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June 12, 2020

IRS Proposes Property Definition In Like-Kind Exchange Rules

IRS Pandemic Relief

The Internal Revenue Service on Thursday proposed a definition of property that can qualify for like-kind exchanges under changes imposed by the 2017 tax reform law, which limited the tax-favorable exchanges to real property.

Under the proposed rules, property that could be swapped in a like-kind exchange includes land, improvements to land, inherently permanent structures, unsevered crops, and water and air space on or above land. Internal Revenue Code Section 1031 permits similar property to be swapped in a tax-deferred transaction in which no gain or loss is recognized. The provision was narrowed by the Tax Cuts and Jobs Act to allow only the exchange of  "real property," which has never been defined, the government said.

"Regulations providing guidance on whether property is real property under Section 1031 are needed because taxpayers need certainty regarding whether any part of the replacement property received in an exchange is non-like-kind property," the government said.

In deciding what types of property should qualify for like-kind exchanges, the IRS and the U.S. Department of the Treasury evaluated other tax definitions of real property but chose not to adopt wholesale an existing regulatory definition, the proposed rules said. Instead, the government said it used certain portions of existing definitions that were consistent with the TCJA's amendment to Section 1031, the government said.

Under the proposed rules, to determine whether something is qualifying property, each distinct asset must be analyzed separately to determine if it is real property, which can be land, an inherently permanent structure or a structural component of an inherently permanent structure.

Real property for Section 1031 purposes includes land and improvements to land, which are "inherently permanent structures and the structural components of inherently permanent structures," the proposed rules said. Inherently permanent structures can include a building, which is any structure enclosing a space within its walls, usually has a roof and can provide a variety of uses, the government said.

Qualifying buildings that are deemed distinct assets under the proposed rules include houses, apartments, hotels, stadiums, shopping malls, factory and office buildings, warehouses, barns, enclosed garages and other listed items.

Inherently permanent structures can also include a building or structure that is permanently affixed to real property that will stay there for an indefinite period of time, the rules said.

For property not specifically listed in the proposed rules, the IRS said several factors could be examined to determine whether something is an inherently permanent structure that qualifies as a distinct asset. Those factors include how the asset is fixed to the property, if the asset is designed to be removed or remain in place, the damage incurred if removed, the time and expense required to move it and other circumstances, the IRS said.

For example, if an office building was specifically designed to support a large sculpture in the atrium that was permanently affixed through the building's foundation, the sculpture would still qualify because it is permanently affixed to the building, is meant and expected to be there indefinitely, would damage the building if removed and would cost a lot of money to remove, the IRS said.

The proposed rules would treat unsevered natural products of land such as crops, plants and timber, as well as mines and wells, as real property that qualifies for like-kind exchanges.

"Natural products and deposits, such as crops, timber, water, ores and minerals, cease to be real property when they are severed, extracted or removed from the land," the IRS said.

Section 1031 land can include "water and air space superjacent to land," the proposed rules said. For example, a marina's boat slips and end ties that are rented out to boat owners are real property because they are superjacent to land, the IRS said.

Certain intangible property can be real property, but only to the extent it derives its value from the real property, is inseparable from that real property and does not produce income other than for the use of the space, the rules said. So a license or permit that solely provides for the enjoyment and use of land can be real property for like-kind exchanges, but if that permit produces other income, it would not qualify, the IRS said.

For example, if a building owner receives a license to operate a casino, the building is a permanent structure for Section 1031, but the gambling license is not real property because it generates income through the operation of the casino business, the government said.

The proposed rules also said local law definitions of real property generally do not control what real property is for purposes of Section 1031, the government said.

The IRS and Treasury did not immediately respond to requests for comments from Law360.

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