New IRS Guidance on 1031 Eligible Property

The Tax Cuts and Jobs Act (TCJA), of 2017 updated the guidelines surrounding 1031 exchanges. This new definition limits the eligibility to “real property.” Since the implementation of the TCJA, taxpayers have debated what qualifies for a 1031 exchange, specifically in the context of cost segregation studies. On June 12th, 2020, the IRS released proposed regulations answering many of these questions.

In order to understand the importance of the regulation, it is critical to understand how a 1031 exchange works. A 1031 exchange allows a real estate investor to defer paying capital gain on the sale of a property as long as the investor exchanges it for another “like-kind property.” For example, take a property an investor purchased in 2010 for $10 million. Between 2010 and 2020, the property has a basis of $7 million after removing $3 million in depreciation. If the investor wants to sell the property for $12 million in 2020, they will have a taxable gain of $5 million ($12 million sale price less $7 million basis). However, if the investor completes a 1031 exchange into a property worth $12 million or more, the investor can defer paying the gain.

Through this example, it is easy to understand the importance of depreciation. Since a 1031 exchange allows a taxpayer to avoid gain, there is no recapture for depreciation taken upon sale. This would incentivize most taxpayers with a 1031 business model to maximize depreciation through a cost segregation study. However, with the TCJA update states taxpayers can only complete a 1031 for “real property.” Many practitioners have debated what qualifies as real property for 1031 purposes. This newly released regulation answers their question.

Under the proposed regulations, the IRS concluded it would not be appropriate to take an “existing definition of real property from another section of the Code.” Additionally, it stated, “the intent of Congress that real property eligible for like-kind exchange treatment under pre-TCJA law should continue to be eligible.” This means land, improvements to land, unsevered crops, and other natural products of land—and inherently permanent structures—qualify as real property. The IRS also specifically states, “local law definitions generally are not controlling in determining” the definition of real property. While there are some minor differences to depreciation law, the majority of what constitutes personal property in a cost segregation study would not qualify as “real property,” and land improvements from the study would qualify.

Additionally, the IRS confirmed taxpayers can disregard personal property that is incidental to the real property. In this definition, the IRS provides a 15% safe harbor. The taxpayer can include personal property in a transaction if it is under the 15% safe harbor.

These regulations are critical to understanding how a cost segregation study and 1031 exchange can work together. If a taxpayer buys a property they plan on including in a 1031 exchange in the future, the cost segregation analysis can generate significant cash flow without concern for recapture, especially if the personal property is under the 15% safe harbor. While there may be limits on personal property in the replacement property, the IRS position to analyze each asset separately provides opportunity for the taxpayer.

These regulations closely follow the advice McGuire Sponsel has provided our clients. Details released in these regulations reinforce the importance of hiring experienced professionals who understand the IRS position as it relates to interactions of different portions of the tax code. If you have any questions about this regulation, please reach out to your McGuire Sponsel representative. Learn more about our Cost Segregation practice here.