Real News in the Definition of Real Property for Purposes of Section 1031 Exchanges
Most real estate investors are familiar with section 1031 exchanges, and by now, most of these investors have also likely been informed that the Tax Cuts and Jobs Act, passed at the end of 2017, limited the application of that section to exchanges of “real property.” Although this change continues to allow real estate investors to benefit from tax deferral through section 1031, it puts more pressure on identifying exactly what type of property qualifies as real property for purposes of that section. Only property that qualifies as real property for that purpose continues to enjoy the benefit of section 1031.
Perhaps somewhat surprisingly, the U.S. income tax has no single definition of real property. Instead, the tax code and regulations will vary the definition of real property from rule-to-rule. Although there are significant similarities in these definitions, enough variation exists to create some doubt regarding how real estate investors should interpret the term “real property” in the context of section 1031.
At the end of 2020, the U.S. Treasury helped address some of this uncertainty by issuing regulations that provide taxpayers with guidance regarding the definition of real property for purposes of section 1031. The regulations are effective for exchanges beginning after December 2, 2020. Generally, the regulations define real property in a common-sense way as land and improvements to land, unsevered natural products of land, water and air space over land, and certain intangible interests in real property.
We will focus here on two aspects of the regulations – (i) the meaning of an “improvement to land” and (ii) the ability to treat certain intangible assets as real property for purposes of section 1031. These categories of assets tend to create the most uncertainty, as many of the other categories of real property listed in the regulations are self-evident.
A significant portion of the new regulations is devoted to teasing out the definition of an “improvement to land.” In this regard, the regulations can be thought of as having two components – (i) a general deference to the state or local law classification of property as real property (the “local law rule”) and (ii) a framework for analyzing whether property that is not classified as real property under the local law rule is nevertheless treated as real property for purposes of section 1031 (the “federal tax rule”).
a. The local law rule:
With respect to the local law rule, the regulations provide that (outside a narrow band of intangible-type assets discussed below), property classified as real property under state or local law on the date it is transferred in an exchange is real property for purposes of section 1031. The relevant state or local law is the law of the jurisdiction in which the property is located. Accordingly, provided that each property subject to an exchange qualifies as real property in the jurisdiction in which the property is located, each property will be considered real property for purposes of section 1031.
It is important to note, however, that differences in local law can potentially result in inconsistent treatment of similar property under the local law rule. For example, let’s assume an investor wants to exchange Property A, which is located in Oregon, for Property B, which is located in Washington, and that both Property A and Property B would be treated as real property under Oregon law. However, assume further that Property B is not considered real property under Washington law. In that case, because Property B is not considered real property in Washington (i.e., the jurisdiction in which it is located), the investor could not rely on the local law classification of Property B to treat that property as real property for purposes of section 1031. Property B may still be considered real property under the federal tax rule described below, but the investor could not rely on the local law rule to qualify the exchange under section 1031.
b. The federal tax rule:
If a taxpayer cannot qualify a potential improvement to land as real property using the local law rule, the taxpayer will need to use the federal tax rule under the regulations to qualify the property as real property. In the typical style of a tax regulation, the U.S. Treasury uses a cascading series of definitions to implement the federal tax rule for improvements to land.
The first thing to understand in analyzing this rule is that the analysis is completed separately for each “distinct asset.” Although a number of assets are per se treated as distinct assets (e.g., central air conditioning and heating systems, elevators, escalators, etc.), the regulations generally provide that all facts and circumstances will be considered in identifying each distinct asset. Relevant factors include whether the item (i) is typically sold as a separate unit, (ii) can be separated from a larger asset (and the cost of doing so), (iii) serves a separate useful function, and (iv) is necessary to the function of a larger asset.
Once a taxpayer has identified the relevant distinct assets, the taxpayer applies the federal tax rule to each such asset to determine if it is an improvement to land. The regulations treat improvements to land as consisting of two general categories – (i) “inherently permanent structures” and (ii) “structural components of inherently permanent structures.”
An inherently permanent structure is a building or other structure that is a distinct asset and “is permanently affixed to real property and that will ordinarily remain affixed for an indefinite period of time.” A building is generally defined in a common-sense manner as a structure enclosing a space within its walls and covered by a roof. For example, this includes houses, apartments, offices, hotels, etc. Thus, provided these assets are permanently affixed to real property (generally, the underlying land), they should, not surprisingly, qualify as inherently permanent structures and therefore as real property for purposes of section 1031.
The definition of inherently permanent structure also covers “other structures” that are permanently affixed to real property and that will ordinarily remain affixed for an indefinite period of time. The regulations list several types of properties that come within this rule, such as roads, bridges, parking structures, broadcasting towers, pipelines, etc. If a distinct asset is not on this list, a taxpayer may still qualify the asset as real property under this rule based on certain factors outlined in the regulations. The factors generally take into account (i) how the asset is affixed; (ii) whether the distinct asset is designed to remain in place or be removed; and (iii) the damage, time, and cost involved with removing the distinct asset. The more these factors indicate that the distinct asset is permanently affixed to real property, the more likely it is that the taxpayer can treat the distinct asset as an inherently permanent structure and therefore as real property for purposes of section 1031.
If a distinct asset does not qualify as an inherently permanent structure, the asset may still be considered real property under the federal tax rule if it qualifies as a structural component of an inherently permanent structure. As a preliminary matter, a taxpayer can only qualify a structural component as real property if (as in the normal case) the taxpayer also holds an interest in the inherently permanent structure served by the structural component. Provided that requirement is satisfied, a distinct asset will be treated as real property through the structural component definition if the asset is a “constituent part of, and integrated into, an inherently permanent structure.” The regulations contain a list of assets that will generally satisfy this standard, including walls, doors, wiring, plumbing systems, central air conditioning and heating systems, and other similar property.
If a distinct asset is not on the list described in the regulations, a taxpayer may still qualify the asset as a structural component of an inherently permanent structure based on a series of factors set forth in the regulations. These factors are similar to those that apply in determining if a structure is an inherently permanent structure (i.e., they generally measure the degree to which the asset is affixed to real property). The more these factors indicate that a distinct asset is a permanent part of the inherently permanent structure, the more likely it is that the asset qualifies as a structural component of such structure and thus as real property for purposes of section 1031.
2. Intangible Assets:
Consistent with historical precedent, the new section 1031 regulations allow certain assets that may be considered intangible assets to qualify as real property (e.g., certain permits and rights related to real property). As with improvements, a taxpayer generally has two avenues to qualify an intangible asset as real property – (i) the local law rule or (ii) the federal tax rule.
a. The local law rule:
The local law rule for intangible assets is generally the same as the rule described above for improvements. That is, if the asset is real property under state or local law on the date it is transferred in the exchange, it will be treated as real property for purposes of section 1031. The regulations, however, exclude certain types of intangible assets from being treated as real property regardless of their classification under state or local law. These excluded intangible assets include (subject to limited exceptions) stocks, bonds, notes, securities, evidence of indebtedness, partnership interests, beneficial interests in trusts, and choses in action (i.e., rights that can be enforced through legal action such as a debt or cause of action in tort). In addition, a license or permit to engage in or operate a business on real property is not real property regardless of its classification under state or local law (e.g., the right to operate a casino at a particular site is not real property).
b. The federal tax rule:
Provided the intangible asset is not one of the excluded intangible assets, a taxpayer can also attempt to qualify an intangible asset as real property under the federal tax rule. Assets that qualify under the federal tax rule include an option to acquire real property, land development rights, a leasehold, an easement, and stock in a limited set of corporations (e.g., housing co-ops). Other similar intangible assets may qualify as real property if (i) the asset derives its value from real property or an interest in real property and (ii) the asset is inseparable from that real property or interest in real property.
Also, although a license or permit to operate a business is not real property, a license, permit, or other similar right that is solely for the use, enjoyment, or occupation of the land or an inherently permanent structure may qualify as real property. To qualify, the license, permit, or other similar right must be in the nature of a leasehold, easement, or other similar right (e.g., a permit granted by the Federal government to use Federal land for a specific purpose may qualify as real property).
The recent section 1031 regulations provide a reminder that, when planning a section 1031 exchange, it is crucial to confirm that the subject properties qualify as real property for purposes of that particular section. As described above, uncertainty in this area will generally involve improvements and intangible assets that are intertwined with real property. With respect to each of these categories, the regulations provide real estate investors with a framework for classifying property as real property under either the local law rule or the federal tax rule. If the investor can qualify the property as real property under one of these rules, the investor’s exchange may come within the scope of section 1031, provided all of the other requirements under that section are satisfied.