If your business is looking to sell real estate and then reinvest those proceeds into other real estate properties, there are tax implications you need to be aware of.
As a result of the Tax Cuts and Jobs Act (TCJA) enacted in 2017, the trading of like-kind personal property for other personal property is now considered a taxable event. Before the TCJA, 1031 exchanges applied to more than just real estate. In response to this change, taxpayers had numerous inquiries about the definition of “real property,” which included whether a like-kind exchange would fail if incidental personal property happened to be received.
Under Section 1031 of the United States Internal Revenue Code (26 U.S.C. § 1031), a taxpayer is eligible to defer their recognition of capital gains and related federal income tax liability when exchanging certain property types.
This is a process known as a 1031 exchange. However, it is extremely important to note that the gain will not be eliminated—it is only deferred. Under the regulations brought forth by the Department of Treasury, real property includes land and land improvements, crops and other natural products of the land, water, etc. The definition of real property also includes any permanent structures such as buildings, roads and bridges. Real property, such as a structural component of an inherently permanent structure (i.e., walls, doors and wiring) also qualifies under Section 1031. The regulations provide a list of structures that qualify as real property, as well as factors that must be used to determine if the property is considered an inherently permanent structure.
Note: Even if a property happens to not be listed in the proposed regulations, it can still be considered real property based upon a consideration of all the facts and circumstances. Certain fixed assets often accompany real property and must be analyzed to determine whether they are part of the real property. Generally, machinery or equipment is not inherently known as a permanent structure. As a result, it is not real property, unless it serves an inherently permanent structure and does not produce or contribute to the production of income other than for the use or occupancy of space. Comparatively, some structural components may be personal property rather than real property for the same reason.
Business owners may perform a functional test for these structural components to determine whether they serve an inherently permanent structure. For example, an argument can be made that under the Treasury regulations, a natural gas line to a furnace may be real property, but a similar gas line to a fryer and oven is not.
This also raises the question of incidental personal property. If a taxpayer happens to receive office furnishings in addition to an office building, does that make the Section 1031 exchange invalid? Based on the Treasury Department and its regulations, the answer would be no. Personal property can be considered incidental to the acquisition of real property whenever a personal property is customarily transferred together with an acquired real property and the fair market value of the personal property does not exceed 15% of the fair market value of the real property. However, the gain will have to be recognized as equal to the lesser of the realized gain on the relinquished property or the fair market value of the acquired personal property.
Bottom line: As long as a taxpayer sells a relinquished investment property and then purchases a replacement investment property within the applicable period, the transfer will often be valid within the eyes of the IRS.
Roman Basi is an attorney and CPA with the firm Basi, Basi & Associates at the Center for Financial, Legal & Tax Planning. He co-authored the article with Michael Hampleman, associate attorney.
