The IRS issued Proposed Regulation 117589-18 on June 11, 2020 (the “Proposed Regs”), in response to legislative changes applicable to like-kind exchange transactions (“1031s”). The Proposed Regs address transactions involving both real property and personal property given that under the Tax Cuts and Jobs Act personal property is no longer eligible for like-kind exchange treatment. The Proposed Regs cover three topics of interest summarized below: tangible property, intangible property, and a safe harbor.

1. Tangible Property

The IRS provided numerous examples of what types of tangible property are real vs. personal. Consider these two very different illustrations.

• Sculptures: A building was specifically designed to house a large sculpture. The sculpture is permanently affixed to supports embedded in the building’s foundation. Removing the sculpture would be expensive and time-consuming and would destroy it. Everyone expects the sculpture to remain in the building indefinitely. The Proposed Regs provide that the sculpture is real property.
• Walls: A building contains interior, moveable, non-load-bearing, drywall partitions. These modular walls were not installed when the building was constructed, were typically removed when tenants vacate, were not designed to stay in place permanently, and can be easily and quickly removed without damaging the modular walls or the building. The Proposed Regs provide that the modular walls are not real property. The Proposed Regs set forth a multi-factor test for assets that are not specifically called out in it.

2. Intangible Property

The Proposed Regs also provide that certain intangible assets qualify as real property. Intangible assets qualify if their use and value relates to the real property itself as opposed to the income producing activity conducted on the real property. For example, view easements, air space rights, land use entitlements, and some permits will be considered real property. In contrast, liquor licenses and business licenses will not be considered real property.

3. Safe Harbor

Finally, the Proposed Regs address an aspect of concern with respect to like-kind exchanges that utilize a Qualified Intermediary (“QI”). Some commentators have raised an issue with respect to exchange accounts maintained by a QI. If some of the funds in the exchange account are used to purchase personal property, their concern is that the ability of the seller of the relinquished property to direct the use of funds in the exchange account for purchasing personal property will disqualify the entire exchange transaction from favorable treatment under Section 1031. The Proposed Regs negate this concern as long as the personal property does not exceed 15% of the fair market value of the replacement property and it’s the type of personal property that is typically included in standard commercial transactions. However, the Proposed Regs also state that the funds used for purchasing personal property will be boot.

In light of the Proposed Regs, negotiations between sellers and buyers as to purchase price allocation will be more important. However, the IRS is more likely to respect those allocations when the parties have opposing objectives.