Just days before we all sat down to eat our Thanksgiving dinners, the Treasury Department gave us something else to digest: final like-kind exchange regulations.[1] These regulations define “real property” for purposes of Code section 1031 and contain several changes from the proposed regulations previously published in June 2020. This article summarizes the regulations and identifies some of the major changes from the proposed regulations.

Background

Code section 1031 defers the recognition of gain or loss on certain exchanges of like-kind property held for productive use in a trade or business or for investment. Prior to P.L. 115-97, commonly referred to as the Tax Cuts and Jobs Act (TCJA), like-kind exchanges of both real property and personal property (with certain exceptions) could qualify for tax deferral under Code section 1031. The TCJA amended Code section 1031 to limit its application to exchanges of real property. Thus, in the post-TCJA world it has become more important to distinguish between real property and personal property for purposes of the like-kind exchange rules.

Final Regulations

1. Definition of Real Property

The final regulations generally define “real property” as land and improvements to land. Improvements to land include “inherently permanent structures” and “structural components” of inherently permanent structures. However, an asset that does not meet these definitions may still qualify as real property for purposes of Code section 1031 if it constitutes real property under the law of the state or local jurisdiction in which it is located. The paragraphs below explore these definitions and rules in greater detail.

1. Inherently Permanent Structures

An “inherently permanent structure” is a building or other structure that is a distinct asset, is permanently affixed to real property, and will ordinarily remain affixed indefinitely. A structure may be affixed to real property by its weight alone.

To the extent they are permanently affixed, certain buildings and structures are specifically listed in the final regulations as inherently permanent structures, including houses, apartments, hotels, motels, enclosed stadiums and arenas, enclosed shopping malls, factories and office buildings, warehouses, barns, enclosed garages, in-ground swimming pools, roads, bridges, tunnels, paved parking areas, parking facilities, stationary wharves and docks, fences, railroad tracks and signals, telephone poles, power generation and transmission facilities, oil and gas pipelines, offshore platforms, derricks, oil and gas storage tanks, and grain storage bins and silos.

Other distinct assets not specifically listed in the regulations may still qualify as inherently permanent structures, and the final regulations provide factors for making such a determination. These factors include (i) the manner in which the distinct asset is affixed to real property, (ii) whether the distinct asset is designed to be removed or to remain in place, (iii) the damage that removal of the distinct asset would cause to the item itself or to the real property to which it is affixed, (iv) any circumstances that suggest the expected period of affixation is not indefinite, and (v) the time and expense required to move the distinct asset.

2. Structural Components

A “structural component” is any distinct asset that is a constituent part of, and integrated into, an inherently permanent structure. Generally, this would include walls; partitions; doors; wiring; plumbing systems; central air conditioning and heating systems; pipes and ducts; elevators and escalators; floors; ceilings; permanent coverings of walls, floors, and ceilings; insulation; chimneys; fire suppression systems; fire escapes; security systems; and humidity control systems.

Other assets may qualify as structural components depending on the following factors: (i) the manner, time, and expense of installing and removing the component, (ii) whether the component is designed to be moved, (iii) the damage that removal of the component would cause to the item itself or to the inherently permanent structure to which it is affixed; and (iv) whether the component is installed during construction of the inherently permanent structure.

3. State or Local Law

If property is not land or an improvement to land under the rules described above, it will generally still qualify as “real property” under Code section 1031 if, on the date it is transferred, it constitutes real property under the law of the state or local jurisdiction in which it is located (the “state or local test”). Notably, the state or local test applies to both tangible and intangible property. The addition of the state or local test is a major change from the proposed regulations, which limited the relevance of state or local law to whether shares in a mutual ditch, reservoir, or irrigation company qualify as real property.

If state law is controlling, can a state change its law to qualify any property as “real property” for purposes of Code section 1031? Aside from the impracticalities of such a change, the final regulations answer this question in the negative. Specifically, the final regulations exclude from the definition of “real property” certain intangible assets regardless of their classification under state or local law (as described in paragraph 2.b. below).

One interesting facet of the state or local test is the disparity in state and local laws across the country. Under the state or local test, a taxpayer could potentially exchange property in State A (which is real property under State A law) for the same type of property in State B (which is not real property under State B law) and fail to qualify under Code section 1031.

4. Contribution to Production of Income

One of the major changes to the definition of “real property” in the final regulations is the elimination of any consideration of whether the property contributes to the production of income. The proposed regulations excluded from the definition of “real property” both tangible and intangible property that contributes to the production of income in a manner unrelated to the use or occupancy of space (e.g., machinery, equipment). The “production of income” test raised concerns among commenters that assets historically considered real property (e.g., gas lines, cooling units, and piping) would be personal property under the regulations even if such assets were permanently affixed to real property. The IRS agreed with commenters and eliminated the production of income test in respect of both tangible and intangible property.

2. Intangible Assets

The final regulations separate intangible assets into three categories: (i) intangible assets that always qualify as real property, (ii) intangible assets that never qualify as real property, and (iii) intangible assets that may qualify as real property.

1. 1. Qualifying Intangible Assets

The final regulations treat the following intangible assets as “real property” for purposes of Code section 1031: fee ownership; co-ownership; a leasehold; an option to acquire real property; an easement; stock in a cooperative housing corporation; shares in a mutual ditch, reservoir, or irrigation company (depending on state law); and land development rights.

1. 2. Non-Qualifying Intangible Assets

The following intangible assets do not qualify as “real property” under Code section 1031 even if applicable state or local law treats them as real property: (i) stock (with the exception of stock described in paragraph 2.a. above), bonds, or notes, (ii) other securities or evidences of indebtedness or interest, (iii) interests in a partnership, (iv) certificates of trust or beneficial interests, and (v) choses in action.

1. 3. Other Intangible Assets

An intangible asset that is not specifically included or excluded from the definition of “real property” may constitute real property if it is so classified under state or local law or if it derives its value from real property and is inseparable from such real property. Additionally, a license or permit may qualify as real property if it (i) is solely for the use, enjoyment, or occupation of land or an inherently permanent structure and (ii) is in the nature of a leasehold, easement, or other similar right. However, a license or permit to engage in or operate a business on real property is not real property under Code section 1031 (regardless of its classification under state or local law).

3. Conclusion

The legislative history of the TCJA indicates Congress intended that real property eligible for like-kind exchange treatment pre-TCJA would continue to be so eligible. From this standpoint, the adoption of the state and local test and the elimination of the production of income test in the final regulations are welcome changes. Additionally, the elimination of the production of income test decreases both the complexity of the regulations and the compliance burden for taxpayers. However, there is still a fair amount of complexity, particularly in the potential for multiple (and conflicting) state and local laws to apply to a single exchange.