On June 11, 2020, in response to changes created by the Tax Cuts and Jobs Act of 2017 (“TCJA”), the IRS released much anticipated guidance for 1031 exchanges in the form of proposed regulations. In the regulations, the IRS addresses the definition of “real property” since 1031 exchanges are now limited to real property for exchanges completed after Dec. 31, 2017. Since personal property is no longer eligible property for a 1031 exchange, it is important for taxpayers to distinguish between real and personal property. This distinction is perhaps even more relevant when the taxpayer has done a cost-segregation study on an exchange property.
Background
When TCJA was first enacted, there was a lot of uncertainty as to what constitutes real property for purposes of 1031 exchanges, as it was not previously defined. The proposed regulations serve to clear up some of this uncertainty, with guidance that is generally favorable to taxpayers. In addition to the typical examples of real property (building, building improvements, etc.), the proposed regulations provide examples of what is considered “inherently permanent structures,” “machinery” and “structural components,” which tend to be shorter tax-life assets identified through a cost-segregation study. The proposed regulations also address the treatment of intangible assets related to real estate, such as easements and permits, stating that such assets should be generally treated as real property for section 1031 purposes to the extent they are solely for the use, enjoyment or occupation of land or an inherently permanent structure.
What this means for taxpayers
When a taxpayer is doing a 1031 exchange with relinquished property that had a previous cost segregation done, the taxpayer will need to review the original cost-segregation report for the details of the shorter tax-life assets (i.e. five, seven or 15-year property). In particular, the detailed descriptions on the cost-segregation report should be reviewed to see whether they property falls within the categories defined in the proposed regulations as “real property.” For example, the proposed regulations list building systems such as HVAC, electrical and plumbing as distinct assets that may be a “structural component.” Many cost-segregation reports would assign shorter recovery life periods for these building systems, thus making them eligible for accelerated tax depreciation. Now under the proposed regulations, these assets may also qualify as real property in a 1031 exchange.
Going forward, any future cost segregation reports should be reviewed in detail, and a best practice recommendation would be to separately classify shorter life assets on the tax depreciation report as real or personal property.
Other observations
- Before the issuance of the proposed regulations, many taxpayers were relying on state and local law to determine what was real vs. personal property for purposes of section 1031. The new rules explain that state or local law is not controlling for defining real property for 1031 exchanges.
- The definition of real property under these proposed regulations only applies for purposes of section 1031. If there is a five-year asset as determined through a cost-segregation study, that asset is still subject to section 1245 depreciation recapture rules even though it is real property for 1031 exchange purposes.
- These are only proposed regulations and would apply to exchanges beginning on or after the date the proposed regulations are published as final regulations. However, taxpayers may rely on the proposed regulations if they are followed consistently and in their entirety for exchanges of real property beginning after Dec. 31, 2017 and before final regulations are published.
- California continues to allow Section 1031 exchanges for both personal and real property.
If you have any questions on the above, GHJ’S Tax Team has as an experienced group of consultants specializing in tax-related laws and programs and can provide the tools your business needs.
