Property Defined for Like-Kind Exchanges
In December of 2020, IRS issued regulations related to like-kind, or 1031 exchanges. Since they are such a great tool to exchange certain property and avoid immediate tax on the gain, we wanted to bring you an update on one of the most basic aspects; the definition of “real property” in order to use this section.
What is a like-kind exchange?
Let’s start with a refresher. A like-kind exchange is the exchange of real property that is used for a business or that is held as an investment for a property of the same type. IRS Section 1031 provides that this kind of disposition allows you to defer the gain or loss for that like-kind property.
What has changed?
This can be a very useful tool for some businesses so many keep tabs on changes that might be coming. Recently, there were proposed changes that seemed like they would narrow the application of this provision. Experts have been waiting and the final regulations are just coming out. One of the changes is the “state and local law test”. The test says that for IRS will rely on local law to determine what kinds of property are considered real property. It also has a provision allowing a determination based on whether it seems like an “inherently permanent structure”.
To determine whether an asset is an inherently permanent structure, IRS would consider whether the item us usually sold as a single unit rather than a component part; whether it can be separated from a larger asset and the cost associated with that separation, if the asset is often viewed as fulfilling a function independently rather than as a part of a larger asset, and whether separating it from a larger asset would compromise its functionality.
We also have “distinct assets” which are considered real property if they are permanently attached to real property and would generally remain attached indefinitely, if the property is an “inherently permanent structure”, or a structural component integrated into an inherently permanent structure. For this distinct asset category, the IRS is looking at the permanency of the asset.
When making this determination related to machinery and equipment located on real estate, the IRS will look to the local and state law classification, whether it would take a substantial amount of time and resources to prepare it to be placed into service, and whether removal would cause the property would be substantially damaged. As usual, all of these analyses would involve a facts and circumstances test. Hopefully these changes and clarity will make it easier for businesses to utilize this section. If you are thinking of engaging in a transaction that could receive this favorable tax treatment, keep in mind that this is a small glimmer of the important analysis and steps to complete the transaction so you will want to obtain the guidance of an attorney.
This article is an overview of legal considerations and does not cover every legal right or obligation, consideration, exception, or restriction. Every business decision should be well researched and discussed with a professional before being made.
To schedule a consultation with a SEED Law attorney, you can give us a call at (816)945–4249 or schedule your consultation here.
