The Modern Regulatory Settlement

Treasury and the Service proposed a definition in June 2020 and finalized a substantially different one six months later. This chapter traces that rulemaking: what the proposal would have done, why the final regulations abandoned its central limitation, how they came to rely on State and local law, and why the incidental property rule was written as it was. It closes with the legislative record since 2020, in which section 1031 has drawn proposals but no amendments. The operative definition is examined in Chapters 13 and 14, its application to marginal interests in Chapter 16, and the incidental property rule in Chapter 17.

8.1 REG-117589-18 and the proposed definition of real property

The need. Before 2018 neither the Code nor the regulations defined real property for purposes of section 1031. After 2017 the question decided whether any part of what a taxpayer received was property on which gain must be recognized under section 1031(b). Treasury and the Service concluded that regulations were needed "because taxpayers need certainty" on that point.¹ The proposed regulations were published on June 12, 2020, with comments due August 11, 2020.² The preamble estimated that 125,000 to 220,000 taxpayers would file Form 8824, the like-kind exchange reporting form, for tax year 2018.³

Declining to borrow. Several regulations already defined real property for other purposes: the capitalization rules under section 263(a), the interest capitalization rules under section 263A, the recapture rules under section 1250, the REIT qualification rules under section 856, and the rules for foreign investment in United States real property under section 897. The preamble explained why none would be adopted wholesale. Those definitions reflect different purposes, some broad and some narrow, and borrowing one would miss what Congress had said it wanted preserved. Some would not treat qualifying mutual ditch company shares as real property. The REIT regulation excludes property with an active function, such as producing or manufacturing a product, "but nothing in pre-TCJA section 1031 law suggests that real property held for productive use in a trade or business or for investment should necessarily be excluded from the definition of real property because of an active rather than passive function."⁴ The proposal instead drew particular elements from the existing definitions.

The proposed definition. Under the proposal, real property comprised land and improvements to land, unsevered crops and other natural products of land, and water and air space superjacent to land. Improvements included inherently permanent structures and their structural components, and each distinct asset was to be analyzed separately. Local law definitions were "generally not controlling," except that State law would decide whether mutual ditch company shares were real property, following the conference report's example.⁵ The proposal also contained a functional limit. Neither tangible property, such as machinery and equipment, nor intangible property, such as licenses and permits, would be real property if it contributed to the production of income unrelated to the use or occupancy of space. Under that test, a gas line installed only to fuel a restaurant's fryers and ovens was not part of an inherently permanent structure, and a license to operate a casino was not real property.⁶ Having declined to borrow the REIT regulation's exclusion for property with an active function, the proposal adopted a functional exclusion of its own.

Incidental property, outdated rules, and reliance. Two further parts of the proposal responded to practice rather than to the definition. Taxpayers and qualified intermediaries had asked whether an intermediary's purchase of an office building together with the personal property in it would put the taxpayer in constructive receipt of all the exchange funds. The proposal answered with a rule disregarding personal property that is typically transferred with the real property in standard commercial transactions and does not exceed 15 percent of the value of the replacement real property, modeled on the incidental property rule already used for identification (8.4).⁷ The proposal also asked for comments on whether regulations that applied only to exchanges before 2018 should be removed. The like-class regulation for personal property remains in the Code of Federal Regulations (7.3).⁸ Taxpayers could rely on the proposed regulations, if followed consistently and in their entirety, for exchanges of real property beginning after December 31, 2017, until final regulations were published.⁹

8.2 T.D. 9935 and the rejection of the "purpose or use" test

The rulemaking. Twenty-one written comments were received, no public hearing was requested, and the final regulations were published as T.D. 9935 on December 2, 2020 (14.1).¹⁰ The final regulations kept the proposal's basic approach and structure but made two changes of substance. They added a general rule deferring to State and local law classifications (8.3), and they eliminated the purpose or use test for tangible and intangible property alike.¹¹

The case against the test. Commenters "uniformly" opposed the purpose or use test (14.2).¹² Their objections went to the congressional baseline and to administration. The test would have treated as personal property items historically treated as real property for section 1031, contrary to the conference report's statement of intent, and machinery and equipment that is inherently permanent should not be disqualified merely because it produces income unrelated to the use or occupancy of space. One commenter added that the test would push small businesses and individuals into cost segregation studies to separate machinery from real property, and that neither the statute nor the regulations defined machinery.¹³ Treasury and the Service agreed. They had received no comments on the test's application to intangible property, but concluded that the same reasoning applied and removed it there too, while stating that the purpose of an intangible remains relevant to its classification.¹⁴

Other revisions and deferred questions. The preamble also revised the definition of inherently permanent structure and addressed requests concerning offshore platforms and pipelines, additional tangible and intangible assets, carpeting and wiring, and easements and leaseholds (Chapters 14 and 16).¹⁵ It declined, as beyond the rulemaking's scope, several requests that bear on other chapters of this treatise. A commenter warned that the interaction of bonus depreciation and section 1031 could produce adverse timing differences and, once 100 percent expensing expired after 2022, larger gains than Congress intended; Treasury and the Service said they would consider the interaction (7.4).¹⁶ Another commenter asked whether Rev. Rul. 2004-86 needed updating. The preamble responded that nothing in the proposed regulations or the 2017 Act "is contrary to the view that a transfer of an interest in a DST, if a grantor trust, is treated as the transfer of the underlying property held by the DST" (6.4 and 21.4).¹⁷ The Treasury decision also corrected an arithmetic error in the examples of the deferred exchange regulation.¹⁸

Effective on publication. The Office of Information and Regulatory Affairs designated the regulations a major rule under the Congressional Review Act, under which a major rule ordinarily takes effect 60 days after publication. Treasury and the Service invoked the Act's good cause exception. They cited the uncertainty taxpayers faced about the role of State and local law, and they quoted an Executive Order of May 19, 2020, whose stated aim was to "give businesses, especially small businesses, the confidence they need to re-open by providing guidance on what the law requires." The regulations took effect on publication.¹⁹ They apply to exchanges beginning after December 2, 2020, and taxpayers may rely on the proposed regulations, if followed consistently and in their entirety, for exchanges of real property beginning after December 31, 2017, and before that date.²⁰

8.3 The State-or-local-law test as adopted

From exception to general rule. The proposal had given State law a single role, deciding the status of mutual ditch company shares, because the conference report's example concerned those shares. Commenters argued that before 2018 State and local law classification had often been the determining factor in characterizing property as real or personal under section 1031, and that the mutual ditch example illustrated a broader intent rather than limiting it.²¹ Treasury and the Service reconsidered. Under the final regulations, property is real property if, on the date it is transferred in an exchange, it is real property under the law of the State or local jurisdiction in which it is located, whether the property is tangible or intangible.²²

The limit taken from the old statute. The same footnote supplied the limit. If real property eligible before 2018 was to remain eligible, property that was never eligible should remain ineligible, including the intangible interests that former section 1031(a)(2) excluded. The final regulations therefore exclude those interests "regardless of the classification of the property under State or local law, because such property never was 'real property eligible for like-kind exchange treatment' prior to enactment of the TCJA."²³ The result is a definition with three routes and one override. Property is real property if State or local law so classifies it, if the regulations list it, or if the regulatory factors make it so, and a State law label of personal property does not prevent real property status under the list or the factors. The listed exclusions, which substantially reproduce the intangible categories struck from the statute in 2017, prevail over all three routes (Chapter 13 and 14.1).²⁴

What the test displaced. Commenters had objected that the proposal replicated Chief Counsel Advice 201238027, which in one of its fact patterns disregarded State law classifying a steam turbine as real property and concluded that the turbine was not of like kind to land. The final regulations declined to address whether properties are of like kind to one another, but they stated that they "do not adopt the reasoning of CCA 201238027 to the extent it suggests that State or local law is disregarded in determining whether property is real property under section 1031."²⁵ Two further requests were refused. A rule treating any asset "essentially the same" as property classified as real property elsewhere would be difficult to apply and to administer, and it resembled the Chief Counsel Advice's analysis. A rule freezing classifications as of May 22, 2008, the effective date of the former mutual ditch provision, would add complexity that would grow as time passed.²⁶

Assessment. The final rule turned State law from an exception into a floor. For most real estate the answer was never in doubt. For fixtures, equipment affixed to land, and interests that some States treat as realty, the settlement means that the law of the property's location can establish eligibility, and the regulatory list and factors can establish it where local law does not. Only the categories excluded before 2018 stay out regardless. The application of that structure to particular interests, including Maryland ground rents, is examined at 14.6, 16.5, and 61.4.

8.4 The incidental personal property rule and its deliberate non-safe-harbor status

The problem it answered. The rule was written for intermediaries, not for the definition of real property. When an exchange closes through a qualified intermediary, the taxpayer is protected from constructive receipt only if the exchange agreement limits the taxpayer's rights to the money as the (g)(6) restrictions require (5.5). Buying a replacement building that comes with furniture or equipment means directing some of the intermediary's funds toward property that is not like kind, and taxpayers and intermediaries had asked whether that would put the taxpayer in constructive receipt of all the funds.²⁷ The rule disregards incidental personal property for that purpose. Personal property is incidental if, in standard commercial transactions, it is typically transferred together with the real property, and its aggregate value does not exceed 15 percent of the aggregate value of the replacement real property.²⁸

The limit and why it stayed at 15 percent. Commenters asked that the 15 percent be measured against the combined value of the real and personal property, as in certain REIT provisions, or that it be raised to 20 percent. The final regulations refused. The rule had been modeled on the existing incidental property rule for identification, and Treasury had determined in the proposal that a higher limit "might induce taxpayers to bundle more personal property with their exchanged property," which "would lead to increased amounts of personal property exchanged with real property under section 1031 and effectively unlock a class of personal property that would no longer be 'incidental' to the real property."²⁹ The limit reflects the 2017 restriction. The rule keeps the intermediary safe harbor intact when ordinary furnishings and equipment come with a building, but it does not make that property eligible for deferral, and the cap keeps it from becoming a route for moving substantial personal property through exchanges (Chapter 7 and 17.4).

Why it is not a safe harbor. Commenters asked that the rule be labeled a safe harbor, fearing it would otherwise be read as a bright line under which exceeding 15 percent makes the whole exchange taxable. Treasury and the Service declined for a structural reason. The safe harbors in the deferred exchange regulation help taxpayers comply with other rules, and the items listed alongside the incidental property rule are items disregarded in deciding whether one of those safe harbors still applies. Calling the rule a safe harbor would be confusing, because it operates as part of the existing safe harbors. The preamble then stated the consequence: personal property above the limit is not disregarded in applying the safe harbors, but acquiring it does not automatically cause the exchange to fail.³⁰ At a commenter's request, the final rule also states that receipt of incidental personal property results in taxable gain, and the preamble confirmed that the rule applies to property that is not real property whether it is tangible or intangible.³¹ The practical consequences are examined at 17.3.

8.5 Subsequent legislative attention and the survival of §1031

Proposals since 2020. Section 1031 has continued to draw proposals. From fiscal year 2022 through fiscal year 2025, the Administration's budgets proposed allowing deferral of no more than $500,000 of gain per taxpayer each year, or $1 million on a joint return, on exchanges of real property, with gain above that amount recognized in the year of the transfer (64.2).³² The Build Back Better Act did not carry that proposal forward. Neither the version reported in the House on September 27, 2021, nor the version the House passed on November 19, 2021, amended section 1031.³³ In 2025 the Billionaires Income Tax Act was introduced in the Senate. For an individual whose income exceeded $100 million, or whose covered assets exceeded $1 billion, in each of the three preceding years, it would treat an exchange to which section 1031 applies as a sale (64.3).³⁴

No amendments. None of these proposals was enacted. The United States Code's source credit for section 1031 lists no amendment after the 2017 Act, and the 2025 reconciliation act, which changed bonus depreciation (7.4) and the opportunity zone rules (Chapter 47), left section 1031 alone.³⁵ Across the provision's history Congress has narrowed it repeatedly, in 1923 and 1924, in 1984, in 1989, and in 2017, and has never repealed it or capped it (Chapter 64).

Assessment. The modern settlement consists of two layers put in place three years apart. The 2017 statute limited exchanges to real property and said, in one footnote, that it meant to keep eligible what had been eligible. The 2020 regulations turned that footnote into a definition that defers to State and local law, lists what is always real property, excludes what never was, and lets ordinary personal property come with a building without disturbing the intermediary safe harbor. The chapters on the property requirement and on transactional structures operate within that settlement.