Revised Like-Kind Exchange Rules
This article provides a quick review of the impact that the Tax Cuts and Jobs Act has had on like-kind exchanges. Beginning after December 31, 2017, like-kind exchange applies only to real property held for use in a trade, business or for investment. Real property held primarily for sale, like a housing developer, still doesn’t qualify. Of particular interest is the new definition of “real property.” Per the November 19, 2018 IRS notice (the “notice”), real property includes land and generally anything built on or attached to it. The notice also clearly states that an “exchange of personal or intangible property, such as machinery, equipment, vehicles, artwork, collectibles and patents, generally don’t qualify.” Furthermore, the notice clarifies that “certain exchanges of mutual ditch, reservoir or irrigation stock are still eligible.” If that stock is for Internal Revenue Code “IRC” Section 1255 property (see definition below) what does this mean to ranchers?
The change in the IRC Section 1031, Like-Kind Exchanges, regarding the exclusion of tangible property is actually a good thing for the most part. It makes the replacement of equipment like tractors, trailers, cars, etc. much easier. True, the gain must be recognized on the asset traded. However, with the ability now to elect to deduct the total value of the acquired asset, businesses have another tool to control their taxable income for the year to avoid the net operating loss penalty.
The Definition of Real Property
The change of adding “real” has created a new issue concerning the definition of real property in the context of the like-kind exchange rules under IRC Section 1031. The question is, does the English common law definition of real property apply? Per Wikipedia, real property is “land that is the property of some person and all structures (also called improvements and/or fixtures) integrated with or affixed to the land, including crops, buildings, machinery, wells, dams, ponds, mines, canals, and roads, among other things. The term is historic, arising from the now-discontinued form of action, which distinguished between real property disputes and personal property disputes. Personal property was, and continues to be, all property that is not real property.”
This English common law definition seems to be used in the Internal Revenue Service (the "IRS") and the Department of the Treasury ("Treasury") final regulations issued on August 31, 2016 which is clarifying the definition of "real property" for Real Estate Investment Trust ("REIT") purposes. Note these regulations specifically identify cell transmission towers, silos, oil and gas storage tanks, among others, as other inherently permanent structures as long as they are permanently affixed and therefore are considered real property for RIET. These are special purpose structures. The final regulations make clear that the list of qualifying assets contained in the regulations is not all-inclusive. Therefore, other assets such as bridges, culverts, special purpose structures and fencing, should qualify as other inherently permanent structures if they meet the facts and circumstances test described in these regulations. Hence, under REIT definition, when farm land is subject to a like-kind exchange under IRC section 1031 the bifurcated assets currently depreciated as tangible property maybe included in the deferral calculations if in fact they are “permanently affixed” to the land and therefore meet the definition of “real property.” This could also include growing crops like hay or blueberries.
However, the instructions for form 8824 states “If you disposed of section 1245, 1250, 1252, 1254, or 1255 property” (see the instructions for Part III of Form 4797), you may be required to recapture as ordinary income part or all of the realized gain.” Does one look at the definitions under IRC sections 1255, 1254, 1252, 1250, 1245 and those corresponding regulations?
Section 1245 property. This type of property includes tangible personal property, such as equipment, that is subject to depreciation, or intangible personal property that is subject to amortization.
Section 1250 property - depreciable real property, including leaseholds if they are subject to depreciation.
Section 1252 property, which is farmland held less than 10 years, on which soil, water, or land-clearing expenses were deducted
Section 1254 property, including intangible drilling and development costs, exploration costs, and costs for developing mining operations,
Section 1255 property, which is cost-sharing payment property for Agricultural Conservation Program and etc. as described in section 126 of the Internal Revenue Code
Therefore, all assets, other than land and non-special purpose agriculture buildings, included in real property exchanges should be separately identified. A detail review of assets included in an exchange should be done and bifurcated in the sells document. Items like wells, irrigation, fencing and special structures are just a few examples of items that should be itemized. Gain may no longer be deferred on that portion of a like-kind exchange of ranch property if further clarification is not forthcoming from the IRS. The instructions for form 8824 states “If you disposed of section 1245, 1250, 1252, 1254, or 1255 property” (see the instructions for Part III of Form 4797), you may be required to recapture as ordinary income part or all of the realized gain”. However, the aforementioned November 19, 2018 notice indicates many of those assets should be included in the like-kind exchange deferral. There is ambiguity among the 8824 form’s instructions and the published guidance at this point so caution is in order on exchanges.
Basics for Completing a Like-Kind Exchange
Once the proper determination is made as to what is included as qualified real estate and subject to deferral there are a number of other requirements to meet to secure the tax deferral. There are 7 primary 1031 Exchange rules. These include:
like-kind property, the property being sold and the property being acquired must be qualified real property
Real Estate must be held as investment or business purposes only, no personal residence or real estate in a foreign country
In order to completely avoid paying any taxes upon the sale of your property, the IRS requires the net market value and equity of the property purchased must be the same as, or greater than the property sold.
In order for the exchange to be completely tax-free avoid boot if possible. Any boot received is taxable to the extent of gain realized on the exchange.
The tax return, and name appearing on the title of the property being sold, must be the same as the tax return and title holder that buys the new property. However, an exception to this rule occurs in the case of a single member limited liability company (“smllc”) which is being ignored for tax reporting,
The property owner has 45 calendar days, post-closing sale of the first property, to identify up to three potential properties of like-kind to purchase.
The replacement property must be received and the transaction completed no later than 180 days after the sale of the exchanged property.
To report a like-kind exchange, file Form 8824 with your tax return for the year you transfer property as a like-kind exchange and the two years following the exchange
In many of these exchanges, business or investment property is disposed of through a qualified intermediary, and the proceeds are used to purchase replacement property of like-kind. This results in a deferral of all or most of the gain that otherwise would be subject to income tax on the disposed real property if the seven rules are followed. The replacement property has a carryover tax basis that is generally the value of the replacement property less the gain deferred in the exchange. Specifically, the basis of the replacement property is equal to:
Basis of the like-kind relinquished property
minus: Boot received
plus: Boot paid
plus: Gain recognized
minus: Loss recognized
equals: new basis
Gain (but not loss) is recognized only to the extent that the boot received exceeds the gain realized. A loss is recognized only if property given is not like-kind and the adjusted basis exceeds its FMV. Your tax advisor should be a resource to help you to get through the many complicated tax laws that surround the real estate like-kind exchange.
Other Tax Updates - Changes in Retirement Tax Law
The Setting Every Community Up for Retirement Enhancement Act, “The SECURE Act”, was signed into law on Friday, December 20. The SECURE Act made one of the biggest changes to retirement legislation since the Pension Protection Act of 2006. It addresses a wide variety of retirement planning topics. Effective on January 1, 2020, there are number of changes but there are a few key areas that may immediately affect your retirement plan. As usual some are good and some are bad:
Required Minimum Distributions (RMDs) Will Start at Age 72, Not Age 70½Starting January 1, 2020, you will need to start withdrawing money from your retirement accounts age 72 instead of 70½. However, if you turned age 70½ in 2019 (born prior to July 1, 1949), you will still need to take your RMD for 2019 no later than April 1, 2020. If you are currently receiving RMDs (or should be) because you are over age 70½, you must continue taking these RMDs. Only those who will turn 70½ (born on or after July 1, 1949) in 2020 or later may wait until age 72 to begin taking required distributions.
You Can Contribute to Your Traditional IRA After Age 70½. Beginning in the 2020 tax year, the new law will allow you to contribute to your traditional IRA in the year you turn 70½ and beyond, provided you have earned income. You still may not make 2019 (prior year) traditional IRA contributions if you are over 70½.
Upon death of the account owner, distributions to non-spouse individual beneficiaries must be made within 10 years. The current rules that allowed a non-spouse IRA beneficiary to "stretch" required minimum distributions (RMDs) from an inherited account over their own lifetime has been eliminated. The rule applies to inherited funds in a 401(k) account or other defined contribution plan as well. There are exceptions for spouses, disabled individuals, and individuals not more than 10 years younger than the account owner. Minor children who are beneficiaries of IRA accounts also have a special exception to the 10-year rule, but only until they reach the age of majority. If you’ve already inherited a stretch IRA, rest easy. The changes from the bill that close loopholes that allowed stretch IRAs applies to beneficiaries of someone who dies after the end of 2019.
The new law allows penalty-free withdrawals from retirement plans for birth or adoption expenses, up to $5,000 limit would apply to each parent, including those who have adopted children. So technically, a couple could take out up to $10,000 from their retirement savings, as long as they both have separate accounts in their own names.
Employers are now required to allow part-time employees who work at least 1,000 hours annually to contribute to their company’s 401(k) plan. You can also work 500 hours for three consecutive years and qualify for this provision.
The tax credit businesses get for starting a retirement plan is increased and the new law makes it easier for small businesses to join multiple-employer plans.
The newly enacted legislation removes roadblocks that made employers wary of including annuities in 401(k) plans by eliminating some of the fiduciary requirements used to vet companies and products before they can be included in a plan
Though there are many more aspects and provisions to the new law, we have highlighted some of the most pertinent. As always, your tax advisor should be a resource to help you to get through the new retirement rules.
Summary
This is a very high overview of some of the issues regarding like-kind exchanges. It is by no means all inclusive. The Tax Cuts and Jobs Act eliminated the ability to treat personal property trades under the exchange rules. There is some hope to avoid gains on items permanently attached to land. The question is the intent of Congress. Did they mean to only exclude the like-kind exchange of equipment like tractors, vehicles, manufacturing and similar equipment from deferral and not impact deferral from the sale of large office buildings, ranches and farms that encompass many individual assets that are permanently attached to the land? Under the REIT definition of real property, when farm land is subject to a like-kind exchange the assets currently depreciated as tangible property may be included in the tax deferral calculation if in fact they are “permanently affixed” to the land. However, the instruction for IRS Form 8824 indicates otherwise. We are still waiting for Regulations to clarify the definition of real property for Section 1031 exchanges. Until then, we just do not have a clear answer. What constitutes “real estate” is an important first determination. The nature and character of the properties involved in the transaction is the next determination. If those hurdles are successfully cleared, the exchange rules can provide a preferential tax result. Your tax advisor should be a resource to help you to get through the complicated tax laws that surround the real estate like-kind exchange. They also may help in understanding the new SECURE Act provisions.