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IRS Releases Final Regulations on Sec. 1031 Like-Kind Exchanges

The Tax Cuts and Jobs Act of 2017 (“TCJA”) made significant changes to types of property that qualifies for like-kind exchange treatment. Specifically, after the TCJA, only real property qualified for tax deferred exchange under Sec. 1031. This substantially reduced the number of transactions Sec. 1031 could apply to, but also led to a number of questions about what would qualify as “real property” eligible for Sec. 1031 deferral in the eyes of the IRS, as that term is not defined in Sec. 1031.

In Proposed Regulations issued in June 2020, the IRS attempted to provide a definition of real property for Sec. 1031 purposes and outlined a purpose or use test that looked to the function of the property in question in determining whether the property was real property eligible for Sec. 1031.  In response to the Proposed Regulations, the IRS received a number of comments contending that the purpose or use test would improperly narrow the scope of definition of real property and may treat property that has long been considered “real property” as not eligible for like-kind exchange.

In Final Regulations issued recently, property will be considered real property if it is specifically listed in the Regulations (including land, improvements to land and inherently permanent structures), if the property is considered real property under state or local law, or if it is considered real property based on all the facts and circumstances as outlined in the Regulations.  The Regulations include numerous examples that help to lend some clarity to the IRS position on the issue of real property.

Another issue raised by the change in the TCJA is the idea of like-kind exchanges involving some amount of non-like kind personal property.  In exchanges of real property, there is occasionally some personal property that comes along with the real property.  In light of the change in TCJA to limit exchanges to only real property, there was concern that the inclusion of some personal property would taint the exchange of real property and make it ineligible for like-kind exchange treatment.

To address this concern, the final regulations provide an incidental property rule that allows a certain amount of incidental personal property to be received without invalidating the like-kind exchange.  According to the Final Regulations, the personal property will be considered incidental to real property acquired if the personal property is typically transferred together with the real property and the aggregate fair market value of the personal property does not exceed 15% of the aggregate fair market value of the replacement property or properties.

While the receipt of incidental personal property will not invalidate the like-kind exchange, it is important to note that the personal property may result in some tax on the transaction.  The preamble to the Final Regulations confirms that any incidental personal property received would still be considered taxable “boot” received in the exchange under the provisions of Sec. 1031.

The Final Regulations provide some much-needed certainly for taxpayers seeking to complete Sec. 1031 exchanges after TCJA.

Author: Brian T Lovett, CPA, CGMA, JD | blovett@withum.com

Please reach out to your Withum tax advisor to see how these new Regulations may impact your like-kind exchange.

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