Section 1031 Final Regulations Defining Real Property and Effect on Qualified Intermediary Exchanges

Tax Update

Date: April 15, 2021

Key Notes:

  • Broad application of real property for 1031 purposes could include certain tax depreciable equipment.
  • Consider allocation to be given in sales and purchase agreement to identify and carve out non-qualifying property from QI transaction.
  • In some instances, could have depreciation recapture and still use proceeds to purchase qualifying replacement property through QI transaction.
  • QI agreement might require representations that only sale proceeds from qualifying relinquished property are received and that such proceeds are used only to purchase qualifying replacement property or without violating 15% permitted non-qualifying amount.

Date: August 11, 2020 / Updated April 15, 2021

Final regulations provide a further expansive approach of qualifying real property for Section 1031 purposes in contrast to the proposed regulations. The following highlight the positive final regulations in (1) and (2) below and reprints the prior memo with revisions shown in bold and underlined to reflect changes made by the final regulations.

  1. The final regulations reverse a position of the proposed regulations and allow real property as determined under the laws of the State or local jurisdiction where such property is located and as of the date such property is transferred to be qualifying real property for Section 1031 purposes. This rule is equally applicable to intangible property.
  2. The final regulations eliminates the proposed regulations position that automatically excluded machinery that produces or contributes to the production of income from qualifying real property. Machinery and equipment can be considered as inherently permanent structures or as structural components of inherently permanent structures an eligible real property for 1031 purposes, if either (a) permanently affixed to real property and reasonably expected to remain affixed for an indefinite period of time or (b) integrated into an inherently permanent structure, regardless in either case of whether such property produces or contributes to the production of income.

As modified by the 2017 Tax Cuts and Jobs Act, property other than real property is no longer eligible for tax-free exchanges under Section 1031 of the Internal Revenue Code of 1986, as amended (Code). Thus, practitioners and taxpayers now face a critical question: What is and is not real property? On June 12, the U.S. Department of the Treasury published proposed regulations providing a definition of what constitutes real property eligible for a like-kind exchange under Section 1031 of the Code and a safe harbor for incidental personal property that may be included in the replacement property without disqualifying the entire exchange from tax-free treatment. The definition of real property and application of the incidental personal property safe harbor do not strictly follow state and local law (REVISED), nor do they follow the distinction of real property and personal property used for depreciation purposes. The proposed regulations provide that real property interests can include fee ownerships, co-ownerships, leaseholds, options to acquire real property, easements or similar interests.

The chart below provides a summary of the types of property that meet the definition of real property under the proposed regulations with revisions from the final regulations shown as bold and underlined. A discussion of the incidental personal property safe harbor follows.

Real Property Category

Qualifying Property Examples

Non-Qualifying Property Examples


  • Water and air space adjacent to land
  • U-shaped boat spaces and end ties
  • Unsevered growing crops, plants and timber
  • Mines and wells
  • Other natural deposits
  • Crops, plants, timber and other natural deposits after they are severed from the land

Land improvements



Inherently permanent structures

  • Houses and apartment buildings
  • Hotels and motels
  • Factories, office buildings and warehouses
  • Barns and enclosed garages
  • Enclosed transportation stations and terminals
  • In-ground swimming pools
  • Roads, bridges and tunnels
  • Paved parking areas and parking facilities
  • Stationary wharves and docks
  • Permanently affixed fences
  • Five-ton, 30 feet tall and 18 feet wide permanently affixed sculpture
  • Inherently permanent advertising displays and outdoor lighting facilities
  • Railroad tracks and signals
  • Telephone poles
  • Power generation and transmission facilities
  • Permanently installed telecommunications cables
  • Microwave cell, broadcasting and electric transmission towers
  • Oil and gas pipelines
  • HVAC systems that serve an inherently permanent structure for the sole purpose of the use or occupancy of the space
  • Gas, electric or water lines that provide fuel solely to a building’s heating system
  • Offshore drilling platforms, derricks, oil and gas storage tanks
  • Grain storage bins and silos
  • Gas, electric or water lines that serve business or manufacturing equipment in a building
  • 12-ton industrial 3D printer and connected generator
  • Manufacturing or business equipment, unless designed not to be moved 
  • Fixtures that are not part of an inherently permanent structure
  • Bus shelters

Structural components of inherently permanent structures

  • Systems that provide building with electricity, heat or water
  • Tenant improvements to inherently permanent improvements
  • Walls, conventional drywall partition systems that can be removed only by demolition and can’t be reused, doors, wiring, plumbing systems, central air conditioning and heating systems, pipes and ducts, elevators and escalators, floors, ceilings, permanent wall, floor, and ceiling coverings, insulation, chimneys, fire suppression systems, including sprinkler systems and fire alarms, fire escapes, security systems, humidity control systems
  • Isolation valves and vents and pressure control and relief values associated with gas pipeline transmission system
  • Generator installed to keep industrial 3D printer operating in event of power outage
  • Steam turbine installed with building construction and used for commercial production of electricity for sale to customers
  • Raised floor system solely to facilitate operation of 3D printer
  • Modular drywall partition systems that are removed when tenant vacates space
  • Property produced for sale; bricks, nails, paint and windowpanes in the hands of the producing taxpayer

Intangible property

  • A license, permit or other similar right that is solely for the use, enjoyment or occupation of land or an inherently permanent structure, and that is in the nature of a leasehold, easement or fee ownership, includes government permit to place cell tower on government land
  • Option to acquire real property
  • Stock held in a co-op
  • Land development rights
  • License or permit to engage in or operate business on real property if license or permit produces or contributes to production of income other than for the use and occupancy of space, including license to operate casino

Incidental Personal Property
Relinquished Property

Relinquished property sales proceeds allocated to incidental personal property are not eligible to be used toward the purchase of replacement personal property, and gain is recognized on the portion of the relinquished property purchase price allocated to personal property.

Observation: The relinquished property sale agreement should break out an allocation of the purchase price between the qualifying real property for Section 1031 purposes and any personal property. The portion of the purchase price allocated to the personal property does not go to the Qualified Intermediary and may not be used to purchase replacement property. The seller should assign its rights in the purchase agreement to the Qualified Intermediary only as it relates to the real property. The portion of the sales proceeds allocated to personal property should be paid directly to the selling taxpayer by the buyer. The 15% exception provided by the proposed regulations to allow for incidental personal property is not applicable to relinquished property sold by the taxpayer in a like-kind exchange, but is applicable only to the replacement property purchased.

Additional Observation: To the extent that the purchase price allocated to Section 1031 real property includes equipment for tax depreciation purposes, consideration should also be given to dividing the Section 1031 real property portion of the purchase price into two components. This suballocation can be divided to determine the amount allocated to relinquished property equipment for depreciation purposes and whether any depreciation recapture is triggered. Even if depreciation recapture is triggered, the proceeds allocable to the relinquished Section 1031 real property can nonetheless be transferred to the Qualified Intermediary to purchase qualifying Section 1031 replacement real property. This is an interesting result from the potentially broad definition of qualifying real property pursuant to the Section 1031 proposed regulations.

Qualified Exchange Agreement: To assure that no sale proceeds associated with relinquished personal property are deposited with a Qualified Intermediary, a standard practice could develop that the taxpayer provide a representation that all sale proceeds deposited with the qualified property are attributable to the sale of real property within the meaning of Section 1031, and that no such sale proceeds deposited with the Qualified Intermediary are attributable to personal property within the meaning of Section 1031.

Replacement Property

It is common that commercial real property is purchased along with some associated personal property, such as a purchase of an office building including the office furniture. In the context of a Section 1031 exchange involving a Qualified Intermediary, a question arose whether any portion of the sale proceeds held by the Qualified Intermediary could continue to be used to purchase personal property that is included with the replacement real property. If the Qualified Intermediary is authorized to purchase replacement property that includes any property other than real property, could this disqualify the entire tax-free exchange treatment? The proposed regulations provide a safe harbor permitting the Qualified Intermediary to purchase replacement property that includes incidental personal property valued at no more than 15% of the aggregate fair market value of the replacement real property without disqualifying the entire Section 1031 exchange. The final regulations clarify that the 15% test is applied by comparing the value of all incidental personal property to the value of all qualifying real property acquired in the same transaction.

Observation: To substantiate that the replacement property purchased does not include personal property exceeding the 15% limit, consideration should be given to having the replacement property purchase agreement include an allocation of the amount paid for the real property within the meaning of Section 1031 versus the personal property. Consideration can also be given to having the taxpayer pay separately for any personal property associated with the replacement property.

Additional Observation: To the extent that the Section 1031 replacement real property includes equipment for tax depreciation purposes, consideration should be given to dividing the Section 1031 replacement real property purchase price into two components. This suballocation can be divided to determine the portion of the replacement property purchase price allocated between the real property and equipment for tax depreciation purposes. This is relevant to determine the tax basis of the relinquished property that continues with the specific replacement property purchased. An application of the multiple property rules of Section 1.1031(j)-1 of the regulations would factor into this calculation, but no guidance is provided through the proposed regulations. Also, the seller of the replacement property might likely request a similar allocation to limit its potential depreciation recapture.

Qualified Exchange Agreement: A standard practice that could develop is for the Qualified Intermediary exchange agreement to require that the taxpayer represent that any personal property included in the replacement property be within the 15% limit. Also, the replacement property purchase agreement assigned by the taxpayer to the Qualified Intermediary can exclude the portion of such agreement allocated to the purchase of personal property when such portion of the purchase price is paid for by the taxpayer directly, as mentioned above.

Effect of Exceeding the 15% Threshold: Surprisingly, the proposed regulations do not address the tax effect if the personal property purchased with the qualified exchange proceeds exceeds 15% of the aggregate replacement property purchased. As was the concern prior to the issuance of the proposed regulations, the entire exchange could be treated as taxable with the resulting aggregate gain taxable in the year that the replacement property is purchased applying the installment sale rules.

Tax Treatment of Applying Qualified Exchange Proceeds to Purchase Any Personal Property: The proposed regulations’ 15% limit for the use of Qualified Intermediary proceeds to purchase personal property only protects the replacement real property to continue to be a qualifying like-kind exchange. To the extent that any portion of the Qualified Intermediary proceeds are used to purchase personal property within the 15% threshold, such portion of the proceeds is taxable. Through the application of the installment sale provisions, such gain should be taxable in the tax year that the personal property replacement property is purchased.


For more information, please contact:

Alexis J. Kim

Francesco A. Ferrante

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