If you're a serious real estate investor, you probably know all about Section 1031 Deferred Exchanges. With a properly structured Section 1031 exchange, you can swap one piece of property for another without paying federal income tax – even if the property you are discharging , is much appreciated.
This longstanding tax break has helped make a lot of fortunes. However, be aware of these two things:
Number 1. The tax plan proposed by Democratic presidential candidate Joe Biden would remove the Section 1031 exchange privilege.
No. 2. The IRS recently enacted new regulations defining what real estate is to determine eligibility for exchange under Section 1031. However, these provisions are of no use to you if you are no longer able to perform a Section 1031 exchange and you cannot perform your exchange before it does. So you may need to act quickly to take advantage of the section 1031 exchange pause before a Biden tax plan can potentially take them away.
In this column, I will address these two considerations after first covering some necessary background information. Here goes.
TCJA eliminated Section 1031 treatment for personal property exchanges, but not real estate exchanges
The Law on Tax Reductions and Employment (TCJA) has permanently removed the tax-privileged treatment under Section 1031 for the exchange of personal property, which is completed after December 31, 2017.
Fortunately, for a properly structured, similar exchange of real estate, tax-privileged treatment according to § 1031 is still available. For today anyway. As always, the treatment according to § 1031 is only permissible for the exchange of similar properties that are held for business or investment purposes.
In order to qualify under the TCJA for treatment under Section 1031, (1) property must be exchanged for property of the same type, and (2) the property posted on the exchange and the replacement property received on the exchange must both be deemed business or investment purposes.
New IRS regulations
Before the TCJA, little attention was paid to what the similar requirement meant in the context of real estate exchanges. Under the TCJA, the IRS was forced to focus on what the similar nature requirement means in the context of real estate exchanges, as only those exchanges are still eligible for Section 1031 treatment.
Enter the recently published proposed regulations.
The term real estate for exchange in Section 1031 means land, land improvements, undivided natural land products, and water and air space over land. One on top of the other means overlaid. Needless to say, I had to look that up too.
Key point: The most important thing to understand here is that any property that is defined as real estate in the proposed regulations can be exchanged for any other property that is defined as real estate in the proposed regulations under Section 1031 – because the same requirement is hit.
Real estate terms in art
None of the information under this heading is likely to surprise you. But for the record, here's what the new proposed regulations say.
An ownership interest in real estate, including fee ownership, co-ownership, lease, option to purchase real estate, relief or similar participation, is considered real estate for similar exchange purposes under Section 1031. So you can exchange any of the above for any of the above. The exchange is a tax deferred section 1031 exchange – provided it is properly structured. You need to speak to your tax advisor about the correct structuring. It can get complicated.
Land improvements mean inherently permanent structures and the structural components of inherently permanent structures. Such improvements can be included in a Section 1031 deferred exchange.
An inherently permanent structure is a building or other structure that is a stand-alone asset that is permanently attached to real estate and that is usually left in place indefinitely.
A building is a structure or a building that encloses a space within its walls and is covered by a roof, the purpose of which is, for example, to provide shelter or shelter or to provide work, office, parking, exhibition or retail space. Buildings include houses, apartments, hotels, motels, closed stadiums and arenas, closed shopping malls, factories, office buildings, warehouses, barns, closed garages, closed transportation stations and terminals, and shops.
Inherently permanent structures also include the following assets when permanently attached to real estate: in-ground swimming pools; Roads, bridges and tunnels; Parking facilities; paved parking lots and other paved areas; special foundations; stationary wharves and docks; Fences; certain permanent lighting displays; permanent outdoor lighting; Railroad tracks and signals; Telephone poles; Power generation and transmission systems; fixed telecommunication cables; Microwave transmission cell, radio and electrical transmission towers; Oil and gas pipelines; Offshore drilling platforms; Drilling rigs, oil and gas storage facilities; and grain storage bins and silos.
Machines and devices can be considered real estate
Machinery and equipment are generally not considered to be inherently permanent structures and therefore are not generally classified as real estate for exchange purposes under Section 1031. However, if a building or other inherently permanent structure contains machinery or equipment as a structural component, the machinery or equipment is classified as real estate as long as it serves the inherently permanent structure and does not produce any income other than for the purpose of obtaining income or contributing to its use or occupancy of space. An example would be HVAC equipment and associated plumbing, plumbing, and wiring.
Personal property associated with real estate is considered real estate
Personal property is considered a side effect of real estate acquired in an exchange if: (1) the personal property in question is transferred in standard business transactions, typically along with the associated property, and (2) the total market value of the personal property is 15% of the do not exceed the total market value of the property. Personal property that passes these tests is classified as part of the associated property and therefore can be placed on a Section 1031 Deferred Stock Exchange. Examples of such personal property would appear to be backup generators, floors, carpets, window treatments, and the like.
What Biden's Tax Plan Would Do
The new proposal for a regulation under Section 1031 seems sensible to me. But like I said before, if you don't do your 1031 exchange before the privilege goes goodbye, they won't be of any use to you. This possible change in tax law could take effect as early as January 1st. If you haven't already done so, contact your tax advisor. Depending on how the November 3rd elections go, you may need to move forward quickly.