Broadly Define Real Property in Like-Kind Exchange Regs, Nareit Says

Aug. 6, 2020

Internal Revenue Service
Attn: CC:PA:LPD:PR
(REG–117589–18)
Room 5203
P.O. Box 7604
Ben Franklin Station
Washington, D.C. 20044

Re: Proposed Like-Kind Regulations Defining Real Property

Dear Sir or Madam:

Nareit¹ appreciates the opportunity to offer our comments to the Treasury Department (Treasury) and the Internal Revenue Service (IRS) with respect to the 2020 Proposed Regulations (REG-117589-18) concerning the definition of “real property” for purposes of section 1031² (the Proposed Regulations). This is an important topic for the real estate industry, and Nareit commends Treasury and the IRS for devoting the time and resources to this matter.

As amended by the law commonly referred to as the Tax Cuts and Jobs Act (the TCJA), section 1031(a) provides that no gain or loss is recognized on the exchange of real property held for productive use in a trade or business or for investment (relinquished real property) if the relinquished property is exchanged solely for real property of like kind that is to be held either for productive use in a trade or business or for investment (replacement real property). However, left unchanged under the TCJA, section 1031(b) provides that a taxpayer must recognize gain on the receipt of money and non-like-kind property in an exchange.

Executive Summary

a. Nareit is sympathetic to the stated concern that the definition of real property for purposes of section 1031 should not be identical to other definitions (including the one under section 856) because of the different policies underlying those sections of the Code.

b. Nareit supports a broad definition of real property for purposes of section 1031.

c. Nareit believes that, although the purpose and use of assets may appropriately be considered for purposes of section 856, the purpose and use of assets should not be an appropriate limitation in the context of section 1031 like-kind exchanges. Instead, assets should be treated as real property eligible for a like-kind exchange if the assets are inherently permanent (or a structural component of an asset that is inherently permanent) without regard to their purpose or use.

d. As a corollary to the foregoing, Nareit believes that machinery that is inherently permanent and transferred with land or a structure thereon also should be treated as real property without regard to its purpose or use.

e. Nareit understands why the IRS did not want state law to be considered in defining real property for purposes of section 1031, but there is substantial prior case law that has relied upon state law for this purpose. In light of Congress' stated intent that the scope of real property not be narrowed as a result of the TCJA, Nareit is concerned that the wholesale disregard of state law classification of property may cause the definition of real property in the Proposed Regulations, when finalized, to be subject to challenge on the grounds that they are inconsistent with Congress' stated intent in certain limited situations. To address this issue, Nareit recommends that the definition of real property be revised to include: 1) land; 2) inherently permanent structures; 3) any structural component of inherently permanent structures; and, 4) any asset that is treated as real property under applicable state law.

f. Nareit supports the special rules for incidental personal property in the Proposed Regulations, including the 15% limitation. Comments are provided concerning how to calculate the 15% limitation.

g. Finally, Nareit identified several points that require further clarification, including how the Proposed Regulations interact with the existing regulations under section 1031 regarding exchanges of multiple properties.

The Proposed Regulations

Prior to the TCJA, both real property and personal property could be eligible for like-kind exchange treatment under section 1031(a). As a result of the TCJA, like-kind exchanges now are limited to real property, which meant that there was additional significance to the definition of real property for purposes of section 1031. The legislative history to the TCJA provided that real property eligible for like-kind exchange treatment under pre-TCJA law should continue to be eligible for like-kind exchange treatment after the enactment of the TCJA.³

There are numerous other definitions provided for real property in regulations outside of section 1031. In particular, Treas. Reg. § 1.856-10 provides a definition of real property for purposes of the REIT provisions of the Code and there are many other provisions, such as the regulations under sections 168, 263 and 1250, that have significant impact on REITs and other real estate investors. The Proposed Regulations do not rely upon any of these other regulations.

Under the Proposed Regulations, real property includes land and improvements to land, unsevered crops and other natural products of land, and water and air space superjacent to land. Improvements to land include inherently permanent structures and the structural components of inherently permanent structures. The Proposed Regulations also provide that local law definitions generally are not controlling in determining the meaning of the term "real property" for purposes of section 1031.

The Proposed Regulations provide that each distinct asset must be analyzed separately from any other assets to which the asset relates to determine if the asset is real property, whether as land, an inherently permanent structure, or a structural component of an inherently permanent structure. The Proposed Regulations also provide a list of structures that qualify as inherently permanent structures. If an asset is not included in the list of inherently permanent structures, the Proposed Regulations provide factors that must be used to determine whether it is an inherently permanent structure for purposes of section 1031.

Under the Proposed Regulations, property that is in the nature of machinery or is essentially an item of machinery or equipment generally is not considered as an inherently permanent structure and not real property under section 1031. In the case, however, of a building or inherently permanent structure that includes property in the nature of machinery as a structural component, the machinery is real property if it serves the inherently permanent structure and does not produce or contribute to the production of income other than for the use or occupancy of space. Structural components of inherently permanent structures are improvements to land and thus real property for purposes of section 1031. A structural component is any distinct asset that is a constituent part of, and integrated into, an inherently permanent structure.

If interconnected assets work together to serve an inherently permanent structure (for example, systems that provide a building with electricity, heat, or water), the assets are analyzed together as one distinct asset component that may qualify as a structural component. For example, a gas line that provides fuel to a building's heating system comprises a part of the structural component that is the heating system, and therefore qualifies as real property for section 1031 purposes. Conversely, if the purpose of a gas line is to provide fuel to business equipment in a building, such as fryers and ovens in a building utilized as a restaurant, the gas line is not a constituent part of an inherently permanent structure and therefore not real property for section 1031 purposes.

The Proposed Regulations define real property only for purposes of section 1031. Consequently, the Proposed Regulations provide that no inference should be drawn from the section 1031 definition of real property for any purpose outside of section 1031, including for REIT purposes, for the classification of property for depreciation purposes, whether depreciation recapture applies, or for defining an asset for disposition purposes under section 168 and the regulations under section 168.

Discussion

Nareit's members are very accustomed to the importance of the definition of real property because of the requirements under section 856 that a REIT's assets consist primarily of interests in real property and its income consists primarily of rents from real property. Thus, Nareit's members spend a lot of time focused on the definition of real property under Treas. Reg. § 1.856-10.

However, Nareit also recognizes that the definition of real property for purposes of section 856 does not necessarily provide the appropriate framework for the definition of real property for purposes of section 1031. The definition in Treas. Reg. § 1.856-10 is focused on the real estate nature of a REIT's assets and income, whereas the scope of real property for purposes of the like-kind exchange rules historically has been much broader. Thus, although it would be more convenient for Nareit if the Proposed Regulations had adopted a definition of real property like that in the regulations under section 856, Nareit recognizes and agrees that such a definition would be inappropriate.

Nareit also believes that a very broad definition of real property for purposes of section 1031 would be most consistent with the legislative history of the TCJA, which stated that the revisions to section 1031 were not intended to narrow the scope of real property that qualified for a like-kind exchange. Indeed, as discussed below, one of Nareit's concerns about the Proposed Regulations is that, in some limited circumstances, the Proposed Regulations would not treat as real property assets that historically have been so treated for purposes of section 1031. Nareit would like to see the Proposed Regulations adopt a definition of real property that is as broad as permissible under the legislative history.

Section 1031 was intended to foster sales and other transfers of real property so as to prevent the “lock down” impact of taxation on assets; a continuing investment in real property without intervening tax consequences is helpful to the liquidity of the real estate markets. Since real estate inherently is an illiquid asset, the like-kind exchange rules in effect for almost 100 years have maintained a deferral mechanism analogous to the merger and acquisition rules for corporate mergers. Because real estate often is a major component of the wealth of both businesses and individuals, any limitation on like-kind exchanges of real estate necessarily would result in reduced liquidity in the real estate market. In this regard, Nareit prefers as broad of a definition of real property as possible to improve the liquidity of real estate markets, which is especially important during economic downturns such as the nation is now experiencing.

Thus, for a variety of reasons, Nareit believes that the definition of real property for purposes of section 1031 should be as broad as possible, and any reliance on the definition of real property under other provisions in the Code would not be appropriate. The Proposed Regulations adopt this approach.

Nareit also agrees that the definition of real property should include land and improvements to land, with improvements to land being defined as inherently permanent structures and the structural components of inherently permanent structures⁴. Thus, we agree, for example, that for purposes of section 1031, an office building is not limited to the land and four walls but also includes all of the structural components of the building, such as elevators, escalators, trash chutes, heating and cooling systems, etc. Nareit believes that all inherently permanent structures should be treated as real estate, without regard to the function of such structures. This determination should be a facts and circumstances test that takes into account the nature of structures and the components thereof to determine whether or not they are inherently permanent.

However, this conclusion is not consistent with the approach taken in the Proposed Regulations. Under the Proposed Regulations, each distinct asset must be considered to determine whether it is an inherently permanent structure (or a component thereof), but assets that could be moved in theory are not treated as inherently permanent. Similarly, the Proposed Regulations provide that property that is in the nature of machinery or is essentially an item of machinery or equipment is generally not an inherently permanent structure and not real property for purposes of section 1031 if such machinery or equipment is used in the production of income.

Nareit respectfully disagrees with this approach. We believe that if an asset is inherently permanent it should be treated as real property for purposes of section 1031 without regard to its purpose or use. Thus, for example, the cooling units and piping in a refrigerated warehouse are inherently permanent and should be treated as part of the real property, without regard to the fact that the cooling units and piping are part of an income-generating structure. Likewise, the Proposed Regulations specifically provide that a gas line used to provide heat within a building is treated as part of the real property, whereas a gas line used to provide gas to fryers in the building is not; we believe that both should be treated as part of the real property if they are inherently permanent parts of the structure. Another example is the wiring that is placed inside a trading floor to allow the user of the floor to operate its trading function; we believe that such wiring is an inherently permanent part of the structure and should be treated as real property. Similarly, all of the permanent electronic systems in a data center should be treated as part of the real estate, even if such systems theoretically could be removed because they are inherently part of that data center.

Following the same analysis, we agree with the conclusion in Example 3 in the Proposed Regulations concerning the Indoor Sculpture, but we do not agree with the conclusion in Example 5 because the printer was designed to remain in place indefinitely. We agree that the generator should be treated as real property, but we disagree with the reasoning that focuses on the purpose and use of the generator. We believe that the generator is inherently permanent and, therefore, should be treated as part of the real property. For the same reason, we disagree with the analysis and conclusion in Example 6.

On the other hand, we are sympathetic to the conclusion reached in Example 7 concerning the raised flooring, which, on the stated facts, is not an inherently permanent structure, although the conclusion is a close one because “flooring” is often treated as part of a building. The stated facts indicate that the raised flooring in this example was not specifically designed for this particular building, which would be consistent with the conclusion that the raised flooring is not part of an inherently permanent structure and not part of the building itself. In this regard, the raised flooring appears to be more like the Modular Partition System in Example 9, and it would therefore fall outside the scope of an inherently permanent structure. We believe that a clarification of Example 7 to reflect that the raised flooring is modular in nature would be helpful. However, if the raised flooring were custom designed for the building, we believe that it should be treated as real property because it would not be like a modular partition system.

Similarly, we also disagree with the conclusion in Example 8 concerning a steam turbine. The turbine is inherently permanent, and it will never be moved. The fact that the turbine is used to generate income should not result in characterization of the turbine as real property for purposes of section 1031; by the same token, a dam should be treated as real property, even if the dam holds back water that is used for the production of income. Nuclear reactors and containment vessels similarly are used for the production of income but are definitely real property if the test is properly focused on whether or not the asset is inherently permanent.

In this regard, Nareit also has considered whether the characterization of an asset for state law purposes should be relevant for purposes of applying section 1031. We are aware that there are numerous prior authorities in which state law was taken into account,⁵ and we are also aware that the legislative history to the TCJA states that the definition of real property under section 1031 as amended was not intended to be narrower than prior law.⁶ On the other hand, Nareit is sympathetic to the drafters' desire to avoid being bound by state law in all situations, e.g., the determination of whether the exchange of one multistate gas pipeline for another qualifies under section 1031 should not depend upon the state law classification of the pipeline from state to state.

Upon reflection, Nareit believes that the total disregard of state law is not consistent with prior authorities, nor is such approach consistent with our view that the Proposed Regulations should adopt a broad definition of real property in accordance with the legislative history of the TCJA. Instead, Nareit believes that the Proposed Regulations should adopt an approach under which any asset (other than land, which is per se real property) is treated as real property for purposes of section 1031 if the asset is: 1) an inherently permanent structure; 2) a structural component of an inherently permanent structure; or, 3) treated as real property under applicable state law.

Under this approach, even if an interstate gas pipeline were treated as personal property under the law of State A but real property under the law of State B, the pipeline would be treated as real property for purposes of section 1031 because it is inherently permanent. Likewise, if the machinery inside a power generating station in State C is treated as real property under state law in State C, such machinery would be treated as real property for purposes of section 1031 without regard to whether it is inherently permanent or a structural component of inherently permanent property. We also believe that any asset which is essentially the same as an asset treated as real property under the foregoing test should be treated as real property for purposes of a like-kind exchange transaction, because such assets certainly would be like-kind and one of the assets was real property (so that both should be treated as real property for purposes of section 1031).

The approach that Nareit has suggested would ensure compliance with the legislative history's directive that the definition of real property should not be narrowed because of the amendment of section 1031 in the TCJA. This approach would also avoid future litigation concerning whether regulations that disregard state law classification are invalid because prior authorities had taken state law into account and the TCJA did not override such authorities. Thus, Nareit believes that its proposed definition of real property would be more consistent with the purpose and Congressional intent of section 1031.

Nareit also agrees that the definition of real property in the Proposed Regulations should result in no inference whether an asset is treated as real property for purposes of other provisions of the Code, including but not limited to the determination whether an asset is real property for purposes of section 856 and for depreciation purposes.

Turning to the incidental personal property safe harbor provided in the Proposed Regulations, Nareit commends the inclusion of this rule. Nareit is comfortable with the 15% threshold provided for this safe harbor because it is similar to the 15% tests in sections 856(d)(1)(C) and 856(c)(9)(A)(ii) in determining a REIT's rents from real property and gain from the disposition of a real estate asset. We note that the REIT 15% tests include the personal property in the denominator of the test, whereas the Proposed Regulations' incidental personal property safe harbor does not, and it may be more convenient for the Proposed Regulations to be consistent with the REIT rules.

Furthermore, Nareit believes that it would be appropriate to add an example clarifying that this 15% safe harbor is not applied on a property-by-property basis but, rather, that 15% of either the relinquished properties or 15% of the replacement properties, taken collectively, can be incidental personal property. This approach is consistent with the treatment of the transfer or receipt of multiple properties by a taxpayer in a like-kind exchange; the determination whether the taxpayer has satisfied the requirements of section 1031(a), and the gain calculation under section 1031(b), are made by reference to all of the relinquished properties taken as a group and all of the replacement properties taken as a group.⁷ Nareit also suggests that the regulations clearly state that the receipt of personal property that falls within this exception could result in taxable gain because the personal property is not real property for purposes of the exchange, but only if the taxpayer does not acquire replacement real property of equal or greater value than its relinquished real property.

We also would like to draw your attention to several points that need further clarification: First, the regulations should clarify that the exchange group rules that applied under prior law will continue to be applicable for purposes of determining gain recognition with respect to any personal property or other boot received in an exchange. An example illustrating the application of the exchange group rules would be helpful.

The Proposed Regulations add Example 6, in which a taxpayer transfers real property with a fair market value of $1,100,000 (and an adjusted tax basis of $400,000) in exchange for replacement property that is an office building comprised of personal property (office furniture) with fair market value of $100,000 and real property with a fair market value of $1,000,000. The exchange group rules are not implicated in that example because the taxpayer is only relinquishing real property.

To provide certainty to the interaction between the Proposed Regulations and the exchange group rules, a second example with the following facts would be helpful. A taxpayer transfers an office building comprised of personal property (office furniture) with a fair market value of $100,000 and real property with a fair market value of $1,000,000 (and an adjusted tax basis of $400,000) in exchange for replacement property that is an office building comprised of personal property (office furniture) with fair market value of $140,000 and real property with a fair market value of $960,000. The new example would conclude that there are two exchange groups, one group for the real property exchange and a second group for the personal property exchange. The taxpayer recognizes gain of $40,000 under section 1031(b), which is the lesser of the realized gain on the disposition of the relinquished real property, $600,000, and the fair market value of the non-like-kind property the taxpayer acquired in the real property exchange, $40,000. The taxpayer also recognizes any gain or loss with respect to the taxable exchange of $100,000 of personal property for $100,000 of personal property.

The new example illustrates that, without the application of the exchange group rules, the taxpayer could be viewed as relinquishing $1,000,000 of real property for a pro rata portion of real and personal property (960/1,100th real property, or $872,727, and 140/1,100th personal property, or $127,273), the result of which is the taxpayer would recognize $127,273 of gain on the real property exchange, as well as any gain or loss with respect to the taxable exchange of $100,000 of personal property for $87,273 of real property and $12,727 of personal property.

Second, we suggest that the examples provided in the definition of "building" in the Proposed Regulations should be expanded to include sheds and carports.

Feel free to contact me at tedwards@nareit.com or (202) 739-9408; Catherine Barre, Nareit's Executive Vice President & General Counsel at cbarre@nareit.com or (202) 739-9422, or Dara Bernstein, Nareit's Senior Vice President & Tax Counsel at dbernstein@nareit.com or (202) 739-9446, if you would like to discuss these issues in greater detail.

Respectfully submitted,

Tony M. Edwards
Senior Executive Vice President
Nareit
Washington, DC

Cc:
The Honorable Michael J. Desmond
The Honorable David J. Kautter