The IRS issued new guidelines in November 2020 affecting 1031 like-kind exchanges. Commenters on the proposed changes argued that continuing to impose the purpose-or-use test would improperly limit the types of real property that would qualify for a 1031 like-kind exchange. The IRS agreed. The purpose-or-use test was removed from the final regulations issued by the IRS. This means qualifying real, investment property will not be subject to a purpose-or-use test when determining its eligibility. The previously obligatory purpose-or-use test is no longer required. This makes it a lot easier for taxpayers to determine their properties eligibility for a 1031 like-kind exchange, as they no longer need to apply for this test.
Like-kind exchanges allow taxpayers to defer taxes when they sell investment property and purchase other like-kind real property. In 2017, the Tax Cuts and Jobs Acts limited like-kind exchanges to real property. This sale and purchase of investment real properties, a like-kind exchange, allows taxpayers to defer the tax on the profit from the sale of the real property.
Real property for like-kind exchanges is defined by the IRS to include land, land improvements made up of buildings, roads, and bridges, structural components like walls, doors, and wiring, unsevered crops and other natural products of land, and water and air space superjacent to the land. For example, a main Internet cable serving an office building would be considered a permanent improvement, but an Internet cable serving the office printers would be considered personal property.
The IRS when classifying real property defers to definitions determined by state and local governments as well. This means that if your state or local government determines that the property is defined as real property, the IRS will uphold that definition for your federal taxes too. For additional information on 1031 tax-deferred exchanges, see the article here.
Due to these changes, a like-kind exchange of personal property is now a taxable event. However, if the exchange of personal property is incidental to the exchange of the real property, the IRS determined the like-kind exchange will be valid. Internet cables and the printers, if they qualify, could be seen as incidental personal property in the sale of an office building, as it would be customary for them to be sold together.
Due to the changes under the Tax Cuts and Jobs Acts, a like-kind exchange of personal property is now taxable unless it is incidental to the like-kind exchange of the real property. The IRS determined that personal property would be considered incidental to the purchase of the real property if:
Example. Silvia sold her old office building and purchased a lot with another office building closer to downtown, which included office furniture. Calculating the fair market value of the office building with land and the fair market value of the office furniture, Silvia determined that the fair market value of the office furniture was 10% of the fair market value of the office building and land.
Since it is customary for office buildings to be sold with office furniture, the purchase of the office furniture would not invalidate Silvia's like-kind exchange, as it meets the first requirement above. Also, since the fair market value of the office furniture is below 15% of the fair market value of the building and land (real property) Silvia purchased, she would meet the requirements of number 2 above as well.
This means that Silvia’s like-kind exchange of real property will be maintained and valid including the cost of the office furniture. As long as Silvia’s sale and purchase of the investment properties meet the other requirements, she will be able to defer her taxes on the sale of her office building.
Executing a 1031 like-kind exchange takes some careful planning, but the payoff is worth the extra time to make sure you qualify for the tax-deferred exchange. In Silvia’s situation, if the office furniture had amounted to more than 15% of the fair market value of the office building, it would have invalidated her 1031 like-kind exchange. She would have gotten hit with a huge tax bill on the sale of her office building. However, with some careful planning, she could make sure the office furniture did not value at more than the 15% limit.
The benefits of understanding 1031 like-kind exchanges can amount to huge tax savings by deferring the taxes on the sale of investment properties. If you are considering selling and purchasing investment real property like buildings and land, schedule an appointment today with Ohio's accounting and tax preparation professionals at Gudorf Tax Group.