By Márcia H. Yafuso Loeffelholz
January 29, 2024
In most sales of investment or business real estate property where there is a “gain” (i.e., income is made on the sale), tax must be paid on that gain at the time of the sale of the property. Internal Revenue Code (“I.R.C.”) § 1031 allows one to defer or postpone the payment of tax if the proceeds of the sale are used to purchase a “like-kind” replacement property, thereby “exchanging” the two properties.
The words “like-kind” refer to the nature or character of the property and not to its grade or quality. The Tax Cuts and Jobs Act enacted in 2017 significantly limited the scope of I.R.C. §1031. As of the date of this article, I.R.C. §1031 applies only to exchanges of real property held for productive use in trade or business or for investment. Accordingly, a primary or secondary residence is not considered “like-kind” and does not qualify for an I.R.C. §1031 exchange.
Despite this narrow application of I.R.C. §1031 to real property, it may come as a surprise to many buyers and sellers that federal regulations define “real property” more broadly beyond land and improvements of land. In fact, “real property” is defined to include certain natural products of the land; water and air space superjacent to land; certain intangible assets (such as leasehold interest with a remaining term of 30 years or more); options to acquire real property; easements; licenses; permits; or other similar rights solely for the use, enjoyment, or occupation of land, or an inherently permanent structure that is in the nature of a leasehold or easement.
The significant breadth of the definition given to “real property” for I.R.C. §1031 purposes was confirmed recently in IRS Private Letter Ruling 202335002, issued September 1, 2023. The IRS concluded that transferable development rights (“TDRs”), which in that instance allowed for greater floor area than would otherwise be permitted by zoning regulations, are of “like-kind” real property within the meaning of I.R.C. §1031. For developers, TDRs for density bonus (as was at issue in the referenced Private Letter Ruling) or for other variances of development restrictions can make certain real properties more attractive.
The determination of whether a particular property is or not a “real property” for purposes of I.R.C. §1031 tax deferred treatment is made case by case based on the specific facts and circumstances, including whether state law considers the rights being acquired (such as TDRs) to be real property. The examples of “real property” in this article are not exhaustive, but illustrative of less known opportunities that can be explored by buyers and sellers entertaining exchange transactions.
For assistance in evaluating whether a potential transaction may qualify for a I.R.C. §1031 like-kind exchange, please contact Márcia Loeffelholz at firstname.lastname@example.org.