In December 2020, the US Internal Revenue Service (IRS) issued final regulations (TD 9935) (the “Final Regulations”) on similar exchanges under Section 1031 of the Internal Revenue Code of 1986, as amended. The Final Provisions, which generally apply to exchanges starting after December 2, 2020, provide much-needed clarity for natural resource-related assets. In addition to various forms of economic interests in existing minerals (i.e., operating or labor interests, royalty interests, and higher royalty interests), oil and gas pipelines (whether above or below ground), offshore platforms (whether for drilling or production), derricks, and oil and Gas storage tanks should generally be treated as real estate within the meaning of Section 1031.
In addition, the Final Provisions (a) revise the definition of “real estate” for the purposes of Section 1031, (b) delete the “purpose or use test” (as described below) for both tangible and intangible assets, and (c ) provided certain other clarifications, including the adaptation of an existing exception for random properties. The Final Provisions also expressly state that the rules of the Final Provisions apply only for the purposes of Section 1031.
§ 1031 in general
Section 1031 generally provides that in connection with an exchange of real estate that is held for productive use in a trade or business or for investment, no gain or loss is recorded if this real estate is exchanged exclusively for real estate of the same type that are also intended to be held either for productive use in a trade or business, or for investment.1 Section 1031 was amended by Section 13303 of the Tax Cuts and Jobs Act to apply to the exchange of real estate for those completed after December 31, 2017 Restrict exchanges (subject to a limited transitional rule for certain assets). Before such a change, Section 1031 could be applied to a wider range of assets (wider than just “real estate”).
On June 12, 2020, the Ministry of Finance (“Treasury”) and the IRS published proposed ordinances in the Federal Register with the proposed ordinances under Section 1031. After reviewing public comments, the final provisions adopt certain parts of the proposed ordinances with changes.
a. Influence of state or local legal definitions on the determination of “real estate”
Under the Final Provisions, real estate is considered real estate for the purposes of Section 1031 if, at the time of the exchange, that real estate is under the law of the state or local jurisdiction in which that real estate is located (the “State or Local Law Test”). The state or local legal test applies to the classification of both tangible and intangible assets.
According to the final provisions, a tripartite approach applies to determining whether real estate is real estate within the meaning of Section 1031. Real estate is classified as real estate for the purposes of section 1031 if the property:
(1) classified as real estate under the state or local legal test (subject to certain exceptions);
(2) expressly listed as real estate in the final provisions; or
(3) Real estate considered based on an analysis of facts and circumstances using the factors provided in the final provisions.
Even if a property is not classified as real estate under the state or local legal test, such a provision does not preclude the property from being considered real estate for the purposes of Section 1031.
b. Purpose or use test is not required
Under the proposed rules, the role of property was taken into account in determining whether that property was real estate for the purposes of Section 1031 (the “Purpose or Use Test”). For example, under the proposed regulations, machines could generally not be classified as real estate if the machines contribute to generating income unrelated to the use or occupancy of the space.
Based on input from commentators, the Treasury and IRS have removed the purpose or use test for tangible property in the final provisions. So, if tangible property is permanently attached to real estate, and usually remains attached to real estate, that property is generally considered to be an inherently permanent structure, and hence real estate for Section 1031, regardless of whether the property is contributing to the generation of income. Under the final regulations, machinery and equipment will be classified as real estate if it includes an inherently permanent structure or structural component, or if it is real estate according to the state or local legal test.
c. Certain intangible assets that are included as real estate
Under the Final Provisions, intangible assets that are real estate for the purposes of Section 1031 include, in part, (i) royalty ownership, (ii) joint ownership, (iii) a lease, (iv) an option to purchase real estate, (v) an relief and (vi) certain other interests.
d. Inherently permanent structure definition revised
Under the proposed Regulations, an inherently permanent structure (which is therefore generally treated as real estate for purposes of Section 1031) includes in part an asset that is permanently attached to real estate and remains attached indefinitely. However, the term “permanently attached” has not been defined in the proposed regulations. For additional clarity, the Final Provisions contain additional language regarding the meaning of “permanently attached” by indicating that “[a]The restraint is considered permanent if it is reasonably expected that it will continue indefinitely based on all facts and circumstances. “2
e. Offshore platforms and pipelines (and certain other natural resource-related assets)
In the proposed regulations, offshore drilling rigs and oil and gas pipelines were specifically listed as inherently permanent structures, which is why this property has been defined as real estate for the purposes of Section 1031. One commentator aptly noted that the adjective “drilling” should be removed from “offshore drilling platform” because an offshore platform used for production is structurally similar to an offshore drilling platform. Taking into account the comments, the final provisions make it clear that “offshore platforms” within the meaning of Section 1031 3 are regarded as inherently permanent structures, in contrast to merely “offshore drilling platforms”. It is also noted in the preamble to the final regulation that an oil and gas pipeline for the purposes of Section 1031 is listed as inherently permanent and therefore real estate, whether it is above or below ground.
In addition, in accordance with the final provisions, the term real estate continues to include unseparated natural products from the state.4 Non-separated natural products from the state include wood, mines, wells and other natural resources. However, natural products and deposits (such as ores and minerals) are no longer real estate once they are segregated, extracted (e.g. produced) or removed from the land. In addition to the oil and gas pipelines and offshore platforms described above, derricks and oil and gas storage tanks inherently include permanent structures (which are considered qualifying improvements to the soil, and hence land ownership, for the purposes of Section 1031).
For natural resource-related assets that are not classified as real estate according to the state or local legal test, nor are specifically listed in the final provisions, that real estate may still be treated as real estate due to the factors described in Treas. Reg. § 1.1031 (a) -3 (a) (2) (ii) (C). Whether certain meters or compressors installed or connected to pipelines or other natural resources are considered real estate within the meaning of Section 1031 must be determined based on their particular facts and circumstances.
For any natural resource-related exchange, taxpayers should continue to analyze the impact of Sections 1245 and 1254 (as an example), which have separate and different rules for realizing profits that may apply depending on the facts of the transfer or the transfer.
1 However, under Section 1031 (b), a taxpayer must recognize a gain on an exchange equal to the money and non-like property (ie, personal property) obtained in the exchange.
2 treasure. Reg. § 1.1031 (a) -3 (a) (2) (ii) (A).
3 treasure. Reg. § 1.1031 (a) -3 (a) (2) (ii) (C).
4 treasure. Reg. § 1.1031 (a) -3 (a) (1).