Owners of investment property are acutely aware of the double-edged sword that awaits a sale. The owners will finally be able to realize the benefit from years of hard work maintaining the appreciated property, but they also could face a substantial tax liability on the sale of the investment property. For taxpayers who wish to continue holding an investment rather than cashing out, Internal Revenue Code (IRC) Section 1031 provides a strategy that allows for tax deferral whereby the taxpayer exchanges the investment property for like-kind property. There have been some major changes to Section 1031 in recent years. Notably, the Tax Cuts and Jobs Act (TCJA) made only exchanges of real property eligible for Section 1031 exchanges, and the Treasury Regulations that were issued in November 2020 provide a revised definition of real property for purposes of Section 1031. However, understand that President Joe Biden’s tax plan, mentioned during the 2020 election, referenced eliminating tax breaks for real estate investors; thus, Section 1031 could be eliminated as a strategy in the future.
A Look at Section 1031
There is a long history of like-kind exchanges in U.S. tax law. These exchanges had their start with Section 202 of the Revenue Act of 1921, Basis for Determining Gain or Loss. It provided that “no gain or loss shall be recognized when any such property held for investment, or for the productive use in trade or business (not including stock-in-trade or other property held primarily for sale), is exchanged for property of a like kind or use.” The purpose was to avoid unfair taxation of ongoing investments and to encourage active reinvestment by not imposing a tax when there is a continuation of investment.1 In 1923, that provision was amended to exclude nonrecognition exchanges of stocks, bonds, notes, choses of action, certificates of trust or beneficial interest, or other securities or evidences of indebtedness or interest, as Congress believed the use of like-kind exchanges in those particular properties could be abused to avoid tax.2 The 1939 IRC codified the like-kind exchange provisions into Section 112(b)(1) while also adding provisions for the recognition of boot received in the exchange, the disallowance of loss on the receipt of boot, and the computation of basis in the property acquired in the exchange. The 1954 IRC codified these provisions into Section 1031 without any substantive changes.
Identification and receipts requirements for Section 1031 exchanges were introduced by the Deficit Reduction Act of 1984 through the addition of Section 1031(a)(3). Under Section 1031(a)(3), the replacement property has to be identified within 45 days after the relinquished property is transferred and received within 180 days. This addition was in response to the case of T. J. Starker v. United States of America, where the 9th Circuit rejected the IRS position that Section 1031 exchanges had to be simultaneous. (The taxpayer agreed to convey timberland in exchange for the other party’s promise to provide the taxpayer with suitable real property within five years or pay the outstanding balance in cash.) Congress wanted time limits to apply to Section 1031 exchanges, as taxpayers could potentially use deferred exchanges and installment sales indefinitely while also having the potential for long-lasting administrative issues.3 In addition, Congress included “interests in a partnership” to the list of property excluded from like-kind-exchange treatment.4
Related-party rules in Sections 1031(f) and 1031(g) were added as part of the Omnibus Budget Reconciliation Act of 1989 to respond to taxpayers’ basis shifting to reduce or avoid gain recognition on the subsequent sale, and also to accelerate a loss on retained property. Thereafter, if a taxpayer exchanges property with a related party in a Section 1031 exchange and either party disposes of the property within two years, the original exchange will not qualify for nonrecognition treatment.
Under Section 1031, no gain or loss is recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind that is to be held either for productive use in a trade or business or for investment. Property held primarily for sale does not meet the requirements of Section 1031. In addition, the property must be identified and the exchange must be completed not more than 180 days after the transfer of the exchanged property. There are also specific rules concerning related-party transactions and foreign real property.
Prior to the TCJA, depreciable personal property was eligible to be exchanged in a tax-free, like-kind exchange, provided the properties were either the same general asset class or same product class. That was changed: the TCJA amended Section 1031(a)(1) to read “real property” rather than “property.”5 Thus, starting Jan. 1, 2018, exchanges of personal or intangible property generally do not qualify for nonrecognition of gain as like-kind exchanges. Nevertheless, with proper planning, the taxable gains from the disposition of personal property can be offset due to the increased expensing allowed under IRC Section 168(k), Bonus Depreciation, and Section 179, Expense.
Whether property is of a like kind is determined by its nature or character. Property is classified as depreciable tangible personal property, intangible or nondepreciable personal property, or real property. Treasury issued final regulations on Nov. 23, 2020, that largely adopted the June 2020 proposed regulations. In Treasury Regulation Section 1.1031(a)-3, effective beginning after Dec. 2, 2020, the definitions of real property were updated. Under these regulations, real property generally includes land, anything permanently built on or attached to land, and any property characterized as real property under state or local law. The final regulations eliminated the purposes or use-test mentioned in the proposed regulations for determining whether property is real property for Section 1031. The regulations also provide a detailed discussion on inherently permanent structures, and list five factors for determining other inherently permanent structures:
• The manner in which the asset is affixed to real property
• Whether the asset is designed to be removed or remain in place
• The damage that removal of the asset would cause to the item or the real property
• Circumstances that suggest the expected period of affixation is not indefinite
• The time and expense required to move the asset6
Under Treasury Regulation Section 1.1031(k)-1(c)(5), language related to the incidental property rule provides that if the exchange included incidental personal property, the transaction would still meet the requirements of IRC Section 1031. The final regulations state that personal property is treated as incidental if it is both typically transferred with the real property and the aggregate fair market value of the incidental personal property transferred with the real property does not exceed 15% of the aggregate fair market value of the replacement property. The incidental property exception is based on the aggregate of the total fair market value of the replacement properties, such that if a taxpayer was exchanging a property for two properties, the 15% limitation would not be considered violated if the personal property does not exceed the total fair market value of the two properties, though it may exceed the fair market value of one of them. If a property is used in part for business and part for personal, the asset cannot be bifurcated into two separate assets; rather it must be considered one asset, with the predominate use of the asset being the determining factor.7 Also, note that the final regulations provide the definitions of real property solely for purposes of Section 1031, and thus property that falls within the definition of Section 1031 could be subject to other sections of the IRC, such as 1245 or 1231.
Future of 1031
There has been discussion of future tax plans that aim to eliminate Section 1031. Leading up to the presidential election, Biden’s tax plan mentioned eliminating tax breaks for real estate investors (with certain income thresholds) without specifically mentioning Section 1031. While only speculation, taxpayers should be aware that Section 1031 could be eliminated, at least temporarily.
1 H.R. 704, 73rd Congress, 2d Sess. (1934).
2 Revenue Act of 1923, ch. 294, 42 Stat. 1560.
3 T. J. Starker v. United States of America, 602 F2d 1341 (9th Cir. 1979); See also H.R. Rep. No. 98-432, 98th Cong., Sess. (1984) and H.R. Conf. Rep. No. 98-861, 98th Cong., 2d Sess. (1984).
4 H.R. Rep. No. 98-432, 98th Cong., Sess. (1984); See also H.R. Conf. Rep. No. 98-861, 98th Cong., 2d Sess. (1984).
5 P.L. 115-97, Section 13303(a); See also Congressional Committee Reports Accompanying the Tax Cuts and Jobs Act.
6 Treas. Reg. Section 1.1031(a)-3(a)(2)(ii)(C).
7 Treas. Reg. Section 1.1031(k)-1(c)(5) and CCA 201605017 (2016).
Edward A. Kollar, CPA, EA, CSEP, is firm director with Baker Tilly US LLP in Wilkes-Barre. He can be reached at email@example.com.
Tim Cotter, CPA, JD, is a senior manager with Baker Tilly US LLP in Wilkes-Barre. He can be reached at firstname.lastname@example.org.