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Most real estate investors are familiar with section 1031 exchanges, and by now, most of these investors have also 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.
Generally, these new 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. Although in many cases a given property will clearly fall within (or without) these categories, this is not always the case, especially when dealing with potential improvements to land (e.g., structural components of buildings) or intangible-type assets that may qualify as real property. Due to the uncertainty that may arise regarding improvements to land and intangible-type assets, this article focuses on these two categories.
With respect to these categories, the new regulations generally grant real estate investors two methods for qualifying property as real property — one based on the definition of real property under state or local law and a second based on the specific definition of real property in the new regulations.
The rule related to the state or local law definition of real property is straightforward. It provides that 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. There are, however, two limitations on this rule that are worth noting. First, in applying this rule, the relevant state or local law is the law of the jurisdiction in which the property is located. Thus, inconsistent definitions of real property across jurisdictions may create inconsistent treatment of property for purposes of section 1031. Second, certain categories of intangible-type assets cannot qualify as real property regardless of their classification under state or local law. This includes most stocks, bonds, notes, securities, other evidence of indebtedness, partnership interests, beneficial interests in trusts and certain rights in legal actions.
If a real estate investor cannot qualify a property as real property using state or local law, the investor may still qualify the property as real property using the specific rules contained in the new regulations. With respect to potential improvements to land, applying these rules requires a two-step process. The first step is to identify each “distinct asset” that is subject to the exchange. The second step is to determine whether each distinct asset qualifies as real property. Although the regulations provide a detailed series of rules for making that determination, a distinct asset will generally qualify as an improvement to land (and therefore as real property) if it is a standard building or an asset that is permanently or indefinitely affixed to such a building or the underlying land.
Similarly, the new regulations also allow an intangible-type asset to qualify as real property for purposes of section 1031 even if the asset is not treated as real property under state or local law. Under this rule, an intangible asset may generally 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. Therefore, assets such as options to acquire real property and land development rights are generally treated as real property for purposes of section 1031 regardless of their state or local law characterization. Furthermore, 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 land or an inherently permanent structure may qualify as real property.
In summary, these new section 1031 regulations provide real estate investors with a framework for classifying property as real property using either (i) state or local law definitions or (ii) the specific definitions provided in the regulations. This framework may be particularly useful when dealing with certain improvements to land or intangible-type assets. If the investor can qualify the property as real property using this framework, the investor’s exchange of that property may continue to enjoy the benefits of section 1031.