Back in 2017, the Tax Cuts & Jobs Act (TJCA) made a big change to Section 1031, which allows taxpayers to put off recognition of capital gains and associated federal income tax liability. The change meant that Section 1031 could be applied only to exchanges of real property that were being held for productive use in a trade or business or for investment, or those that were not held primarily for sale.
But what qualifies as “real property”?
After nearly four years, we have an answer. But, like all things having to do with tax code, the answer is: It’s complicated. Let’s walk through some FAQs about 1031 exchanges.
Why does this clarification matter?
Because of the TJCA, the gains or losses made on personal property exchanges after Dec. 31, 2017, weren’t eligible for deferral. That included personal property associated with real property.
According to Russell Marsan, Senior Vice President of IPX 1031, the legislative intent “was that real property that qualified for like-kind exchange treatment prior to the TCJA would continue to qualify post-TCJA.” In June 2020, the IRS issued proposed regulations that would define “real property.” After a comment period, the Treasury issued final regulations in December 2020.
What’s the new definition of real property?
The Treasury’s new regulations state that Section 1031 will abide by each state’s definition of real property.
How does Idaho define real property?
Idaho Code states that real property includes “1) lands, possessory rights to land, ditch and water rights, and mining claims, both lode and placer; 2) that which is affixed to land; 3) that which is appurtenant to land.” In other words: Land and improvements, unsevered natural products of land, and water and air space superjacent to land.
What counts as an improvement?
Quite a bit, turns out. Any structure that is inherently permanent or the structural components of a permanent property count as an improvement. So, for example, an in-ground swimming pool would count as an improvement, but an above-ground swimming pool would not. Russell has a good list of improvements here.
What if I’m not sure that the IRS would recognize an improvement on my land?
The IRS clarified their rules for considering types of improvements. To determine eligibility, the IRS will look at:
- The manner in which the asset is affixed to real property
- Whether it is designed to be permanent or removable
- Damage that removal would cause either to the asset or the real property
- Circumstances suggesting that the asset is not intended to be indefinitely affixed
- Time and expense required to move the asset.
How does the IRS determine structural components?
There are four criteria, but they essentially boil down to: Would it be extremely difficult or cost prohibitive to move the component? The criteria include:
- The manner, time and expense of installing and removing the component
- Whether the component is designed to be moved
- Damage that removal would cause to the component or the structure
- Whether it was installed during construction of the inherently permanent structure
What’s an unsevered natural product?
Those include land for growing crops, plants, and timber, as well as mines, wells, and other natural deposits like water and ore. However, these are not classified as real property if they are removed (through mining, for example).
What about other items associated with the property, like development rights?
A number of intangibles are now classified as real property, including:
- Fee ownerships like co-ops, leaseholds, options to acquire real property
- Easements or stock in a co-op housing corporation
- Shares in a mutual ditch, reservoir, or irrigation company that is treated as real property
- Land development rights
- License and permits in the nature of a leasehold, easement or similar right, that are solely for the use, enjoyment or occupation of the land or permanent structure (for example, a land use permit for a cell tower on land would qualify as real property).
If my property was ineligible before passage of the TCJA, is it eligible now?
No, not even if it could be considered real property under Idaho law.
Where can I learn more?
Every year, Russell offers advanced 1031 classes here in the Treasure Valley. We’re hoping to have him back as soon as it’s safe! In the meantime, we highly recommend his informative Insight Blog.