For like-kind exchanges after 2017, Code Section 1031(a) provides that real property held primarily for sale is not eligible for like-kind exchange treatment. Only real property held for productive use in a trade or business or for investment is eligible for like-kind exchange treatment as long as such real property is exchanged solely for real property of a like kind which is to be held either for productive use in a trade or business or for investment.
Generally, a vacation home or second home not held as rental property is classified as real estate held for personal use and does not qualify for Code Section 1031 treatment. However, there are certain safe harbor and other rules that may apply to allow a like-kind exchange.
As examples of exchanges of property of a like kind, Regulation Section 1.1031(a)-1(c) provides that no gain or loss is recognized if a taxpayer who is not a dealer in real estate exchanges city real estate for a ranch or farm, or exchanges a leasehold of a fee with 30 years or more to run for real estate, or exchanges improved real estate for unimproved real estate. In light of this regulation, the Tax Court has indicated that a short-term leasehold of real property is not equivalent to a fee interest for purposes of the like-kind exchange rules (Capri, Inc. v. Commissioner, 65 Tax Court 162 (1975)). According to the Tax Court, this characterization of short-term leasehold interests derives not from any particular state law characterization but from the negative implication of Regulation Section 1.1031(a)-1(c). As a result, in VIP’s Industries Inc. & Subsidiaries v. Commissioner, Tax Court Memo. 2013-157, the Tax Court held that a corporation’s leasehold interest in a motel property was not like kind with respect to the fee interests in two other real properties and, therefore, the transaction in which the motel property was transferred and the two fee interests were acquired did not qualify as a like-kind exchange under Code Section 1031.
An exchange of a remainder interest in real estate for a remainder interest in other real estate is a like-kind exchange if the nature or character of the two property interests is the same (Revenue Ruling 78-4). However, the exchange of a life estate expected to last less than 30 years for a remainder interest is not a like-kind exchange, because the nature and character of the two property interests are not the same (Revenue Ruling 72-601).
The term “real property” is defined for purposes of Code Section 1031 as:
(1) land and improvements to land,
(2) unsevered natural products of land; and
(3) water and air space superjacent to land (Regulation Section 1.1031(a)-3(a)(1)).
Under Regulation Section 1.1031(a)-3(a)(5), an intangible interest in real property of one of the three types described above is real property for purposes of Code Section 1031. Generally, property that is real property under state or local law is real property for purposes of Code Section 1031 and the final regulations (Regulation Section 1.1031(a)-3(a)(1)). Property is considered real property under state or local law if, on the date it is transferred in an exchange, the property is real property under the law of the state or local jurisdiction in which that property is located (Regulation Section 1.1031(a)-3(a)(6)).
The term “improvements to land” is defined as:
(1) inherently permanent structures; and
(2) the structural components of inherently permanent structures (Regulation Section 1.1031(a)-3(a)(2)(i)).
Inherently permanent structures include any 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. Affixation is considered permanent if it is reasonably expected to last indefinitely based on all the facts and circumstances (Regulation Section 1.1031(a)-3(a)(2)(ii)(A)). A building is any structure or edifice enclosing a space within its walls, and covered by a roof, the purpose of which is, for example, to provide shelter or housing, or to provide working, office, parking, display, or sales space. Buildings include the following distinct assets if permanently affixed: houses, apartments, hotels, motels, enclosed stadiums and arenas, enclosed shopping malls, factories and office buildings, warehouses, barns, enclosed garages, enclosed transportation stations and terminals, and stores (Regulation Section 1.1031(a)-3(a)(2)(ii)(B)).
The final regulations define “inherently permanent structures” to include the following distinct assets, if permanently affixed: in-ground swimming pools; roads; bridges; tunnels; paved parking areas, parking facilities, and other pavements; special foundations; stationary wharves and docks; fences; inherently permanent advertising displays for which an election under Code Section 1033(g)(3) is in effect; inherently permanent outdoor lighting facilities; railroad tracks and signals; telephone poles; power generation and transmission facilities; permanently installed telecommunications cables; microwave transmission, cell, broadcasting, and electric transmission towers; oil and gas pipelines; offshore drilling platforms, derricks, oil and gas storage tanks; and grain storage bins and silos. Affixation to real property may be accomplished by weight alone (Regulation Section 1.1031(a)-3(a)(2)(ii)(C)).
If property is not listed above as an inherently permanent structure, the determination of whether the property is an inherently permanent structure is based on the following factors:
(1) the manner in which the distinct asset is affixed to real property;
(2) whether the distinct asset is designed to be removed or to remain in place;
(3) the damage that removal of the distinct asset would cause to the item itself or to the real property to which it is affixed;
(4) any circumstances that suggest the expected period of affixation is not indefinite; and
(5) the time and expense required to move the distinct asset (Regulation Section 1.1031(a)-3(a)(2)(ii)(C)).
Example: Chelsea owns an office building and a large sculpture in the atrium of the building. The sculpture measures 30 feet tall by 18 feet wide and weighs five tons. The building was specifically designed to support the sculpture, which is permanently affixed to the building by supports embedded in the building’s foundation. The sculpture was constructed within the building. Removal would be costly and time consuming and would destroy the sculpture. The sculpture is reasonably expected to remain in the building indefinitely. The sculpture is not an inherently permanent structure listed in Regulation Section 1.1031(a)-3(a)(2)(ii)(C), and, therefore, Chelsea must use the factors provided in the regulations to determine whether the sculpture is an inherently permanent structure. The factors all support the conclusion that the sculpture is an inherently permanent structure because the sculpture (1) is permanently affixed to the building by supports embedded in the building’s foundation; (2) is not designed to be removed and is designed to remain in place indefinitely; (3) would be damaged if removed and would damage the building to which it is affixed; (4) is expected to remain in the building indefinitely; and (5) would require significant time and expense to move. Therefore, the sculpture is real property.
Example: Milton owns 400 bus shelters, each of which consists of four posts, a roof, and panels enclosing two or three sides. Milton enters into a long-term lease with a local transit authority for use of the bus shelters. Each bus shelter is prefabricated from steel and is bolted to the sidewalk. Bus shelters are disassembled and moved when bus routes change. Moving a bus shelter takes less than a day and does not significantly damage either the bus shelter or the real property to which it was affixed. The bus shelters are not permanently affixed enclosed transportation stations or terminals, are not buildings, nor are they listed as types of other inherently permanent structures. Therefore, the bus shelters must be analyzed under the factors provided in Regulation Section 1.1031(a)-3(a)(2)(ii)(C). The factors all support the conclusion that the bus shelters are not inherently permanent structures because the bus shelters (1) are not permanently affixed to the land or an inherently permanent structure; (2) are designed to be removed and not remain in place indefinitely; (3) would not be damaged if removed and would not damage the sidewalks to which they are affixed; (4) will not remain affixed indefinitely; and (5) would not require significant time and expense to move. Thus, the bus shelters are not real property.
The term “structural component” means any distinct asset that is a constituent part of, and integrated into, an inherently permanent structure. If interconnected assets work together to serve an inherently permanent structure (for example, systems that provide a building with electricity, heat, or water), the assets are analyzed together as one distinct asset that may be a structural component. A structural component may qualify as real property only if the taxpayer holds its interest in the structural component together with a real property interest in the space in the inherently permanent structure served by the structural component. If a distinct asset is customized, the customization does not affect whether the distinct asset is a structural component. Tenant improvements to a building that are inherently permanent or otherwise classified as real property because they meet the definition of structural components are real property for purposes of the like-kind regulations. However, property produced for sale, such as bricks, nails, paint, and windowpanes, that is not real property in the hands of the producing taxpayer or a related person, as defined in Code Section 1031(f)(3), but that may be incorporated into real property by an unrelated buyer, is not treated as real property by the producing taxpayer (Regulation Section 1.1031(a)-3(a)(2)(iii)(A)).
Structural components include the following items, provided the item is a constituent part of, and integrated into, an inherently permanent structure: walls; partitions; doors; wiring; plumbing systems; central air conditioning and heating systems; pipes and ducts; elevators and escalators; floors; ceilings; permanent coverings of walls, floors, and ceilings; insulation; chimneys; fire suppression systems, including sprinkler systems and fire alarms; fire escapes; security systems; humidity control systems; and other similar property (Regulation Section 1.1031(a)-3(a)(2)(iii)(B)).
If a component of a building or inherently permanent structure is a distinct asset and is not listed as a structural component in the above paragraph, the determination of whether the component is a structural component is based on the following factors:
(1) the manner, time, and expense of installing and removing the component;
(2) whether the component is designed to be moved;
(3) the damage that removal of the component would cause to the item itself or to the inherently permanent structure to which it is affixed; and
(4) whether the component is installed during construction of the inherently permanent structure (Regulation Section 1.1031(a)-3(a)(2)(iii)(B)).
Example: GenCo owns a building with a large steam turbine attached as a fixture to the building. The steam turbine is a component of a system used for the commercial production of electricity for sale to customers in the ordinary course of GenCo’s business as an electric utility. The steam turbine also generates electricity for GenCo’s building. The steam turbine takes up a substantial portion of the building and is designed to remain in place indefinitely once installed in GenCo’s building. The steam turbine was installed during the construction of the building and its removal would be costly and cause damage to the building. The steam turbine is not listed as an example of a structural component under Regulation Section 1.1031(a)-3(a)(2)(iii)(B) and therefore must be analyzed using the factors provided in Regulation Section 1.1031(a)-3(a)(2)(iii)(B)(1) through (4). The steam turbine (1) is costly to remove from the building in which it is located, (2) is not designed to be moved, (3) if removed, would cause damage to the building, and (4) was installed during the construction of the building. These factors all support the conclusion that the steam turbine is a structural component of GenCo’s building and real property under the final regulations.
Example: PlaneParts Inc. owns a building that it uses in its trade or business of manufacturing airplane parts. The building includes an industrial 3D printer that can print airplane wings and an electrical generator that serves the building in a backup capacity. The 3D printer weighs 12 tons, is designed to remain in place indefinitely once installed in the building, and its removal would be time-consuming and very costly and would cause significant damage to the building. The 3D printer was installed during the building’s construction. The generator also was installed during construction and is designed to remain in place indefinitely once installed. Although costly and time-consuming to remove, removal of the generator will not result in substantial damage to the generator or the building. Since the 3D printer is not listed in Regulation Section 1.1031(a)-3(a)(2)(iii)(B) as an example of a structural component, it must be analyzed using the factors listed in Regulation Section 1.1031(a)-3(a)(2)(iii)(B)(1) through (4). The 3D printer (1) is time consuming and costly to move, (2) is not designed to be moved, (3) if removed, would cause significant damage to the building in which it is located, and (4) was installed during construction of the building. These factors support the conclusion that the 3D printer is a structural component of the building and real property under the regulations. Thus, the 3D printer is real property.
The electrical generator is also not listed as an example of a structural component and must be analyzed using the factors provided in Regulation Section 1.1031(a)-3(a)(2)(iii)(B)(1) through (4). The generator (1) is time consuming and costly to move, (2) is not designed to be moved, (3) if removed, would not result in significant damage to the generator or the building in which it is located, and (4) was installed during the construction of the building. These factors, considered in the aggregate, support the conclusion that the generator is a structural component of the building. Although the generator’s removal would not result in significant damage to the generator or the building, that factor does not outweigh the factors supporting the conclusion that it is a structural component. Consequently, the generator is a structural component of the building and real property under the final regulations.
Assume that when installing its 3D printer, PlaneParts also installed a raised flooring system for the purpose of facilitating the operation of the 3D printer. The raised flooring system is not designed or constructed to remain permanently in place. Rather, the raised flooring system can be removed, without any substantial damage to the system itself or to the building, and then reused. The raised flooring was installed during the building’s construction. Although floors are listed as an example of a structural component in Regulation Section 1.1031(a)-3(a)(2)(iii)(B), the raised flooring system installed to facilitate the operation of PlaneParts’ 3D printer is not a constituent part of, and integrated into, an inherently permanent structure and, therefore, is not flooring as listed in the regulation. Thus, the raised flooring must be analyzed using the factors listed in Regulation Section 1.1031(a)-3(a)(2)(iii)(B)(1) through (4). The raised flooring (1) is installed and removed quickly and with little expense, (2) is designed to be moved and is not designed specifically for the particular building of which it is a part, (3) is not damaged, and the building is not damaged, upon its removal, and (4) was installed during construction of the building. These factors, considered in the aggregate, support the conclusion that the raised flooring is not a structural component of the building. Although the raised flooring was installed during construction of the building, that factor does not outweigh the factors supporting the conclusion that the flooring is not a structural component. Therefore, the raised flooring is not real property.
Unsevered natural products of land, including growing crops, plants, and timber; mines; wells; and other natural deposits, generally are treated as real property for purposes of the regulations. Natural products and deposits, such as crops, timber, water, ores, and minerals, cease to be real property when they are severed, extracted, or removed from the land (Regulation Section 1.1031(a)-3(a)(3)).
Example: Fred owns an apple tree farm and harvests the apples annually. The apple trees are natural products of the land under the regulations, and thus are real property. Upon severance from the land, the harvested apples cease to be part of the land and therefore are not real property. Storage of the harvested fruit upon or within real property does not cause the harvested fruit to be real property.
A distinct asset is analyzed separately from any other assets to which the asset relates to determine if the asset is real property, whether as land, an inherently permanent structure, or a structural component of an inherently permanent structure. Buildings and other inherently permanent structures are distinct assets. Assets and systems listed as a structural component in Regulation Section 1.1031(a)-3(a)(2)(iii)(B) are treated as distinct assets (Regulation Section 1.1031(a)-3(a)(4)(i)).
The determination of whether a particular separately identifiable item of property is a distinct asset is based on all the facts and circumstances. In particular, the following factors must be taken into account:
(1) whether the item is customarily sold or acquired as a single unit rather than as a component part of a larger asset;
(2) whether the item can be separated from a larger asset, and if so, the cost of separating the item from the larger asset;
(3) whether the item is commonly viewed as serving a useful function independent of a larger asset of which it is a part; and
(4) whether separating the item from a larger asset of which it is a part impairs the functionality of the larger asset (Regulation Section 1.1031(a)-3(a)(4)(ii)).
Intangible assets that are real property for purposes of Code Section 1031 and the final regulations include the following items: fee ownership; co-ownership; a leasehold; an option to acquire real property; an easement; stock in a cooperative housing corporation; shares in a mutual ditch, reservoir, or irrigation company described in Code Section 501(c)(12)(A) if, at the time of the exchange, such shares have been recognized by the highest court of the state in which the company was organized, or by a state statute, as constituting or representing real property or an interest in real property; and land development rights. Similar interests are real property for these purposes if the intangible asset derives its value from real property or an interest in real property and is inseparable from that real property or interest in real property (Regulation Section 1.1031(a)-3(a)(5)(i)).
The following intangible assets are not real property for purposes of Code Section 1031 and the final regulations, regardless of the classification of such property under state or local law:
(1) stock not described in Regulation Section 1.1031)(a)-3(a)(5)(i), bonds, or notes;
(2) other securities or evidences of indebtedness or interest;
(3) interests in a partnership (other than an interest in a partnership that has in effect a valid election under Code Section 761(a) to be excluded from the partnership provisions of the Code);
(4) certificates of trust or beneficial interests; and
(5) choses in action (Regulation Section 1.1031(a)-3(a)(5)(i)).
A license, permit, or other similar right that is solely for the use, enjoyment, or occupation of land or an inherently permanent structure and that is in the nature of a leasehold, easement, or other similar right, generally is an interest in real property under the regulations. However, a license or permit to engage in or operate a business on real property is not real property or an interest in real property, regardless of its classification under state or local law (Regulation Section 1.1031(a)-3(a)(5)(ii)).
Example: Jennifer receives a special use permit from the government to place a cell tower on federal government land that abuts a federal highway. Government regulations provide that the permit is not a lease of the land, but is a permit to use the land for a cell tower. Under the permit, the government reserves the right to cancel the permit and compensate Jennifer if the site is needed for a higher public purpose. The permit is in the nature of a leasehold that allows Jennifer to place a cell tower in a specific location on government land. Therefore, the permit is an interest in real property.
Example: Kelly owns a building and receives a license from the state of Ohio to operate a casino in the building. The license applies only to Kelly’s building and cannot be transferred to another location. Kelly’s building is an inherently permanent structure under Regulation Section 1.1031(a)-3(a)(2)(ii)(A) and, therefore, is real property. However, Kelly’s license to operate a casino is not a right for the use, enjoyment, or occupation of Kelly’s building, but is rather a license to engage in or operate the casino business in the building. Therefore, the casino license is not real property or an interest in real property.
Please contact the office of Don Fitch Accountancy at (760)567-3110 or Email Don.Fitch@CPA.com if you have any questions or would like additional information.
DON FITCH, CPA
74478 Highway 111 #3
Palm Desert, CA 92260
Toll Free: (877)CPA-Help or (877)272-4357
Cell: (760)567-3110
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Email: DonFitchCPA@paylesstax.com
Website: https://www.paylesstax.com
P.S. My firm is based upon referrals. Please feel free to refer my firm to anyone you know that is looking for a new CPA and/or tax preparer. Thank you in advance.
(Updated 03/21/2021 08:05)