Qualified Intermediary Raises 2 Issues With Like-Kind Exchange Regs

August 11, 2020

Internal Revenue Service
Comments and Requests for a Public Hearing Section
Via Federal eRulemaking Portal
https://www.regulations.gov

RE: IRS and REG-117589-18

Ladies and Gentlemen:

The following comments are respectfully submitted in response to 85 FR 35835-01, 2020 WL 3100975(F.R.), Proposed Rules Department of the Treasury, Internal Revenue Service, 26 CFR Part 1, REG-117589-18, RIN 1545-BP02: “Statutory Limitations on Like-Kind Exchanges,” issued on Friday, June 12, 2020.

I serve as Chief Counsel to Madison Exchange, L.L.C. (“Madison Exchange”). Madison Exchange is in the business of accommodating IRC § 1031 like-kind exchanges of real property as a qualified intermediary. Through subsidiaries, we also provide exchange accommodation titleholder services pursuant to Rev. Proc. 2000-37. I have served in this capacity since 2003.

In general, I support the new proposed regulations. It is helpful to move toward a uniform federal definition of what constitutes real property for purposes of IRC § 1031. That move is now made urgent by the Tax Cuts and Jobs Act of 2017 (“TCJA”). However, I have a few specific comments and suggestions.

First, I believe that the approach of the proposed regulations in their treatment of machinery and fixtures that serve machinery should be modified.

In the absence of a federal definition of IRC § 1031 real property, the IRS and the courts have long relied on state law definitions. For example, in Rev. Rul. 55-749, 1955-2 C.B. 295, the IRS held that, “Where under applicable state law, [Emphasis is mine.] water rights are considered real property rights, the exchange of perpetual water rights for a fee interest in land constitutes a nontaxable exchange of property of like kind within the meaning of section 1031(a) of the Internal Revenue Code of 1954 . . .” See also PLR 8810034 (a California coop conversion), PLR 200137032, (a New York coop conversion) and PLR 200631012 (a New York coop exchange for real property). Each of these coop rulings explicitly relies on state law to determine that coop interests constitute real property.

In Oregon Lumber Company v. C.I.R., 20 T.C. 192 (U.S. Tax Court, 1977), the U.S. Tax Court relied on Oregon case law to determine that Oregon followed a minority rule concerning treatment of unsevered timber as personal property, and not real property. In Wiechens v U.S., 228 F. Supp. 2d 108 (U.S.D.C., Ariz., 2002), the US District Court looked to Arizona state law to determine that perpetual water rights are real property rights, although it found that the plaintiff's particular water rights derived from a subcontract and did not constitute a real property right under Arizona law.

Therefore, except where there has been clear federal authority to the contrary, taxpayers and tax practitioners have long relied on broadly accepted state law definitions of what constitutes real property.

Under common law and under the overwhelming majority of state law, there is a class of property that can be roughly described as being “trade fixtures.” Those are items that are semi-permanently affixed to real property and that perform functions (such as manufacturing, cooking, decorative lighting, etc.) that go beyond basic building functions or that support those special functions (such as special purpose electrical lines and plumbing). The proposed regulations go to some length to exclude trade fixtures from being treated as real property. I believe that should be re-examined for a few reasons.

First, as I mentioned, trade fixtures have always been treated as real property for state law purposes, except in the case where someone plans to remove and to relocate them. Ownership of those fixtures is commonly transferred along with the real property to which they are attached. Their value is used to determine the value of the real property to which they are attached for real property tax assessments. Most taxpayers (at least in my experience) tend to depreciate trade fixtures along with the value of the building that they are attached to, rather than paying for a cost segregation study and risking having to pay IRC § 1245 recapture when the property is sold. This is all consistent with the general treatment of trade fixtures as part of real estate.

Second, treating trade fixtures as personal property injects substantial complications, costs and doubt into many common real estate transactions, such as restaurants, factories, hotels, nursing homes and medical facilities.

Third, much of the harm that this change will cause cannot be assessed now, when there is 100% bonus depreciation of trade fixtures. Much of what the taxpayer looses on the sale of its relinquished property is likely to be made up when it buys replacement property. However, that will not always be the case. There is likely to be an appreciable chilling effect on many transactions that are currently treated as simple exchanges of like-kind property.

Fourth, it seems inappropriate to me to treat walk-in refrigeration units, commercial ovens, electric power generation equipment and similar items in a manner that is different from cell towers and oil pipelines.

I would suggest that trade fixtures should continue to be treated as real property for IRC § 1031 purposes, so long as there is no intention of removing those fixtures from the property to which they are attached.

There is a second aspect of the proposed regulations that I would like to comment on. That is the proposed 15% limit on incidental property in Treas. Reg. 1.1031(k)-1(g)(7). For most purposes, this seems to me to be fair and appropriate. There is one specific case that I have found where I believe that different treatment would be appropriate. In many real estate transactions, buyers, sellers, title insurers, mortgage lenders or other tenants in common may require taxpayers to pay substantial amounts of money into escrow for capital improvements, operating reserves, interest escrows, insurance escrows, etc. Taxpayers with 1031 exchanges are, unfortunately, often caught by surprise by these substantial escrows. To me, it seems bad enough that the money that they put into escrow constitutes taxable “boot.” This new proposed regulation, however, could threaten the validity of the taxpayer's entire exchange. That is especially likely to be true when there is also significant physical incidental property and intangibles that are also part of the transaction. A nursing home with its substantial personal property assets and certificate of need is a good example of a property that is likely to present issues if escrows push the incidental property limit over 15%.

I would suggest that escrows required by other parties to a real estate transaction, including buyers, sellers, title insurers, mortgage lenders and other tenants in common should be excluded from the 15% incidental property limit. Perhaps this can be accomplished by expressly including closing escrows as “transactional items” under Treas. Reg. 1.1031(k)-1(g)(7)(ii) and by excluding escrows from the definition of “personal property that is incidental to real property” under Treas. Reg. 1.1031(k)-1(g)(7)(iii).

Respectfully submitted,

Lee David Medinets, Esq.
Chief Counsel, Madison Exchange, L.L.C.
MADISON 1031
Lakewood, NJ