Follow-up Reg Comment Focuses on Incidental Personal Property Rule

July 18, 2020

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

Dear Internal Revenue Service:

I wish to submit an additional comment regarding a proposed rulemaking. I previously submitted comments on June 19, 2020, and now wish to address a different issue.

On June 12, 2020, proposed regulations (REG-117589-18) were published in the Federal Register (85 F.R. 35835-35846) concerning the definition of real property for purposes of a like kind exchange under section 1031 of the Internal Revenue Code.

My only comment addresses the 15 percent “incidental personal property” rule of Prop. Reg. §1.1031(k)-1(g)(7)(iii). I believe that if this rule is satisfied, then the personal property included in the larger item of real property should not be treated as separate from the real property for all purposes of IRC §1031.

Background

Section 13303 of the Tax Cuts and Jobs Act (P.L. 115-97), commonly referred to as the “TCJA,” amended IRC §1031 for like kind exchanges completed after December 31, 2017, by limiting its application to real property that is not held primarily for sale. One of the major changes is that exchanges of property involving personal property are no longer considered like kind exchanges. For example, a business vehicle that is traded in on the acquisition of new business vehicle is a taxable exchange after 2017.

Several practitioners have questioned how this affects the exchange of real property where there is also personal property included in the real property exchanged. For example, if a taxpayer exchanges a commercial property (land, building and personal property) for another commercial property (land, building and personal property), must the taxpayer recognize gain attributable to disposition of the personal property because the personal property in both the relinquished and replacement properties is not eligible for IRC §1031 treatment?

The IRS has proposed a 15 percent “incidental personal property” rule. See Prop. Reg. §1.1031(k)-1(g)(7)(iii). Under this rule, personal property that is incidental to real property acquired in an exchange will be disregarded in determining whether a taxpayer's rights to receive, pledge, borrow or otherwise obtain the benefits of money or other property held by a qualified intermediary. Personal property will be treated as incidental to real property acquired in an exchange if, in a standard commercial transaction, the personal property is typically transferred together with the real property, and the aggregate fair market value of the personal property transferred with the real property does not exceed 15 percent of the aggregate fair market value of the replacement real property.

However, this rule only applies in determining whether a taxpayer's rights to receive, pledge, borrow or otherwise obtain the benefits of money or other property held by a qualified intermediary. In other words, this rule only applies to the safe harbors of Treas. Reg. §1.1031(k)-1(g) and doesn't address the real problem in these transactions. Under Example 6 at Prop. Reg. §1.1031(k)-1(g)(8), the personal property still results in gain on the exchange:

(vi) Example 6. (A) In 2020, B transfers to C real property with a fair market value of $1,100,000 and an adjusted basis of $400,000. B's replacement property is an office building and, as a part of the exchange, B also will acquire certain office furniture in the building that is not real property, which is industry practice in a transaction of this type. The fair market value of the real property B will acquire is $1,000,000 and the fair market value of the personal property is $100,000.

(B) In a standard commercial transaction, the buyer of an office building typically also acquires some or all of the office furniture in the building. The fair market value of the personal property B will acquire does not exceed 15 percent of the fair market value of the office building B will acquire. Accordingly, under paragraph (g)(7)(iii) of this section, the personal property is incidental to the real property in the exchange and is disregarded in determining whether the taxpayer's rights to receive, pledge, borrow or otherwise obtain the benefits of money or other property are expressly limited as provided in paragraph (g)(6) of this section. Upon the receipt of the personal property, B recognizes gain of $100,000 under section 1031(b), the lesser of the realized gain on the disposition of the relinquished property, $700,000, and the fair market value of the non-like-kind property B acquired in the exchange, $100,000.

Under this example, even though the personal property received in the exchange did not exceed 15 percent of the fair market value of the replacement real property ($100,000 divided by $1,00,000 equals 10 percent) and was treated as “incidental,” the $100,000 is considered non-like-kind property received in the exchange, resulting in $100,000 of recognized gain.

Thus, the 15 percent “incidental personal property” rule is completely ineffective. It accomplishes nothing.

The 15 percent “incidental personal property” rule should treat incidental personal property as part of the larger item of real property

The preamble to the proposed regulations states that the “incidental personal property” rule was based on the existing rule in Treas. Reg. §1.1031(k)-1(c)(5): Here is that rule:

(5) Incidental property disregarded. — (i) Solely for purposes of applying this paragraph (c), property that is incidental to a larger item of property is not treated as property that is separate from the larger item of property. Property is incidental to a larger item of property if — 

(A) In standard commercial transactions, the property is typically transferred together with the larger item of property, and

(B) The aggregate fair market value of all of the incidental property does not exceed 15 percent of the aggregate fair market value of the larger item of property.

(ii) This paragraph (c)(5) may be illustrated by the following examples.

Example 1. For purposes of paragraph (c) of this section, a spare tire and tool kit will not be treated as separate property from a truck with a fair market value of $10,000, if the aggregate fair market value of the spare tire and tool kit does not exceed $1,500. For purposes of the 3-property rule, the truck, spare tire, and tool kit are treated as 1 property. Moreover, for purposes of paragraph (c)(3) of this section (relating to the description of replacement property), the truck, spare tire, and tool kit are all considered to be unambiguously described if the make, model, and year of the truck are specified, even if no reference is made to the spare tire and tool kit.

Example 2. For purposes of paragraph (c) of this section, furniture, laundry machines, and other miscellaneous items of personal property will not be treated as separate property from an apartment building with a fair market value of $1,000,000, if the aggregate fair market value of the furniture, laundry machines, and other personal property does not exceed $150,000. For purposes of the 3-property rule, the apartment building, furniture, laundry machines, and other personal property are treated as 1 property. Moreover, for purposes of paragraph (c)(3) of this section (relating to the description of replacement property), the apartment building, furniture, laundry machines, and other personal property are all considered to be unambiguously described if the legal description, street address, or distinguishable name of the apartment building is specified, even if no reference is made to the furniture, laundry machines, and other personal property.

Treas. Reg. §1.1031(k)-1(c)(5) illustrates that in a standard commercial transaction, if property typically transferred together with a larger item of property does not exceed 15 percent of the fair market value of the larger item of property, then it may be disregarded for purposes of the 45-day identification requirement.

Accordingly, the 15 percent “incidental personal property” rule in the proposed regulations should treat incidental personal property as part of the larger item of the real property for all purposes of IRC §1031. Example 6 at Prop. Reg. §1.1031(k)-1(g)(8) should be removed.

The rule should apply to both the relinquished property and the replacement property. If 15 percent or less of the fair market value of the real property relinquished in the exchange is personal property, then it may be disregarded and treated as the real property. Similarly, if 15 percent or less of the fair market value of the real property received in the exchange is personal property, then it may be disregarded and treated as the real property.

§1.1031(a)-3(a)(7) Should Be Added to the Proposed Regulations

To address the incidental personal property, the IRS should add paragraph (7) to Prop. Reg. §1.1031(a)-3(a), and the language should be based on Treas. Reg. §1.1031(k)-1(c)(5). Here is proposed language for Prop. Reg. §1.1031(a)-3)(a)(7):

(7) Incidental personal property disregarded. — (i) Solely for purposes of applying this paragraph (a), personal property that is incidental to a larger item of real property is not treated as property that is separate from the larger item of real property. Personal property is incidental to a larger item of real property if — 

(A) In standard commercial transactions, the personal property is typically transferred together with the larger item of real property, and

(B) The aggregate fair market value of all of the incidental personal property does not exceed 15 percent of the aggregate fair market value of the larger item of real property.

(ii) This paragraph (a)(7) applies to both the property relinquished in the exchange and the replacement property received in the exchange.

(iii) This paragraph (a)(7) may be illustrated by the following examples.

Example 1. For purposes of paragraph (a) of this section, furniture, laundry machines, and other miscellaneous items of personal property will not be treated as separate property from an apartment building with a fair market value of $1,000,000 if the aggregate fair market value of the furniture, laundry machines, and other personal property does not exceed $150,000. For purposes of paragraph (a) of this section, the apartment building, furniture, laundry machines, and other personal property are treated as 1 real property.

Example 2. (A) In 2020, B transfers to C an office building with a fair market value of $1,100,000 and an adjusted basis of $400,000. The $1,100,000 fair market value includes personal property with a fair market value of $25,000.

(B) In the exchange, B receives an office building as replacement property. As a part of the exchange, B also will acquire certain office furniture in the building that is not real property, which is industry practice in a transaction of this type. The fair market value of the office building is $1,000,000 and the fair market value of the personal property is $100,000.

(C) The fair market value of the personal property in the office building that B transfers ($25,000) does not exceed 15 percent of the fair market value of the office building that B transfers ($1,075,000). Also, the fair market value of the personal property in the office building that B receives ($100,000) does not exceed 15 percent of the fair market value of the office building that B receives in the exchange ($1,000,000). Accordingly, under paragraph (a)(7) of this section, the personal property is incidental to the real property in the exchange and is not treated as property that is separate from the larger item of real property.

Thank you for the opportunity to submit this comment.

Sincerely yours,

David M. Fogel, CPA
Roseville, CA