A significant change to Sec. 1031 made by the Tax Cuts and Job Act (TCJA) is impacting like-kind exchange transactions.
Prior to the TCJA, both real property and personal property were eligible for like-kind exchange treatment. However, the TCJA has restricted the tax-deferral benefits of Sec. 1031 to only real property.
But what is the definition of real property versus personal property for purposes of Sec. 1031? And how does the definition impact the need to allocate sales price between personal property and real property? What is the potential benefit of cost segregation or 179D study?
Sometimes personal property for depreciation purposes is clearly also personal property for Sec. 1031 purposes.
For example, the sale of an apartment building often includes appliances. In that case, the sales documents should break out the portion of the sales price that is attributable to those appliances. The appliances are personal property for depreciation purposes and for Sec. 1031 purposes.
The same is true in the case of a hotel sale. The furniture, TVs and bedding are personal property for both depreciation and Sec. 1031 purposes and will necessitate a bifurcation of the sales price.
However, sometimes personal property for depreciation purposes is not considered personal property for Sec. 1031 purposes. For purposes of like-kind exchanges, the courts (but not the IRS) have previously held the definition of real property under state lawapplies, not the income tax rules for property depreciation computations.
Under state law, the way property is classified for tax depreciation purposes is irrelevant. As such, fixtures identified as personal property under cost segregation and therefore depreciable using shorter tax lives (e.g., wall coverings, carpeting, and special purpose wiring affixed to the building) are still considered real property under state law. As such, they remain eligible for like-kind exchange treatment.
The same is true for land improvements, such as parking lots and sidewalks.
Although the TCJA removed personal property from qualifying for Section 1031, footnote 726 of the Committee Report states, “It is intended that real property eligible for like-kind exchange treatment under present law will continue to be eligible for like-kind exchange treatment under the provision.”
Given this footnote, we believe Congress intended the treatment of fixtures as real property under pre-TCJA law to continue to apply.
Therefore, there are two takeaways:
- It is important to bifurcate the sales price of property between real and personal if either the buyer or the seller is engaging in a like-kind exchange.
- Cost segregation and Sec. 179D studies are still beneficial for both the relinquished property and the replacement property and should have little to no detrimental impact on the tax deferral benefits of the like-kind exchange.
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