
Real Property Includes Improvements and Inherently Permanent Structures
As mentioned above, real property includes improvements to land. Improvements include:
- inherently permanent structures, and
- the structural components of inherently permanent structures.
Each distinct asset must be analyzed separately to determine if it land, an inherently permanent structure, or a structural component of an inherently permanent structure. The regs identify several specific items, assets and systems as distinct assets, and provides factors for identifying other distinct assets.
Inherently Permanent Structures: Buildings and Machinery
Inherently permanent structures include any building or other structure that is permanently affixed to real property and that will ordinarily remain affixed for an indefinite period of time. A building is any structure or edifice enclosing a space within its walls, and usually covered by a roof, the purpose of which is, for example, to provide shelter or housing, or to provide working, office, parking, display, or sales space. Buildings also include several distinct assets if permanently affixed, such as houses, hotels, enclosed stadiums shopping malls, factory and office buildings, and warehouse.
The proposed regulations also identify other structures that qualify as inherently permanent structures, and provide factors that must be used to determine if other property is an inherently permanent structure.
Property that is in the nature of machinery or is essentially an item of machinery or equipment is generally not an inherently permanent structure unless it serves the inherently permanent structure and does not produce or contribute to the production of income other than for the use or occupancy of space.
Inherently Permanent Structures: Structural Components
Structural components of inherently permanent structures are improvements to land and, thus, are real property. A structural component is 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 qualify as a structural component.
However, a structural component may qualify as real property only if the taxpayer holds its interest in the component together with a real property interest within the physical space of the inherently permanent structure. Customization of a distinct asset in connection with the rental of space does not affect whether the asset is a structural component.
The proposed regulations list properties that are structural components, and provide factors for determining whether other components are structural components. The proposed regs also address tenant improvements to a building, and property produced for sale that is not real property in the hands of the producing taxpayer.
Unsevered Natural Products are Real Property
The proposed regulations provide that unsevered natural products of land are generally real property. These include growing crops, plants, and timber, as well as mines, wells and other natural deposits. Natural products and deposits, such as crops, timber, water, ores, and minerals, cease to be real property when they are severed, extracted, or removed from the land.
Intangible Assets as Real Property
An intangible asset is real property or an interest in real property to the extent that the asset:
- derives its value from real property or an interest in real property,
- is inseparable from that real property or interest in real property, and
- does not produce or contribute to the production of income other than consideration for the use or occupancy of space.
For instance, a license, permit, or other similar right generally is an interest in real property if (1) it is solely for the use, enjoyment, or occupation of land or an inherently permanent structure, and (2) it is in the nature of a leasehold, easement, or fee ownership. In contrast, a license or permit is not an interest in real property if it produces or contributes to the production of income other than consideration for the use and occupancy of space.
Incidental Personal Property and Qualified Intermediaries
The proposed regs provide that personal property that is incidental to replacement real property is disregarded in determining whether a taxpayer’s rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by a qualified intermediary are expressly limited as provided in Reg. §1.1031(k)-1(g)(6).
Personal property is incidental to real property acquired in an exchange if:
- in standard commercial transactions, the personal property is typically transferred together with the real property; and
- its aggregate fair market value does not exceed 15 percent of the aggregate fair market value of the replacement real property.
This incidental property rule in the proposed regulations is based on the existing rule in Reg. §1.1031(k)-1(c)(5), which provides that certain incidental property is ignored in determining whether a taxpayer has properly identified replacement property.
The regulations are proposed to apply to like-kind exchanges that begin on or after the date they are published as final regs. However, taxpayers may rely on them for exchanges of real property beginning after December 31, 2017, if the proposed regs are followed consistently and in their entirety.