Section 1031 in the aftermath of the Tax Cuts and Jobs Act.
By Phil Jelsma
The first major tax reform bill enacted since 1986, the Tax Cut and Jobs Act (also known as the "Act") — effective Jan, 1, 2018 — is comprehensive and far reaching, with many provisions directly and indirectly impacting the commercial real estate industry.
Of special interest to the industry, the Act repealed Section 1031 like-kind exchanges for personal and intangible property, which means gain from the sale of personal property such as furniture, fixtures, and equipment will be fully taxable. It left in place the rules for real estate exchanges, such as the 45-day identification period, 180-day exchange period, and the general definition that all real estate in the United States is like-kind to all other real estate in the United States. In many respects, the real estate industry was spared from the issues that impacted auto dealers on trade-ins and sports teams on player trades.
Code Section 1031 provides that gain or loss is not recognized when property used in a trade or business, or held for investment, is exchanged for like-kind property held for use in a trade or business or for investment. Prior to 2018, Section 1031 applied to real property, personal property, and intangible property, although each type had its own definition of "like-kind." For real property, all real property in the United States is like-kind to all other real property in the United States. For personal property, like-kind means generally that the property must be like-kind or in the same depreciation class. For intangible property, the IRS looks at the nature or character of the rights involved, like a patent or copyright, and the nature or character of the underlying property to which the intangible property relates.
Under the Act, Personal property assets, such as aircraft, livestock, autos, trucks, businesses, franchises, machinery and equipment, boats, art, and collectibles may no longer be exchanged tax-free under Section 1031. In addition, patents, trademarks, FCC licenses, broadband spectrum, and other intangibles are also fully taxable. You would think that this would have a major impact on consumers of capital goods — but it has not. Exchanges are still happening at a brisk pace. The reason lies in bonus depreciation.
The cost of tangible personal property used in a trade or business — new or used — acquired after Sept. 27, 2017, can be expensed in the year placed in service. For example, assume a taxpayer exchanges land and a building with a value of $10 million for personal property with a value of $1 million and a zero-tax basis for a second building with an identical amount of personal property. Although the exchange of land and building for a building will be tax-free under Code Section 1031, the exchange of personal property of $1 million for other personal property worth $1 million will result in a $1 million gain. It is likely most of the gain will be taxed as depreciation recapture, i.e., taxed as ordinary income. However, the taxpayer will have a cost basis in the new personal property of $1 million, which can be expensed in the year of service. As a result, these will be a $1 million deduction to offset the $1 million gain. As a result, due to personal property, the effect of the new Section 1031 rules has been negligible, making exchanges still very popular.
How long will this work? Not long, because the full expensing of assets expires in 2022. Thereafter, bonus depreciation will be reduced to 80 percent in 2023, 60 percent in 2024, 40 percent in 2025, and 20 percent in 2026. The effects of these changes, under this real pain of repealing Section 1031 for personal property, will be felt beginning in 2023.
Perhaps the good news is that California has not adopted either the limitations on exchanges of personal or intangible property or the bonus, deprecation rules. As a result, for California tax purposes, an exchange of personal property or intangible property for like-kind personal property or intangible property is still tax-free.
In general, real estate businesses appear to fare better than other industry groups under the Act. In some respects, both the repeal of Section 1031 and the new rules on carried interests can be managed. Under some of the provisions, especially those impacting 1031 exchanges, the potential limitations on interest and net operating losses will definitely limit the ability of these enterprises to operate in a business-as-usual fashion.
Phil Jelsma is a partner and chair of the tax practice team at Crosbie Gliner Schiffman Southard & Swanson LLP, a San Diego–based commercial real estate law firm with offices in Los Angeles. He is a veteran attorney who is recognized as a leading joint-venture and tax attorney with a 30-year background in real estate exchange transactions, syndications, nonprofit corporations, and international tax planning.