- The Evolution of Current Tax Reform
- H.R. 1, the Tax Cuts and Jobs Act
- Statutory Exclusions
- Disregarded Entities
- The Legal Standard is “Like”, not identical
- Half-Truths and Non-Truth about §1031
- Half-truth 1: All real property is of “like-kind” to all other real property
- Half-truth #2: State law determines what is real property.
- Resulting Principles
- Other Code Sections and Regulations defining “Real Property”
- Partnership Issues
- Depreciation Recapture and §1031
- Expanded §179 Expensing
- §1031 Exchanges involving §1245 property
- Is §1245 Property real property?
- The Recapture Hurdle
- Other considerations under the new law
Limitations On §1031 Exchanges Under The New Trump Tax Act
[Adapted from work of the American Bar Association Section of Taxation
The Evolution of Current Tax Reform
In 2014, Senator Baucus and the Senate Finance Committee proposed repeal of §1031 real property exchanges, and by establishing a pooling cost recovery system for personal property there would be no need for personal property exchanges under §1031.
The Obama Administration proposed to limit gain deferral under §1031 to $1,000,000 and eliminate §1031 exchanges of art and other collectibles.
The NAR, NAREIT, FEA, Real Estate Round Table and many more groups commented and lobbied against the changes while the Congressional Joint Committee on Taxation estimated that the “Repeal Score” would be $41 Billion in additional tax revenue over 10 years.
A study by Ernst & Young sponsored by the Federation of Exchange Accomodators (FEA) and the The §1031 Like-Kind Exchange Coalition comprised of more than a dozen industry associations: National Association of Realtors (NAR), National Association of Real Estate Investment Trusts (NAREIT), Real Estate Roundtable (RER), National Multifamily Housing Council (NMHC), International Council of Shopping Centers, Inc. (ICSC), Alternative & Direct Investment Securities Association (ADISA), Associated Equipment Distributors (AED), Equipment Leasing and Finance Association (ELFA), Iowa Soybean Association (ISA), American Rental Association (ARA), and American Car Rental Association (ACRA), claimed other effects wiped out the projected $41 Billion repeal score, including
- A “lock-in” effect on property ownership
- Increased cost of capital – decrease in investment
- Negative impact on Main Street USA
- Slower economic growth & shrinking GDP
- Total impact on U.S. GDP = $8.1 Billion reduction per year
Reviewing more than 1.6 million commercial real estate transactions between 1997 and 2014, the study’s authors found the widespread use of §1031 improves liquidity and increases investment in the real estate market. The findings also show that some perceptions about the provision were not accurate.
According to the study, the temporary tax deferral provided by like-kind exchanges contributes not only to an increase in real estate investment but also an increase in overall taxes paid to the Treasury. The study found that government figures for the cost of §1031 like-kind exchanges are likely largely overstated and the benefits of the provision are overlooked.
The Economic Impact of Repealing or Limiting §1031 Like-Kind Exchanges in Real Estate was a microeconomic study by Professor David C. Ling, University of Florida, Professor Milena Petrova, Syracuse University, July 9, 2015; Supplemental Report August 20, 2017 by: Profs. David Barker, University of Iowa; David C. Ling; Milena Petrova, sponsored by FEA which found significant benefits from like-kind exchanges in 2015 because they
- encourage investment
- contribute significant federal tax revenue
- lead to job creation
- result in less debt
A revision to the study in 2017 just before the recent Tax Reform Act found that
- repeal would have a negative impact on real estate values
- the official revenue loss to the government is overstated
- revenue loss to the government is overstated due to a variety of factors
The study claimed that
- “The elimination of exchanges would disrupt many local property markets and harm both tenants and owners.”
- “The cost of §1031 is significantly overstated…”
- The many ‘micro’ and ‘macro’ benefits of providing investors with the flexibility to dispose of highly illiquid, capital intensive assets via an exchange exceed the costs.”
Supplemental findings in 2017 by Prof. David C. Ling, Prof. Milena Petrova, and Prof. David Barker found that repeal of §1031 like-kind exchanges would have a negative impact on real estate values and that the official revenue loss to the government attributed to §1031 exchange was overstated as the result of a variety of factors.
Use of like-kind exchanges is widespread. In 2017, before the change in the Tax Code, nearly 6% of all commercial real estate transactions were like-kind exchanges. In high-tax states like California, Oregon, Colorado and Arizona, like-kind exchanges made up between 10-18% of real estate transactions.
When Trump tax bill finally passed, and 2018 began, Like-kind Real Property Exchanges remained, however, popular tax deferred personal property exchanges such as those involving Artwork, Collectibles, Franchises, and Broadcast Rights had been eliminated.
H.R. 1, the Tax Cuts and Jobs Act
§13303 of the Senate amendment revised §1031(a)(1) of the Code to provide that:
“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 or productive use in a trade or business or for investment.”
- Stock in trade, inventory and other property held “primarily for sale” to customers
- Securities and promissory notes
- Partnership interests
- Certificates of trust or beneficial ownership
§1031(a)(2) – excludes real property “held primarily for sale” (i.e., “dealer” property)
§1031(h) – real property located in the U.S. is not like kind to real property outside of the U.S.
Acquiring 100% interest in a single-member limited liability company is treated as an asset acquisition (PLR 201216007, private letter ruling)
Acquiring a beneficial interest in a grantor trust is treated as acquiring an undivided interests in the trust’s assets (Rev. Rul. 2004–86)
The “Illinois Land Trust” (Rev. Rul. 92-105) standard
The Legal Standard is “Like”, not identical
“§1031(a) requires a comparison of the exchanged properties to ascertain whether the nature and character of the transferred rights in and to the respective properties are substantially alike.”
“In making this comparison, consideration must be given to the respective interests in the physical properties, the nature of the title conveyed, the rights of the parties, the duration nature or character of the properties as distinguished from their grade or quality.”
Koch v. C.I.R., 71 T.C. 54, 65 (1978)
Half-Truths and Non-Truth about §1031
Non-Truth: Incidental personal property is disregarded.
- Reg. Sec. 1.1031(k)-1(c)(5) The “15% rule” is an identification rule only.
- Reg. Sec. 1.1031(j)-1 still governs dispositions of multiple properties in a single exchange. All personal property is now included in “residual group.”
Half-truth 1: All real property is of “like-kind” to all other real property.
Real Property of like kind
- Commercial building and an unimproved lot (Burkhard Inv. Co. v. U.S., 100 F.2d 642 (9th Cir. 1938))
- City real estate and a ranch or a farm (Treas. Reg. Sec. 1.1031(c)(2); Rufland v. C.I.R., T.C. Memo. 1977-8)
- Tenancy-in-common interest and a fee interest (Rev. Rul. 79-44)
- A fee and a leasehold with 30 years or more to run (Treas. Reg. Sec. 1.1031(c)(2); Rev. Rul. 78-72)
- A remainder interest in one property and a life estate in another property where the life tenant has a life expectancy of at least 30 years (Rev. Rul. 78-4)
- A fee interest and a condominium unit (Rev. Rul. 77-423)
- A fee interest and a perpetual easement (PLR 9215049)
- Cell towers affixed to land and cable telecommunication signal distribution property affixed to land (PLR 201706009)
- A fee interest and shares in a co-op which includes a long-term occupancy right (PLR 200137032)
- A fee interest and perpetual water rights (Rev. Rul. 55¬749)
- A fee interest and most mineral estates (Rev. Rul. 73-428; Rev. Rul. 72-117)
- A fee interest in land and a fee interest in land with unharvested crops (Rev. Rul. 59-229)
Perhaps real property, but not “like kind”
- A leasehold of less than 30 years and a fee in another property (VIP Indus. Inc. v. C.I.R., T.C. Memo. 2013-157)
- A fee interest in land and building and a building only, at least in according to the IRS. (Rev. Proc. 2004-51)
- A fee interest in timberland and limited duration cutting rights (Oregon Lumber Co. v. C.I.R., 20 T.C. 192 (1953))
- Water rights of limited duration and a fee interest (Wiechens v. U.S., 228 F. Supp. 2d 1080 (D. Ariz. 2002))
- Attached railroad track and unattached railroad track (TAM 200424001, technical advice memorandum)
- A fee interest and a “carved out” mineral interest (i.e., a “production payment”) (C.I.R. v. P.G. Lake, Inc., 356 U.S. 260 (1958))
Half-truth #2: State law determines what is real property.
Which state law? Property tax? Lien priority? Transfer tax? Sales tax? and whose interpretation of which state law?
In the application of a federal revenue act, state law controls in determining the nature of the legal interest which the taxpayer had in the property. (Aquilino v. U.S., 363 U.S. 509 (1960))
A mineral right is real property under Louisiana state law and thus of like kind to other real property. (C.I.R. v. Crichton, 122 F.2d 181 (5th Cir. 1941))
Coal supply contracts constituted real property interests under New Mexico law and were of like kind to a relinquished gold mine. (Peabody Nat. Res. Co. v. C.I.R., 126 T.C. 261 (2006)) ILM 201238027 (Sept. 21, 2012)
“[S]tate law property classifications are not determinative of whether property is of like kind. Rather, the Service should consider all facts and circumstances, including state law and federal tax law classifications as appropriate.”
ILM 201238027, Natural Gas Pipelines
Whether natural gas pipelines are deemed to be realty or personalty for state or federal tax law purposes does not override the basic nature and character of the property involved. Natural gas pipelines are generally treated as real property because they are inherently permanent structures that are affixed to real property and will ordinarily remain for an indefinite period of time.
ILM 201238027, Steam Turbine and Natural Gas Pipeline
A steam turbine that is attached as a fixture in a land improvement and natural gas pipeline that is constructed along a right of way on real property are not of like kind. A Steam turbine is treated as personalty, machinery used in the production of electricity, while the natural gas pipeline is treated as real property.
- Identical assets are like-kind regardless of their classification under state law; however, with the recent elimination of personal property of any kind from §1031 treatment, it is critical to determine if such assets constitute “real property “.
- Where state laws classify assets differently, federal law will uniformly determine the “real vs. personal” property classification. Thus, assets classified under state law as real property may not be like-kind to other real property regardless of comparable ownership rights.
Other Code Sections and Regulations defining “Real Property”
- Treasury Regulations §1.856-3 defines “real estate assets” and “interests in real property” for REIT taxation.
- Code §48 determines property status for old ITC credit.
- Code §168 sets forth cost recovery rules.
- Code §263A provides uniform capitalization rules.
- Code §1245 details depreciation recapture on disposal of business property.
§1031(a)(2)(D) regarding exchanges of partnership interests has been repealed. Partnership interests cannot be exchanged because they are intangibles, and thus ineligible for §1031 treatment.
The exception is §761(a) elections out of Subchapter K.
- TIC interests, Delaware statutory trusts, and mineral royalty trusts appear to be unaffected.
- Fractional interests in aircraft are excluded as personal property.
- Drop and swap and swap and drop transactions should remain largely unchanged.
The technical termination rules of §708(b)(1)(B) have been repealed which should make is easier for buyout of a partner to be an element of a partnership exchange.
Depreciation Recapture and §1031
Changes made in the 2017 Tax Act increase the likelihood of depreciation recapture issues in an otherwise non-taxable §1031 exchange of real property.
Recaptured depreciation is treated as ordinary income and not capital gain.
§1245 recapture is more likely due to enhanced §179 expensing and 100% bonus depreciation.
§1250 recapture is more likely due to 100% bonus depreciation.
§1245 recapture for real property occurs for
- Cost segregation recharacterization of fixtures from personal to real property for depreciation purposes only (e.g. wall coverings, lighting, special wiring).
- Special categories of §1245 real property, primarily agricultural: single purpose agricultural buildings, trees, ponds. §1245(a)(3)
- §179 qualified real property.
Expanded §179 Expensing
“Qualified real property” (QRP) can be expensed to $1M under §179(f).
Improvements made to non-residential real property AND made after the property is first placed in service can also be expensed.
There are two categories of QRP:
- 1st category: (A) roofs; (B) heating, ventilation, and air-conditioning property; (C) fire protection and alarm systems; and (D) security systems.
- 2nd category: “Qualified Improvement Property (QIP): Interior improvement other than: (1) enlargement of building; (2) elevator or escalator; (3) structural framework. (defined in §168(e)(6)).
QRP expensing applies to interior improvements for office tenants, and retail and other commercial properties.
Bewareof possible §1245 recapture when properties with §179 expensing are exchanged.
§1031 Exchanges involving §1245 property
When commercial building and land containing §1245 tangible personal property are exchanged for an apartment building and land of equal fair market value (FMV) and equity, three questions must be answered:
- Is the §1245 Property real property for the purposes of a §1031 exchange?
- If so, is it like-kind to other real property?
- If so, what is the effect of depreciation recapture in the exchange?
Is §1245 Property real property?
Certain special categories of §1245 real property, like QRP or §1245(a)(3) real property are eligible for §1031 exchanges subject to depreciation recapture in many cases.
Fixtures classified as personal property are sometimes considered real property under state law but personal property for §168 purposes.
In ILM 200648026 the IRS states property classified as “tangible personal property” for §168 purposes does not control classification of real or personal for other code sections such as §263A.
But in ILM 201238027, the IRS includes §48, §263A and §1245 in analysis of whether property is real or personal for federal tax purposes in like-kind real property determination.
Although there is no guidance yet from the IRS, §168 classification may not control in real property or like-kind determination because §168 is based on the broad personal property classification under §48 (ITC). §1031, by contrast, has historically had broad definition of real property and like-kind real property.
The Recapture Hurdle
The taxpayer still must consider that the depreciation recapture rules override gain deferral under §1031.
Replacement property must have same amount of §1245 property as relinquished property or there will be §1245 recapture as ordinary income.
The replacement property can be any §1245 property to avoid recapture but it does not need to be same depreciation class. For example, a relinquished §179 roof can be exchanged for replacement §1245 property with a similar life if it is otherwise like kind real property.
§1250 property is defined as all depreciable real property that is not §1245 real property.
Replacement property under §1031 must have §1250 property at least equal to the excess of accelerated depreciation over straight line (S/L) depreciation.
Non S/L §1250 Assets such as land improvements including sidewalks and landscaping can be depreciated on a 15 year accelerated basis, or qualify for the 100% bonus depreciation which is being phased out phased out through 2027).
Other considerations under the new law
- §108 adjustments to basis can be used to offset cancellation of indebtedness income.
- There is a question whether interior improvements made to non-residential property as defined in §168(e)(6)) qualify as QIP.
- QIP can still be expensed under §179, but the recapture provisions are more onerous. Bonus depreciation is not available if the taxpayer is an “electing real estate business” for interest deductibility, as the taxpayer must elect the ADS (Alternative Depreciation System).
- §179 expensing is still available for an electing real estate business.
- A new §199A deduction provides a deduction of up to 20% of “qualified business income” for non-corporate taxpayers, but is limited to (a) 50% of W-2 wages or (b) 25% of W-2 wages plus 2.5% of unadjusted basis of qualified property. Qualified property includes depreciable real property, but excludes land.
- The new law is still unclear how to compute unadjusted basis in the case of property acquired in a like-kind exchange.
- The new interest expense limitation under §163(j) limits deductibility of business interest expense to 30% of “EBITDA” and starting in 2022, the limit is 30% of “EBIT”.
- Under the new tax law there is no grandfathering of pre-existing debt except for “real property trade or business” and “farming business” and an election must be made. There is also an exception for small businesses eligible to use the cash method.
- Taxpayers subject to the limitation should note that it reduces the advantages of post-exchange refinancings.
- Segregation of real estate assets into a qualifying business may make sense for both the interest expense limitation and for the §199A deduction but could limit the ability to coordinate exchanges.