By Michael Benguigui, CPA
The IRS recently released long awaited guidance on Sec. 1031 (like-kind exchanges) and defines what property qualifies for the deferred tax treatment. With the enactment of Tax Cuts and Jobs Act (TCJA), rules provide that no gain or loss is recognized on the sale or exchange of “real property” held in a trade or business or for investment. Prior to the TCJA, “personal property” (like automobiles, machinery or equipment) applied for the deferral. This change means a real estate investor recognizes gain to the extent of money and personal property ineligible for the tax deferral.
With the new Biden Administration, it is wondered whether Sec. 1031 will be changed or eliminated as an avenue to higher taxes. Some proposals call for rolling back tax breaks for investors with incomes over $400,000.
A like-kind exchange is key to taxpayers who sell real estate and it may be important to take advantage of the deferred tax treatment sooner rather than later. With that, the purpose of this article is to identify what “real property” is.
Real property includes land and improvements to land. Improvements to land include both inherently permanent structures and the structural components of inherently permanent structures. Inherently permanent structures are buildings or other structures that are permanently affixed to real property and that will ordinarily remain affixed for an indefinite period of time.
The following are examples of inherently permanent structures: walls, partitions, doors, wiring, plumbing system, 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.
The following factors help determine whether something is an inherently affixed structural component:
- The manner, time and expense of installing and removing the component
- Whether the component is designed to be moved
- The damage that removal of the component would cause to itself or to the inherently permanent structure it is affixed to
- Installed during construction of the inherently permanent structure
Items not permanently affixed to real property, such as appliances, furniture and other personal property are ineligible for like-kind exchange deferral at the time of sale.
Real property includes certain intangible items such as the following:
- Leasehold interests with lease term of at least 30 years
- Stock held by a person as a tenant-stockholder in a cooperative housing corporation
- Development rights for land
- License, permit or other similar right for sole use, enjoyment or occupation of land or inherently permanent structure
Incidental Property Rule:
In terms of a replacement property purchase, usually the real estate being acquired will include personal property as part of the acquisition. The like-kind exchange rules will consider personal property to be incidental to real property acquired if:
- Personal property is transferred together with the real property
- The aggregate fair market value of the incidental personal property transferred with the real property does not exceed 15% of the aggregate fair market value of the replacement real property (15% limitation). This limitation is calculated by comparing the value of the incidental properties to the value of all the replacement real properties acquired in the same exchange
The 15% limitation is not a bright-line test (or Safe Harbor) for determining whether a transaction fails to meet the requirements of an exchange under Sec. 1031 as all of the facts and circumstances of the taxpayer’s situation are considered.
Get in the Know
If you are contemplating selling real estate, the new guidance on the like-kind exchange rules can create pitfalls and trap the unwary taxpayers. Couple that with a new Administration that may bring about change and it is important that you have a knowledgeable advisor in your corner that can help you navigate the nuances.
About the Author
Michael Benguigui, CPA is a Senior Manager at Sax LLP and a member of the firm’s Real Estate Practice. He specializes in tax and accounting services for property owners, developers and private equity investors. Michael can be reached at firstname.lastname@example.org.