Final Section 1031 Regs Eliminate "Purpose or Use Test" from Real Property Definition

(Parker Tax Publishing December 2020)

The IRS issued final regulations under Code Sec. 1031 which amend the current like-kind exchange regulations to add a definition of real property to implement statutory changes limiting Code Sec. 1031 treatment to like-kind exchanges of real property. In the final regulations, the IRS eliminated the "purpose or use test" from the definition of "real property" in response to negative practitioner comments on the burdens that test would impose. T.D. 9935.

Background

As amended by the Tax Cuts and Jobs Act (TCJA), Code Sec. 1031(a) provides that no gain or loss is recognized on the exchange of real property held for productive use in a trade or business or for investment (relinquished real property) if the relinquished real property is exchanged solely for real property of a like kind that is to be held either for productive use in a trade or business or for investment (replacement real property). Under Code Sec. 1031(b), which was not amended by TCJA, a taxpayer must recognize gain to the extent of money and non-like-kind property the taxpayer receives in an exchange.

Also unchanged by TCJA, Code Sec. 1031(a)(3) provides that real property a taxpayer receives in an exchange is not of like-kind to the relinquished property unless, within 45 days after the taxpayer's transfer of the relinquished real property, the real property is identified as replacement real property to be received in the exchange. Reg. Sec. 1.1031(k)-1(c)(4) provides a limit on the number of properties, or the fair market value of the properties, a taxpayer may identify to meet the requirements of Code Sec. 1031(a)(3). However, under Reg. Sec. 1.1031(k)-1(c)(5), property is disregarded in evaluating the identification rules if it is incidental to a larger item of property and therefore, is not treated as property separate from the larger item. Property is incidental to a larger property if, in standard commercial transactions, the property is typically transferred with the larger item of property, and the aggregate fair market value of all of the incidental property does not exceed 15 percent of the aggregate fair market value of the larger item of property.

Under Reg. Sec. 1.1031(k)-1(f)(1) and (2), if a taxpayer actually or constructively receives money or non-like-kind property for the relinquished property before the taxpayer receives like kind replacement real property, the transaction is a sale or taxable exchange and not a like-kind exchange, even though the taxpayer may ultimately receive like-kind replacement real property. Reg. Sec. 1.1031(k)-1(g)(2) through (5) provides safe harbors, the use of which results in a taxpayer not being considered in actual or constructive receipt of the consideration for the relinquished property.

Under Reg. Sec. 1.1031(k)-1(g)(4)(i), in the case of a taxpayer's transfer of relinquished property involving a qualified intermediary (QI), the determination of whether the taxpayer is in actual or constructive receipt of money or non-like-kind property is made as if the QI is not the agent of the taxpayer. However, Reg. Sec. 1.1031(k)-1(g)(4)(i) applies only if the agreement between the taxpayer and the QI expressly limits the taxpayer's rights to receive, pledge, borrow, or otherwise obtain the benefits of money or non-like-kind property held by the QI. Reg. Sec. 1.1031(k)-1(g)(7) lists items received in an exchange that are disregarded in determining whether a taxpayer's rights to receive, pledge, borrow, or otherwise obtain the benefits of money or non-like-kind property are expressly limited.

In June, the IRS issued proposed regulations (REG-117589-18) under Code Sec. 1031. The proposed regulations provided a definition of real property for purposes of Code Sec. 1031 and provided rules addressing the receipt of personal property that is incidental to the taxpayer's replacement real property in an exchange (incidental property rule). Last week, the IRS published final regulations in T.D. 9935 that adopt the proposed regulations with modifications in response to comments from practitioners.

Final Regulations

The final regulations retain the basic approach and structure of the proposed regulations, with certain revisions. In particular, the final regulations revise the definition of "real property" in the proposed regulations to provide that property is classified as real property for Code Sec. 1031 purposes if, on the date it is transferred in an exchange, the property is real property under the law of the state or local jurisdiction in which that property is located. The final regulations also revise the proposed definition of "real property" to eliminate, with regard to both tangible and intangible properties, any consideration of whether the particular property contributes to the production of income unrelated to the use or occupancy of space (referred to as the "purpose or use test"). Finally, in Reg. Sec. 1.1031(a)-3(a)(7), the final regulations retain the language of the proposed regulations clarifying that the rules of the final regulations apply only for purposes of Code Sec. 1031 and that no inference is intended with respect to the classification or characterization of property for other purposes of the Code.

Definition of Real Property

Under the proposed regulations, state law controlled whether shares in a mutual ditch, reservoir, or irrigation company are real property for purposes of Code Sec. 1031, but aside from those enumerated asset types, state or local law definitions were not controlling for purposes of determining whether property is real property for Code Sec. 1031 purposes. In response to comments, the IRS revised the definition of "real property" in the final regulations to provide that, in general, property is real property for purposes of Code Sec. 1031 if, on the date it is transferred in an exchange, that property is classified as real property under the law of the state or local jurisdiction in which that property is located (state and local law test). The state and local law test applies to both tangible and intangible property classifications.

However, consistent with Congressional intent, the final regulations provide that property ineligible for like-kind exchange treatment before enactment of the TCJA remains ineligible, including real property that was excluded from the application of Code Sec. 1031. Before amendment by the TCJA, former Code Sec. 1031(a)(2) explicitly excluded certain assets from the application of Code Sec. 1031. Accordingly, the final regulations exclude from the definition of real property the intangible assets listed in Code Sec. 1031(a)(2) before its amendment by the TCJA, regardless of the classification of the property under state or local law, because such property never was real property eligible for like-kind exchange treatment before enactment of the TCJA.

Under the proposed regulations, real property included land and improvements to land, and improvements to land included both inherently permanent structures and the structural components of inherently permanent structures. Inherently permanent structures were buildings or other structures that are permanently affixed to real property and that will ordinarily remain affixed for an indefinite period of time. A list of structures that qualify as buildings or as

other inherently permanent structures was provided in the proposed regulations. A structural component was any distinct asset, as defined in the proposed regulations, that is a constituent part of, and integrated into, an inherently permanent structure.

The proposed regulations also considered the function of property in determining whether the property is real property for Code Sec. 1031 purposes (purpose or use test). In particular, neither tangible property, such as machinery or equipment, nor intangible property, such as licenses or permits, was classified as real property under the proposed regulations if the property contributed to the production of income unrelated to the use or occupancy of space, irrespective of any other factor under the proposed regulations.

According to the IRS, practitioners uniformly disagreed with the purpose or use test. The purpose or use test, practitioners said, improperly narrowed the scope of the definition of "real property" for Code Sec. 1031 purposes and, if adopted in the final regulations, would have treated certain types of property that have historically been treated as real property for Code Sec. 1031 purposes as personal property, contrary Congress's intent. Accordingly, the IRS revised the final regulations to eliminate a purpose or use test for tangible property. With regard to tangible property, if such property is permanently affixed to real property and will ordinarily remain affixed for an indefinite period of time, the property is generally an inherently permanent structure and thus defined as "real property" for Code Sec. 1031 purposes, irrespective of the purpose or use of the property or whether it contributes to the production of income. A structural component likewise is characterized as real property under the final regulations if it is integrated into an inherently permanent structure, regardless of whether the structural component contributes to the production of income. Therefore, under the final regulations, items of machinery and equipment are characterized as real property if they comprise an inherently permanent structure, a structural component, or are real property under the state or local law test.

Incidental Property Rule

The proposed regulations addressed the receipt of personal property that is incidental to the taxpayer's replacement real property in an exchange (incidental property rule). The incidental property rule provided that, for exchanges involving a QI, personal property that is incidental to replacement real property (incidental personal property) is disregarded in determining whether a taxpayer's rights to receive, pledge, borrow, or otherwise obtain the benefits of money or non-like-kind property held by the QI are expressly limited as provided in Reg. Sec. 1.1031(k)-1(g)(6). However, as personal property, incidental personal property is non-like-kind property that generally results in gain recognition under Code Sec. 1031(b) on the exchange. Personal property is incidental to real property acquired in an exchange if (1) in standard commercial transactions, the personal property is typically transferred together with the real property, and (2) the aggregate fair market value of the incidental personal property transferred with the real property does not exceed 15 percent of the aggregate fair market value of the replacement real property (i.e., the 15-percent limitation).

The final regulations include the incidental property rule to provide assurance to taxpayers that a qualified intermediary's use of exchange proceeds to acquire incidental personal property will not cause the taxpayer to fail to meet the requirements of Code Sec. 1031. In response to a comment, the IRS added language to the final regulations specifically providing that the receipt of incidental personal property in a Code Sec. 1031 exchange results in taxable gain to the taxpayer. The final regulations also clarify that the 15-percent limitation is calculated by comparing the value of all of the incidental properties to the value of all of the replacement real properties acquired in the same exchange.

Effective Date

The final regulations apply to exchanges beginning after the final regulations are published in the Federal Register. However, a taxpayer may rely on the proposed regulations, if followed consistently and in their entirety, for exchanges of real property beginning after December 31, 2017.

For a discussion like-kind exchanges, see Parker Tax ¶113,101.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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