If you’re a serious real estate investor, you probably know all about tax-deferred Section 1031 like-kind exchanges. A properly structured Section 1031 exchange allows you to swap one piece of real estate property for another without paying any federal income tax — even if the property you’re unloading is greatly appreciated.
This longstanding tax break has contributed to the making of many fortunes. However, consider these two things:
No. 1. Democratic presidential candidate Joe Biden’s proposed tax plan would eliminate the Section 1031 exchange privilege.
No. 2. The IRS recently issued new regulations that define what constitutes real property to determine eligibility for Section 1031 like-kind exchanges. But those regulations won’t do you any good if your ability to make a Section 1031 exchange is eliminated, and you fail to get your exchange done before that happens. So, you might have to move fast to take advantage of the Section 1031 exchange break before a Biden tax plan could potentially take it away.
In this column, I’ll address both of these considerations after first covering some necessary background information. Here goes.
TCJA eliminated Section 1031 treatment for personal property exchanges but not for real property swaps
The Tax Cuts and Jobs Act (TCJA) permanently eliminated tax-favored Section 1031 treatment for exchanges of personal property that are completed after 12/31/17.
Thankfully, tax-favored Section 1031 treatment is still available for properly structured like-kind exchanges of real property. For today, anyway. As has always been the case, Section 1031 treatment is only allowed for exchanges of like-kind property that’s held for business or investment purposes.
So, to qualify for Section 1031 treatment after the TCJA: (1) real property must be exchanged for like-kind real property, and (2) the property relinquished in the exchange and the replacement property received in the exchange must both be held for business or investment purposes.
New IRS regulations
Before the TCJA, little attention was given to the question of what the like-kind requirement meant in the context of real property exchanges. After the TCJA, IRS has been forced to focus on what the like-kind requirement means in the context of real property exchanges, because only those exchanges still qualify for Section 1031 treatment.
Enter the recently released proposed regulations.
The term real property for Section 1031 exchange purposes means land, improvements to land, unsevered natural products of land, and water and air space superjacent to land. Superjacent means overlying. Needless to say, I had to look that up too.
Key point: The most important thing to understand here is that any property that is defined by the proposed regulations as real property can be exchanged under Section 1031 for any other property that is defined by the proposed regulations as real property — because the like-kind requirement will be met.
Real property terms of art
None of the information under this heading is very likely to surprise you. But for the record, here’s what the new proposed regulations say.
An ownership interest in real property, including fee ownership, co-ownership, a leasehold, an option to acquire real property, an easement, or a similar interest counts as real property for Section 1031 like-kind exchange purposes. So, you can exchange any of the above for any of the above, and the exchange will be a tax-deferred Section 1031 exchange — if it’s properly structured. Proper structuring is something you need to talk to your tax advisor about. It can get complicated.
Improvements to land means inherently permanent structures and the structural components of inherently permanent structures. Such improvements can be included in a tax-deferred Section 1031 exchange.
An inherently permanent structure is any building or other structure that is a distinct asset and is permanently affixed to real property and that will ordinarily remain affixed for an indefinite period.
A building is any structure or edifice enclosing a space within its walls, and 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 include houses, apartments, hotels, motels, enclosed stadiums and arenas, enclosed shopping malls, factories, office buildings, warehouses, barns, enclosed garages, enclosed transportation stations and terminals, and stores.
Inherently permanent structures also include the following assets if they are permanently affixed to real property: in-ground swimming pools; roads, bridges, and tunnels; parking facilities; paved parking areas and other paved surfaces; special foundations; stationary wharves and docks; fences; certain permanent lighting displays; permanent outdoor lighting; railroad tracks and signals; telephone poles; power generation and transmission facilities; permanently installed telecommunications cables; microwave transmission cell, broadcasting, and electric transmission towers; oil and gas pipelines; offshore drilling platforms; derricks, oil and gas storage tanks; and grain storage bins and silos.
Machinery and equipment can count as real property
Machinery and equipment are generally not considered to be inherently permanent structures and are therefore generally not classified as real property for Section 1031 exchange purposes. However, if a building or other inherently permanent structure includes machinery or equipment as a structural component, the machinery or equipment is classified as real property as long as 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. An example would be HVAC equipment and related ductwork, plumbing, and wiring.
Personal property incidental to real property counts as real property
Personal property is considered incidental to real property acquired in an exchange if: (1) the personal property in question is typically transferred together with the related real property in standard commercial transactions, and (2) the aggregate fair market value of the personal property does not exceed 15% of the aggregate fair market value of the real property. Personal property that passes these tests is classified as part and parcel of the associated real property and can therefore be included in a tax-deferred Section 1031 exchange. Examples of such personal property would apparently include backup power generators, flooring, carpeting, window treatments, and the like.
What Biden’s tax plan would do
The new proposed Section 1031 regulations seem reasonable to me. But, as I said earlier, they won’t do you any good if you fail to get your 1031 exchange done before the privilege goes bye-bye. That potential tax-law change could take effect as early as January 1. If you’ve not already done so, get with your tax advisor pronto. You may have to move fast, depending on how the Nov. 3 election turns out.