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IRS Issues Final Regulations on 1031 Exchanges

December 17, 2020

New regulations on 1031 “like-kind” exchanges have been issued by the IRS, including an updated definition of real property, and the receipt of personal property in an exchange.

Taxpayers, you’ll want to read up on final regulations on 1031 “like-kind” exchanges issued by the IRS recently. Among other things, the new regulations address the definition of real property. Here’s what you should be aware of.

What is a like-kind exchange?

Under Section 1031 of the Internal Revenue Code (IRC) you are allowed to defer gains on real or personal property, as further described below, used in a business or held for investment if, rather than selling it, you exchange it solely for property of a like-kind.

TCJA Rules

In the past, 1031 exchanges could be completed not just for real property, but for personal property in limited situations. In general, the IRS was fairly flexible on what property could be exchanged under a 1031 exchange. For example, you could swap an apartment building for a strip mall, or you could swap one business or investment property for multiple replacement properties. However, under the December 2017 Tax Cuts and Jobs Act (TCJA), Congress eliminated tax deferred like kind exchange treatment for exchanges of personal property.

As of January 1, 2018, taxpayers were unable to exchange personal or intangible property such as vehicles, artwork, collectibles, patents and other intellectual property in a 1031 exchange. In addition, like-kind exchange treatment applied only to exchanges of real property held for use in a trade or business or for investment. An exchange of real property held primarily for sale would not qualify as a like kind exchange.

This limitation led to some questions as to what property is eligible for an exchange. As we covered in a blog this past July, https://kahnlitwin.com/blogs/tax-blog/irs-issues-proposed-regulations-on-like-kind-exchanges the IRS proposed rules that would amend existing regulations to add a definition of real property.

What are the final regulations?

The new rules clarify that “real property” now includes land, and anything permanently built on or attached to land, and also includes anything that is characterized as real property by the applicable state and local laws. Certain other intangible property (including leaseholds and easements) will also qualify as real property.

For purposes of section 1031, real property is considered as such if it is:

  • Specifically listed as real property in the final regulations
  • Classified as real property under the state and local law test included in the final regulations
  • Considered real property based on all the facts and circumstances under the various factors provided in the final regulations.

The new regulations provide a definition of real property without “any consideration of whether the particular property contributes to the production of income”. Property not eligible for like-kind exchange treatment prior to TCJA remains ineligible.

Additionally the IRS has removed the “purpose or use test”. Items of machinery or equipment may be real property for purposes of section 1031 if they comprise an inherently permanent structure, a structural component or are real property under the state or local law test regardless of their purpose or use or whether they contribute to the production of income.

Good or bad news?

This is welcome news for many taxpayers, because in certain cases, items of personal property for depreciation purposes are included as real property for 1031 exchange purposes. Taxpayers now have further incentive to use cost segregation studies in conjunction with 1031 exchanges, since certain personal property may not qualify for 1031 exchange purposes, and the sale may result in a gain; however, the purchase of new personal property that is identified under a cost segregation study could be eligible for 100% bonus depreciation.

Need help understanding the changes? Contact us.

Don’t forget to check out our 2020 Year End Tax Planning Guides for Individuals and Businesses.

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