Replacement Property Identification Issues Involving Incidental Property
If you are reading this article you are most likely already familiar with 1031 exchange transactions and the requirement to identify like-kind replacement property within a certain timeframe and pursuant to very specific identification rules in order to properly qualify for tax-deferred exchange treatment.
The proper and timely identification of your like-kind replacement property is crucial for a successful 1031 exchange, so you must be careful and accurate when completing your identification forms or instructions to your Qualified Intermediary.
The Department of the Treasury Regulations requires that the identification of potential like-kind replacement properties be made in writing, that the descriptions be unambiguous, and that the property that you ultimately acquire as part of your 1031 tax-deferred exchange be substantially the same property as the like-kind replacement properties identified.
Identifications that are ambiguous or unclear could result in an invalid identification of like-kind replacement property and the subsequent disallowance of your tax-deferred exchange on the disposition of your relinquished property.
The majority of 1031 exchange transactions involve the disposition (sale) and subsequent acquisition of like-kind real property. In many cases, the real estate to be acquired includes small amounts of personal property such as furniture, fixtures, and equipment referred to as incidental property.
Property is considered incidental property to a larger item of property if (a) it is typically transferred together with the larger item of property in standard commercial transactions, and (b) the aggregate fair market value of all incidental property does not exceed fifteen percent (15%) of the aggregate fair market value of the larger item of property.
Incidental property poses two distinct problems. The first problem is how do you draft your identification of like-kind replacement properties when your acquisition includes incidental property, and the second problem is what happens when you actually acquire your identified like-kind replacement properties when the incidental property is included in the purchase transaction?
Identification of Incidental Property
The identification process can pose certain challenges when you are identifying potential like-kind replacement properties that include incidental property. The Department of the Treasury Regulations provides us with examples of identifying incidental property. The issue that the Treasury Regulations address is whether incidental property would be considered one overall property or separate properties for identification purposes.
The Treasury Regulations make it clear that the incidental property will not be treated as separate properties for identification purposes and will not need to be specifically and separately identified if the property is incidental to a larger item of personal property or real property.
Example No. 1: For example, a tool kit and spare tire transferred with a truck valued at $10,000 will not be considered separate property, if the aggregate fair market value of the tool kit and spare tire does not exceed $1,500. A written description of the make, model, and year of the truck would seemingly comply with the identification requirements for the truck, tool kit, and spare tire. The truck, tool kit, and spare tire are considered one property for purposes of the 3-property identification rule.
Example No. 2: Laundry machines, furniture, and other miscellaneous items of personal property will not be treated as separate property from an apartment building with a fair market value of $1,000,000 if the aggregate fair market value of the personal property does not exceed $150,000 and the personal property is considered unambiguously described if the apartment building is described in accordance with the regulation and no separate identification of the personal property must be made.
Acquisition of Incidental Property
It is important to remember that only investment real property can be exchanged for other investment real property in order to be considered like-kind property and qualify for tax-deferred exchange treatment.
The fact that the Department of the Treasury Regulations allows us to ignore incidental property for identification purposes in your 1031 tax-deferred exchange does not mean that the incidental property is also ignored in the computation of any taxable gain.
Even though the incidental property is considered to be one overall property for identification purposes and a separate identification is not necessary, the multi-property 1031 exchange rules still apply in computing gain.
So, incidental personal property received in conjunction with the acquisition of your like-kind replacement property in a 1031 exchange will be taxable to the extent that your 1031 tax-deferred exchange funds are used to pay for the incidental personal property.
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