Under tax law, a taxpayer is able to defer the recognition of gain on exchanges of property deemed to be of like-kind. Prior to the Tax Cuts and Jobs Act of 2017 (“the Act”) like-kind property included both real and personal property.
The Act changed what property is considered like-kind and removed personal property. Therefore, personal property such as vehicles, heavy equipment, and other items are no longer considered like-kind property.
The like-kind exchange rules have never defined what constituted real property. Due to the changes made by the Act, there is now increased importance in defining real property, as any ambiguity has an increased potential to create confusion and inaccurate results.
In order to address this, the Final Regulations TD 9935 (“the regulations”) approved on November 18, 2020 provided a definition to real property for these purposes.
The regulations define property as real property if it fits into the following categories:
Some intangible assets are also included in the definition of real property. To be considered real property, an asset must derive its value and be inseparable from the real property or interest in real property. Additionally, the asset must not produce/contribute to the production of income other than consideration for the use or occupancy of space.
The proposed regulations cite a special government use permit, to place a cell tower on government land as an example of real property, while rejecting a license from a state to operate a casino in the building as an example of real property.
Often, a cost segregation study will be used in conjunction with the purchase of real estate acquired in a like-kind exchange. The cost segregation study aims to increase depreciation by allocating the depreciable basis to shorter class lives that may qualify for 100% bonus depreciation. So what happens if your newly acquired building includes personal property? Does the presence of personal property automatically disqualify a transaction as a like-kind exchange?
Not necessarily. Under the regulations, the definition of real property includes inherently permanent structures, and their associated structural components. Permanent structures are buildings or other structures that are permanently affixed to real property and that will ordinarily remain affixed for an indefinite period of time. Therefore, real property for like-kind exchange purposes would include many components of a building that are segregated in a cost segregation study and treated as personal property for depreciation purposes.
In addition, the regulations state that, if a taxpayer acquires personal property that is considered incidental to the real property acquisition, then the taxpayer can rest assured that their like-kind exchange is valid.
The regulations specify that up to 15% of the value of all property acquired is permitted to be personal property in order to avoid having your exchange fail and having to recognize all of the gain.
Even if the 15% threshold is maintained, this will not prevent the portion of the property received which is deemed personal property to be considered “boot,” creating taxable gain during an otherwise ‘nontaxable’ transaction.
State and Local Tax Considerations
Not every state and local tax jurisdiction conforms with the federal income tax ramifications of like-kind exchanges. Some jurisdictions automatically conform to the Internal Revenue Code as currently in effect, while others have specific conformity dates and modification provisions. Complicating this analysis is the notion that states and localities may have add-backs or carve-outs specifically for like kind exchanges.
According to Jaime Reichardt, a principal in Citrin Cooperman’s State and Local Tax Practice, “the ramifications of such a transaction can be even more complex when involving a change in taxpayer residency or the situs of the properties included in the exchange, since some states will look to impose tax when there is an ultimate recognition event based on the location of the property originally disposed of under the deal. These types of “look back” rules can have significant ramifications for the state taxes imposed and calculation of credit for tax paid to another state/locality in the home jurisdiction.”
IRS deputy commissioner for examinations, De Lon Harris, expects to audit 50% more partnerships in 2021 than 2020, with more than 50 new positions being posted for tax law specialists and revenue agents. Over the past few years, we have also seen New York State become increasingly vigilant in this area, with an expectation this trend will continue as state budget deficits grow.
It is of the utmost importance to get your tax advisor and legal counsel involved early, in order to optimize the tax benefits and reduce any risks associated with misinterpretation of conflicting statutory rules.