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The COVID-19 pandemic has had a significant impact on the Los Angeles and Orange County real estate markets and portfolios. While the residential market continues to stay strong due to the limited housing supply, other real estate holdings, including commercial office, retail, and hospitality have been sharply impacted. According to the Los Angeles Business Journal, core office portfolios are down 5% – 10% from pre-COVID levels. The uncertainty about expected rent incomes due to the increasing popularity of remote workplaces is a driving change. As a result, many companies are looking to diversify their real estate portfolio and move to less risky investments. From a tax perspective, these businesses have relied on 1031 like-kind exchanges to defer capital gains tax on transactions for many years. Unfortunately, 1031s were changed with tax reform as now only real property is eligible, creating significant uncertainty for many. The good news is the IRS recently released proposed regulations defining real property, making it easier to leverage these exchanges. To help clients, prospects, and others, JLK Rosenberger has provided a summary of key details below.
Inherently Permanent Structures
The proposed regulations define an inherently permanent structure to include any building or other structure permanently affixed to real property and is expected to remain so for an indefinite period. A building is defined as any structure enclosing a space within its walls, covered by a roof, whose purpose is to provide shelter or housing, for working, office, parking, display, or sales space. Examples of these structures include apartments, motels, factories, office buildings, barns, enclosed transportation spaces, terminals, and stores. If the property is not included in the examples above, an asset may be deemed inherently permanent based on the manner it is affixed to real property, whether it is designed to be removed or remain in place, damage the removal would cause, and the time and expense it would take to move it.
It is important to note that the proposed regulations assert that any machinery or equipment is considered inherently permanent and not real property for purposes of a 1031 exchange. The only exception is when the machinery serves the inherently permanent structure and does not produce income other than for the use of occupancy of space.
Natural Unsevered Land Products
The proposed regulations clarify that unsevered natural land products generally should be treated as real property for 1031 exchange purposes. Examples provided include growing crops, plants, timber, mines, wells, and other natural deposits. It is important to note that natural products and deposits stop being considered real property when they are severed, extracted, or removed from the land.
Intangible Property Exceptions
There is also guidance about when intangible property is considered real property for 1031 exchange purposes. An intangible asset is considered real property to the extent it derives value from the real property, is inseparable from it, and does not produce income other than for the use or occupancy of space. For example, a license that is specifically for the use or occupation of an inherently permanent structure and is in the nature of the leasehold easement is considered real property.
Incidental Personal Property
After the tax reform changes, there was concern that the acquisition of incidental personal property, as replacement property, would cause the transaction to fail if the taxpayer were relying on the qualified intermediary safe harbor. The proposed regulations assuage this fear by stating the receipt of such property alone will not cause the taxpayer to lose 1031 benefits. Personal property is incidental to real property when, as part of a standard commercial agreement, it is transferred together with the real property, and the total fair market value of such property does not exceed 15% of the same value of the replacement real property.
A taxpayer is permitted to rely on the proposed regulations for an exchange completed after December 31, 2017, assuming the regulations are implemented uniformly.
As Los Angeles and Orange County real estate companies diversify their portfolio, it is imperative to re-examine 1031 exchanges to determine its tax-saving potential. Given the complexity of these exchanges, it is essential to consult with a qualified advisor to guide you through the process. If you have questions on the information outlined above or need assistance with transactional tax planning, JLK Rosenberger can help. For additional information, call us at 949-860-9902 or click here to contact us. We look forward to speaking with you soon.