Ezra Dyckman and Aaron S. Gaynor

When a taxpayer exchanges a Midtown office building for apartment complexes in Williamsburg, or a SoHo retail building for a warehouse in Long Island City, that taxpayer is largely thinking about the real estate traded. However, most exchanges of real estate also involve exchanges of incidental personal property—such certain tenant improvements or lobby furniture—which often has material value. Due to a 2017 change to I.R.C. section 1031, some taxpayers will now owe tax with respect to that exchanged personal property. New proposed regulations and other parts of the 2017 changes to the tax law mitigate the consequences to exchanging taxpayers.

Background

In general, section 1031 permits a taxpayer to exchange (within a prescribed time period) certain qualifying property ("relinquished property") for certain other qualifying property ("replacement property") without having to pay current tax on the disposition of the relinquished property. The tax is effectively deferred until the sale of the replacement property, which itself could be exchanged, further deferring the tax.

Prior to the 2017 tax act, known as the "Tax Cuts and Jobs Act" (the TCJA), section 1031 applied to both real property and personal property. However, the TCJA limited the scope of that section to real property. After the TCJA, essentially, tax is due as if the personal property exchanged had been sold for cash. Aggravating matters for taxpayers is that, to the extent the gain on the exchange of that personal property consists of "recapture" of previous depreciation deductions, it will be taxed at ordinary income rates, rather than the lower capital gains rates.

Suppose, for example, a taxpayer exchanges $85 of real property and $15 of personal property (with respect to both of which the taxpayer has a $0 basis) for $85 of real property and $15 of personal property. Assuming that all requirements of section 1031 had otherwise been met, prior to the TJCA the taxpayer would not have had any current tax on the exchange. However, after the TCJA, the taxpayer has to pay tax with respect to the $15 of personal property, as if it were sold for cash.

Proposed Regulations

On June 12, 2020, the IRS published in the Federal Register proposed regulations defining "real property" for purposes of like-kind exchanges under section 1031.

The IRS looked to other definitions of real property in the federal tax law, noting in the preamble to the proposed regulations that none was a perfect fit. However, the ultimate definition borrows heavily from other standards, in particular, the standard for real estate investment trusts (REITs), which is familiar to many in the real estate industry and their tax advisors. Moreover, the IRS expressly stated that it adopted a "broader" standard of real property for these purposes than some of the existing standards provide.

Notably and specifically, both the preamble and the operative language of the proposed regulations indicate that the definition of real property is more expansive for purposes of section 1031 than it is for depreciation purposes. The proposed regulations specifically contemplate a "structure or a portion of a structure" that may be real property as defined in the proposed section 1031 regulations, but personal property for depreciation purposes. One could imagine, for example, certain parts of a tenant improvement that meet the standard of real property for section 1031 purposes, but that are depreciated as personal property.

This is a favorable approach for taxpayers. With respect to the relinquished property, a taxpayer may now credibly claim that, for section 1031 purposes, the entire property is real property, even though the taxpayer had previously depreciated a portion of the property as personal property. This means that the entire relinquished property is eligible for a tax-deferred exchange.

Additionally, with respect to the replacement property, the taxpayer may now credibly claim that, for section 1031 purposes, the entire property is real property (deferring all tax), but then depreciate a portion of it as personal property (which has a faster depreciation recovery period). There are some limitations to this approach, however.

Generally, to the extent that a taxpayer does not "trade up" and acquire replacement property in excess of its relinquished property, the taxpayer takes a "carryover" basis in its replacement property. This means, practically, that taxpayers often have relatively low basis in their replacement property. (If a taxpayer had high basis in his relinquished property, it may not have bothered with the exchange, as there may not have been much gain to defer.) If the taxpayer has low basis in its replacement property, there will not necessarily be a lot of value in accelerating depreciation deductions.

Additional Relief Under the TCJA

One aspect of the TCJA that mitigated against the loss of tax-deferred exchanges of personal property was the taxpayer's increased ability to immediately deduct the cost of certain property acquired, as either "bonus depreciation" under I.R.C. section 168(k) or as an expense under I.R.C. section 179 (which may generally be used in the alternative or in conjunction).

Your cynical authors would like to point out, however, that the change to section 1031 is permanent and there are limitations to the benefits of section 168(k) and section 179. Specifically, section 168(k) effectively phases out by 2027, and that section 179 has a fixed dollar limit to its benefit. Having said that, combining these accelerated deductions with deferral under section 1031 creates a potent benefit for exchanging taxpayers. Moreover, the proposed regulations further blunt the impact of the TCJA by adopting a broad definition of real property. While the TCJA changes were not welcome by taxpayers, the IRS has thoughtfully granted some relief in the form of these proposed regulations.

Ezra Dyckman is a partner at Roberts & Holland. Aaron S. Gaynor is an associate at the firm.