Effective December 2, 2020, the IRS issued its final terms (the “Final Terms”) clarifying what real estate is under Section 1031 of the Internal Revenue Code. The IRS created these regulations to provide guidance in response to legislative changes to the Tax Reduction and Employment Act that would prevent personal property from being eligible for Section 1031 treatment. Here are some highlights from the Final Regs, including some important changes from the regulations proposed in June 2020 (the “Proposed Regs”).
- Improvements are real estate. No surprises here. Basically, inherently permanent structures (such as buildings) and the structural components contained therein (such as electrical wiring) are real estate. The Final Regs have discarded the purpose or usage test of the Proposed Regs so taxpayers don’t have to think about whether or not gas lines that a restaurant tenant installed solely to heat their fryers are real estate – according to the Final Regs, gas lines are real estate.
- If it’s real estate under state or local law, it’s likely real estate for 1031 purposes. On this point too, the final provisions deviated from the proposed provisions. The Final Regs rely more generally on state and local laws in determining what constitutes real estate. The state and local legal test applies to both tangible and intangible property and controls, unless: (a) Federal law expressly classifies the type of property as personal property. (b) the final regulations explicitly classify the type of property as real estate; or (c) after analyzing the various applicable factors provided by the Final Regs, this is considered real estate.
- Intangible real estate is real estate if it is derived from real estate or an interest in real estate and is inextricably linked to real estate or real estate interests. Think: co-ownership shares in real estate, leases, options to buy real estate, easements and land development rights. The IRS commentary on the Final Regs indicated that leases and easements may need to be long term to be of the nature, but the Final Regs only deal with what qualifies as real estate. The final provisions expressly exclude certain securities, including holdings in partnerships, from being classified as real estate. The proposed and final rules generally apply to the classification of intangible property.
- Random personal property will not disqualify your 1031 exchange if it is worth 15% or less of the deal. It has to be the type of personal property that is normally transferred with real estate (like the washing machines that come with the home you buy). You will still see a gain on that personal property, but you will not lose your 1031 tax treatment for the remainder of the transaction. The proposed and final rules are also in line with this rule.
Thankfully, the Final Regs clarify what real estate is for 1031 purposes, and do it in a tax-friendly way. Hopefully 1031 will stay long enough to make this blog post worth reading!