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The COVID-19 pandemic has significantly changed the way many companies do business. While some have been forced to downsize or change operations as a result of government orders, others have transitioned to a remote work environment. These changes have created a strained commercial real estate market in Los Angeles with a drop in retail occupancy and an office occupancy reduction by 2.7M square feet. This reality led many to look for industrial and multi-family real estate opportunities while moving away from retail, hotels, and other underperforming areas. A key challenge during diversification is how to manage the related tax implications of a sale. For years industry companies have relied on 1031 like-kind exchanges, but the Tax Cuts and Jobs Act limited the saving potential.
New restrictions were added that limited exchanges to include only real property, creating confusion because the definition was different depending on which section of the tax code was referenced. This resulted in many abandoning like-kind exchanges as a tax savings tool in favor of Qualified Opportunity Zone investments, among other tactics. To provide needed guidance, the IRS issued proposed regulations in June, and then final regulations in November. To help clients, prospects, and others, JLK Rosenberger has summarized the key details below.
Final Regulations for 1031 Exchanges
The final regulations retain many familiar elements of an exchange. For example, two pieces of property do not have to be completely alike to qualify for an exchange, and they both must be located in the U.S. Finally, exchanges must still follow the same rules regarding timelines. This includes the requirement that a replacement property must be identified within 45 days, and the new property must close within 180 days of the original closing date.
What changed? The final regulations now offer a clear and concise definition, with examples, of what constitutes real property. The property eligible for like-kind exchanges falls into six main categories, which includes the following;
- Includes water and air space superjacent to the land.
- Inherently Permanent Structures
- Includes a building, house, apartment, hotel, warehouse or barn, parking garage, pool, fence, outdoor lighting, and oil and gas pipeline, among other permanent structures.
- Structural Components (also a type of improvement to land)
- Defined as a distinct asset that is part of an integral to an inherently permanent structure. Only qualifies as real property if it cannot be separated from the physical space of the permanent structure. Includes walls, doors, floors, ceilings, wiring, plumbing, central air or heating, pipes or ducts, elevators or escalators, insulation, fire escapes, security systems, and more. This type of property can also include certain machinery.
- Unsevered Crops
- Includes crops, plants, timber, mines, wells, and other natural deposits. This type of property no longer meets the real property qualification if it is removed or otherwise severed from the land.
- Certain Intangible Property
- Includes some licensing agreements. To qualify, the intangible property cannot contribute to income other than to grant ownership of a space. Includes fee ownership or co-ownership, a leasehold, option to acquire real property, easement, or other similar interest. Copyrights, patents, and franchise licenses are examples of intangible property that do not qualify for 1031 exchanges.
Real estate investors can determine if a structural component qualifies for 1031 by evaluating the asset against the following factors:
- Whether it is designed to be removed or to stay in place
- How the asset is affixed to the property
- How much damage would be caused to the property or the asset if the asset were removed
- Any circumstances that may suggest the time period for the attached asset is limited
- Time and expense required to move the asset
The final regulations provide important insights into what property actually qualifies for a 1031 like-kind exchange. Although it is more limited than in previous years, a 1031 offers a compelling tax deferral opportunity that should not be dismissed. If you have questions about the information outlined above or need assistance with a tax or accounting issue, 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.