Like-kind exchanges, also known as “1031 exchanges” due to the governing Internal Revenue Code section, remain an extremely valuable tax deferral tool. Over the past three years, the entire landscape of this code section has changed due to the passage of The Tax Cuts and Jobs Act of 2017 (TCJA) which limited like-kind exchanges to one property type: real property. Prior to the TCJA like-kind exchanges applied to both personal and real property used in a trade or business. Personal property exchanges included a wide array of assets such as machinery, equipment, vehicles, intellectual property, collectibles, franchise licenses, precious metals, livestock, etc…
Absent in the TCJA rule changes to code section 1031 was a thorough definition of “real property” and whether a like-kind exchange would fail if the exchange included personal property incidental to the receipt real of property. In response to these questions on November 23, 2020, the Treasury Department and IRS issued final regulations.
Definition of real property:
- Property is real property for purposes of section 1031 if, on the date, it is transferred in exchange, that property is classified as real property under the law of the State or local jurisdiction in which that property is located (State and local law test); or
- Specifically listed as real property in the final regulations (land and inherently permanent improvements to land such as a building or road); or
- Considered real property based on all the facts and circumstances
Incidental personal property:
Personal property is considered incidental to the real property and does not disqualify a like-kind exchange if acquired:
- Through a standard commercial transaction in which the personal property is typically transferred with the real property, and
- The aggregate fair market value of all the incidental property does not exceed 15% of the aggregate fair market value of the replacement real property
Notwithstanding the above updates, many rules remain unchanged. Taxpayers must still identify their replacement property within 45 days and complete the exchange within 180 days. All real estate in the United States, improved and unimproved, also remains like-kind to all other domestic real estate. Foreign real estate does not classify as like-kind to US real property. Also, if the taxpayer actually or constructively receives money or non-like-kind property for the relinquished property prior to the exchange, the transaction is a sale and will be considered a taxable exchange.
Prior to the sale of real property please contact your WG advisor to better understand the pros & cons of entering into a like-kind exchange.