Overview
The Tax Cuts & Jobs Act (TCJA) altered the qualifying property types for §1031 exchanges. For exchanges completed after 12/31/17, no gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment. See P.L. 115-97, Sec. 13303(c)(1) and IRC Sec. 1031(a)(1).
Therefore, personal property no longer qualifies for gain deferral under §1031. But how do you determine if property is real or personal? The answer may depend on when the property exchange began.
Defining Property
Prior to the TCJA, Internal Legal Memorandum 201238027 provided that Federal Income Tax law, not State laws, controlled whether exchanged properties were of like kind for purposes of §1031. State law property classifications, while relevant for determining if property is real or personal property, are not determinative of whether properties are of the same nature and character. §§48, 263, 263A, 856, 897, 1245, and 1250 of the Internal Revenue Code and the regulations thereunder are informative as to whether property is real or personal for various federal income tax purposes.
Treas. Reg. §1.1250-1(e)(3) defines “real property” as any property which is not personal property within the meaning of §1.1245-3(b). §1.1245-3(b) provides that the term “personal property” means (1) tangible personal property (as defined in §1.48-1(c), relating to the definition of “section 38 property” for purposes of the investment credit), and (2) intangible personal property.
§1.48-1(c) of the regulations, in addition to providing that “[l]ocal law shall not be controlling for purposes of determining whether property is or is not “tangible” or “personal,” defines the term “tangible personal property” to mean any tangible property except land and improvements thereto, such as buildings or other inherently permanent structures (including items which are structural components of such buildings or structures). Tangible personal property includes all property (other than structural components) which is contained in or attached to a building. Further, all property which is in the nature of machinery (other than structural components of a building or other inherently permanent structure) shall be considered tangible personal property even though located outside a building. Therefore, by negative implication, real property consists of land and improvements thereto, such as buildings or other inherently permanent structures, including items which are structural components of such buildings or structures.
This definition is similar to those in other sections of the IRC. For example, §1.263A-8(c)(1) of the regulations provides, in part, that real property includes land, unsevered natural products of land, buildings, and inherently permanent structures.
A cost segregation study makes the express claim that assets reclassified to a shorter recovery period, other than the land improvements, Qualified Leasehold Improvement Property, Qualified Restaurant Property, Qualified Retail Improvement Property, and Qualified Improvement Property (which are all still real property), are not structural components of a bldg. or any other inherently permanent structure. Therefore, under the pre-TCJA definition of real property for §1031, those assets were personal property ineligible for deferral.
In June of 2020, Treasury released Prop. Reg. §1.1031(a)-3 to define “real property” for purposes of §1031 in a manner that would respect the intent of Congress that real property eligible for like-kind exchange treatment under pre-TCJA law should continue to be eligible for like-king exchange treatment in years beginning after 2017. If followed consistently and in their entirety, the proposed regulations applied to exchanges of real property beginning after December 31, 2017, and before the final regulations were published (12/3/20; see below).
Under the proposed regulations, real property included land and improvements to land, unsevered crops and other natural products of land, and water and air space superjacent to land. Improvements to land included inherently permanent structures and the structural components of inherently permanent structures. See Prop. Reg. §1.1031(a)-3(a)(1).
This definition of real property generally tracked with Treasury’s prior guidance and included the position that State law was not controlling for purposes of determining what qualifies as real property: Except for a State’s characterization of shares in a mutual ditch, reservoir, or irrigation company described in paragraph (a)(5)(i) of this section, local law definitions are not controlling for purposes of determining the meaning of the term real property under this section. See Prop. Reg. §1.1031(a)-3(a)(1). Therefore, under the proposed regulations, 5- & 7-yr property reclassifications from a cost segregation study were still personal property for purposes of §1031.
Fast forward to the release of the final regulations, applicable to exchanges beginning after 12/2/20, and taxpayers got a materially different definition of what is real property for purposes of §1031. Under Treas. Reg. §1.1031(a)-3(a)(1), real property for §1031 purposes means land, improvements to land, and property that is real property under State or local law. See also §1.1031(a)-3(a)(6): property is real property within the meaning of paragraph (a)(1) of this section under State or local law if, on the date it is transferred in an exchange, the property is real property under the law of the State or local jurisdiction in which that property is located.
According to this definition, it is possible that under State law, 5- & 7-yr property identified in a cost segregation study would qualify as real property. As an example, under Florida law, “real property” means land, buildings, fixtures, and all other improvements to land (Fla. Stat. §192.001(12)); the surface land, improvements thereto, and fixtures (Fla. Stat. §212.02(10)(h)); or the land and improvements thereto and fixtures (Fla. Stat. §212.06(14)(a)).
Goods are “fixtures” when they become so related to particular real estate that an interest in them arises under real estate law (See Fla. Stat. §680.309(1)(a)); or items that are an accessory to a building, other structure, or land and that do not lose their identity as accessories when installed but that do become permanently attached to realty (Fla. Stat. §212.06(14)(b)).
Therefore, in Florida and other similar jurisdictions, assets that are treated as personal property for Federal Income Tax depreciation purposes under §168, may qualify as fixtures under State Law, and as such, for exchanges beginning after 12/2/20, the same assets would qualify as real property for §1031 purposes under Treas. Reg. §1.1031(a)-3(a)(1) & (6).