Things to ponder when considering a land sale
If your company wants to sell real estate and then reinvest those proceeds into other real estate, there are tax implications to consider.
As a result of the Tax Cuts and Jobs Act (TCJA) enacted in 2017, trading similar personal property for other personal property is now considered a taxable event. Before the TCJA, 1031 exchanges applied to more than just real estate. In response to this change, taxpayers had numerous questions about the definition of “real estate,” including whether a similar exchange would fail if personal property happened to be received.
Under Section 1031 of the United States Internal Revenue Code (26 USC § 1031), a taxpayer is eligible to defer recognition of capital gains and related federal income tax obligations when exchanging certain types of real estate.
This is a process known as a 1031 exchange. However, it is extremely important to note that the profit is not eliminated – it is only deferred. Under the regulations established by the Ministry of Finance, real estate includes land and land improvements, crops and other natural products of land, water, etc. The definition of real estate also includes all permanent structures such as buildings, roads and bridges. Immovable property, such as a structural part of an inherently permanent structure (i.e. walls, doors, and wiring) also falls under Section 1031. The regulations list structures that qualify as immovable property, as well as factors to be used to determine whether the immovable estate is considered an inherently permanent structure.
Remark: Even if a real estate is not listed in the proposed regulations, it can still be considered real estate based on all the facts and circumstances. Certain fixed assets often accompany real estate and must be analyzed to determine whether they are part of the real estate. In general, machinery or equipment is not inherently known as a permanent structure. As a result, it is not real estate unless it serves an inherently permanent structure and does not generate income or contribute to production other than for the use or occupation of the space. In comparison, some structural components may be personal property rather than real estate for the same reason.
Business owners can perform a functional test on these structural components to determine if they serve an inherently permanent structure. For example, it could be argued that under Treasury regulations, a natural gas pipeline to a furnace can be real estate, but a comparable gas pipeline to a deep fryer and furnace cannot.
This also raises the question of incidental personal property. If a taxpayer also receives office furnishings in addition to an office building, does that make the exchange of Article 1031 invalid? Based on the Ministry of Finance and its regulations, the answer would be no. Personal property can be considered ancillary to the acquisition of real estate when a personal property is usually transferred together with an acquired real estate and the fair market value of the personal property does not exceed 15% of the fair market value of the real estate. However, the gain will have to be recognized as being equal to the lesser of the realized gain on the ceded property or the fair market value of the personal property acquired.
Briefly: As long as a taxpayer sells a relinquished investment property and subsequently purchases a replacement investment property within the applicable term, the transfer is often valid in the eyes of the tax authorities.
Roman Basi is a lawyer and CPA at Basi, Basi & Associates at the Center for Financial, Legal & Tax Planning. He co-authored the article with associate attorney Michael Hampleman.