1031 Exchanges – Proposed Regulations on the Definition of Real Property Released

The Tax Cuts and Jobs Act (TCJA) revised what qualifies for 1031 exchange treatment as items of real property only. With this change, many were left wondering how a cost segregation analysis may play into these new definitions and requirements. If a cost segregation study was completed and items were identified within the building as personal property for depreciation purposes, would those be excluded from 1031 exchange treatment? How may that change the cost segregation and 1031 industries? Proposed regulations (REG-117589-18) were released on June 11, 2020 to provide a definition of real property and some clarification on these changes.

What is Considered Real Property?

Real property is defined in numerous areas of the code, none of which were believed by the regulation drafters to satisfy the intent and modifications to the 1031 provisions outlined in the TCJA. As a result, these proposed regulations provided a new definition of real property solely for 1031 purposes. In addition, it was mentioned that local law definitions are not controlling for purposes of determining the meaning of the term real property for these purposes. 

The regulations outline a building and its inherently permanent structures for purposes of 1031 as being permanently affixed to real property and that will ordinarily remain affixed for an indefinite period of time. The proposed regulations provide that each distinct asset must be analyzed separately from any other assets to which the asset relates to determine if it is real property.  

Property that is in the nature of machinery or is essentially an item of machinery or equipment is generally not an inherently permanent structure and not real property for purposes of the proposed regulations. In the case, however, of a building or inherently permanent structure that includes property in the nature of machinery as a structural component, the machinery is real property provided it serves the inherently permanent structure and does not produce or contribute to the production of income other than for the use or occupancy of space.

NOTE: the items of machinery that are installed to contribute to the production of income other than for the use of occupancy of space are those items that would typically be identified within a cost segregation study as personal property.

What Does This Mean?

The requirement that the determination of what is real property is made at a distinct asset level seems to indicate that an understanding of the various components within a building will be necessary to ensure that only real property is exchanged. Very rarely would these items be identified separately enough and as thoroughly as outlined within the regulations without a cost segregation study. From a 1031 exchange standpoint, very rarely have individual items within a building that are permanently affixed to the structure be specifically outlined and called out separately. The new regulations seem to indicate that a cost segregation would almost be necessary to truly confirm that what is being exchanged in a 1031 is real property. In addition, any items of personal property as determined by these regulations that are permanently affixed to the building and would go along with the sale of a building should be excluded from the 1031 transaction and sold via a separate agreement to maintain the tax benefits of a 1031 exchange.

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Julie Helms, CPA

Director, Specialty Tax Services

Julie Helms is the Director of the Specialty Tax Services group, which provides strategy, counsel and project work for a wide variety of businesses. She 10+ years of experience advising clients with fixed assets, specializing in cost segregation and expense vs. capital analyses. Julie has mastered the art of taking complicated tax law concepts and translating them into creative solutions for her clients.

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