If you own business or investment property, or want to exchange real property for others, you might take some time to become acquainted with “like-kind exchanges”, also known as a 1031 exchange.
As with all tax code changes, the IRS consistently makes clarifications to previously unclear areas or adjusts the language based on new policy. In 2020, there were some larger changes noted to section 1031 of the tax code. This section deals with like-kind exchanges of real property.
In today’s blog from the Cincinnati CPAs of LongSchaefer, we explain some like-kind exchange updates that clarify real property and escrow policies.
Defining “Real Property”
In the past, the definition of real property held more ambiguity. There was little difference between the state and local definitions.
The new language allows real property to be defined by local and state guidelines in addition to the list included in the final regulations. Property must also pass a facts and circumstances test.
The final regulations include updated and specific categories such as land and improvements to land, unsevered natural products of land, and water and airspace superjacent to land. Please note that property previously excluded prior to the 2017 TCJA is still excluded.
The purpose or use test that the IRS previously required to determine whether the property contributed to unrelated income no longer applies to like-kind exchanges.
Instead, the final rules state that if the tangible property is both permanently affixed and will remain affixed to the real property for an indefinite period of time, it’s considered inherently permanent and a part of the real property.
This does not automatically include temporary items that might be easily removed from the structure, including installed appliances, sheds, carports, Wi-Fi systems, and trade fixtures.
In addition, if interconnected assets serve an inherently permanent structure together, they are now analyzed as one distinct asset rather than separate assets. For example, a gas line powering a heating unit would qualify as part of the heating unit. However, if the gas line solely powered a stove or oven, it would not qualify.
Facts and Circumstances Test
Not all fixtures and assets are automatically included in the inherently permanent rule. Use the facts and circumstances test to determine if it’s eligible to be considered a part of the real property.
For each fixture, ask:
- Is the asset designed to be removed?
- Would removing the asset cause damage to the real property?
- How much time or expense do you need to move the asset?
- Are there any circumstances that suggest the fixture can stay attached for a finite period of time?
While there is still some room to get better, the facts and circumstances test are a vast improvement. The previous rule may have led to expensive and inefficient cost segregation studies.
In the past, non-real property that could be transferred as part of an exchange could potentially violate escrow rules that permit a Qualified Intermediary to facilitate an exchange not made in real-time. This is also called a third-party exchange.
The new regulations for like-kind exchanges now allow some leeway. Definitions say the fixtures or non-real property is deemed as typical for the kind of property transfer or if the aggregate value does not exceed 15 percent of the fair market value of the real property.
The new regulations are now considered incidental and will not be in violation of the escrow rules. Keep in mind, real property is still a separate transaction. These transactions are not included in the gains deferment of the exchanged real property.
The new regulations for like-kind exchanges maintain the transaction must be structured as an exchange. The seller cannot receive funds from the sale before becoming owner of the new property. Qualified intermediaries can hold the properties or funds in an escrow account within the prescribed time limit. As such, the transaction looks like an exchange.
Most of the time, the sale of any investment property not considered your primary residence can result in capital gains tax. Utilizing a 1031 like-kind exchange can help defer that tax until later. You could see a lower tax liability down the road.
On April 28, 2021, President Joe Biden introduced a new economic plan that would impact 1031 exchanges. His proposal would abolish 1031 exchanges on real estate profits higher than $500,000. As we move further into 2021, LongSchaefer will continue to monitor the impact.
Talk to LongSchaefer’s Trusted Business Advisors
If you would like to discuss tax strategies in business or investment properties, give LongSchaefer’s Cincinnati CPAs a call at 513-245-0300. Our team can help you understand if the decision you are making falls in line with applicable tax laws and if it’s the best strategy for your real property investments.