Like-kind exchanges and power plants
Like-kind exchanges are largely limited to swaps of land, buildings, transmission lines, gas pipelines and other “real property.”
Proposed regulations that the IRS issued in June dashed any hope that power plants would be considered “real property” for this purpose.
Any swap of one property for another normally triggers an income tax on gain. The gain is the difference between the value of the property received in the exchange and the “tax basis” that the owner had in the original property.
However, no tax is triggered if the swap qualifies as a “like-kind exchange.”
Congress limited the ability to claim a like-kind exchange to trades of “real property” in the Tax Cuts and Jobs Act in late 2017. The change applies to exchanges after 2017.
New proposed IRS regulations to implement the change define “real property” as “land and improvements to land, unsevered crops and other natural products of land, and water and air space superjacent to land.” Two pieces of real property are considered of like kind. Thus, timberland can be swapped for a mine without triggering a tax. The two properties do not have to be identical in use or value, but any cash received by one of the parties is taxed to the extent of gain.
Each distinct asset involved in the exchange must be separately analyzed for whether it is real property.
Improvements to land are real property if they are considered “inherently permanent” structures like buildings.
However, machinery is not real property, unless it is something like a heating or air conditioning system that is a structural component of a building. Even then it must heat or cool the building as opposed to serving as the power source to run machinery inside the building that is used to produce goods for sale.
The taxpayer cannot own just the machinery and not also have a legal interest in the physical space in the building served by the machinery, like ownership, a lease or other right to use the space.
The IRS chose to define “real property” for purposes of like-kind exchanges close to how it uses the term for REIT and FIRPTA purposes. REITs, or real estate investment trusts, must own at least 75% real property. FIRPTA, or the “Foreign Investment in Real Property Tax Act,” subjects foreign investors to US tax on their capital gains from investments in US real property.
Gas pipelines qualify as real property. Each part of the pipeline must be analyzed separately. Isolation valves, vents and pressure-control and relief valves qualify as structural components of the pipeline because they are specially designed for the pipeline and are embedded enough that they would cause damage and be time consuming and expensive to remove. For the same reason, meters that measure the gas carried by the pipeline are not real property. However, they may qualify as part of the like-kind exchange if they are considered incidental. Otherwise, any gain on them must be reported in the exchange.
The like-kind exchange rules are in section 1031 of the US tax code.
The taxpayer must recognize gain to the extent of any cash or non-like-kind property received in the exchange.
Like kind refers to the nature or character of the property and not its grade or quality. Thus, if two pieces of land are exchanged, it does not matter whether one of the sites is unimproved and the other is improved. However, the improvements must be analyzed separately for whether they are real property.
A taxpayer may count any number of properties as the replacement real property as long as they do not have an aggregate fair market value more than 200% of the value of the relinquished property. If they are more valuable than this, then the limit on number of replacement properties is three.
Personal property, like equipment or furniture, that is incidental to the real property is ignored if such items are typically transferred with the larger item of real property in standard commercial transactions. The equipment must not be worth more than 15% of the value of the larger item of real property.