Defining Real Property

When the Tax Cuts and Jobs Act confined nonrecognition to real property, a definitional question that had been peripheral became the gate through which every exchange must pass.

Treasury answered it in December 2020. This chapter examines that answer, which is more permissive than the proposal that preceded it, and in one important respect more permissive than most secondary accounts report.

14.1 The regulatory framework and how it arrived

Proposed regulations were published on June 12, 2020.¹ Twenty-one written comments were received. No public hearing was requested or held. Final regulations were published as T.D. 9935 on December 2, 2020, and they differ from the proposal in a way that matters more than any other feature of the project.²

The regulations are effective December 2, 2020 and generally apply to exchanges beginning after that date.³ A reliance rule bridges the gap created by the three-year interval between the statutory change and the regulatory answer: a taxpayer 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 December 2, 2020.⁴ The words "consistently and in their entirety" foreclose selecting favorable proposed provisions while applying the final rules elsewhere.

A correction document issued in February 2021.⁵ Its seven corrections are confined to preamble pages and change no regulatory text, but one is substantive for anyone reading the preamble discussion of the State law test, where a truncated sentence was rewritten. Preamble citations to that discussion should be to the corrected version.

The operative structure the regulations adopt is disjunctive. Property is real property for section 1031 purposes if it qualifies under the federal definitions supplied by the regulation, or if it is real property under the law of the State or local jurisdiction where it is located. Either route suffices. A single category of excluded items overrides both.

14.2 The rejected "purpose or use" test

The most consequential feature of the final regulations is a test they do not contain, and a treatise that omits this history will misstate current law in the direction of restrictiveness.

The proposed regulations would have made the character of an item depend in part on what it did. Tangible property that contributed to the production of income unrelated to the use or occupancy of space would have been disqualified from treatment as an inherently permanent structure, and a parallel limitation applied to intangibles. The preamble calls this the purpose or use test.

Commenters uniformly disagreed with it and urged its omission.⁶ Treasury and the Service agreed and eliminated it, for tangible and intangible property alike.⁷

The revised rule for tangible property is stated in the preamble in terms worth quoting, because they establish the breadth of the definition: if property is permanently affixed to real property and will ordinarily remain affixed for an indefinite period of time, it is generally an inherently permanent structure and thus real property for section 1031 purposes, "irrespective of the purpose or use of the property or whether it contributes to the production of income."⁸

The practical significance is large. Industrial and specialized installations, machinery affixed to a building, and equipment integral to a production process are not disqualified because they generate income of their own. Affixation and permanence govern, not function.

One qualification applies to intangibles. Whether an intangible produces income other than consideration for the use or occupancy of space is not considered, but the preamble states that the purpose of the intangible property "remains relevant to the real property determination."⁹ The distinction is fine and is developed at 14.5.

14.3 The federal definition

The regulation opens with a general statement. Real property means land and improvements to land, unsevered natural products of land, and water and air space superjacent to land.¹⁰

Each element carries weight.

Land requires no elaboration and is the paradigm case.

Improvements to land is the category that does the work, and it divides into inherently permanent structures and the structural components of those structures. A building is the obvious instance; the regulation reaches considerably further.

Unsevered natural products of land brings within the definition growing crops, standing timber, and mineral deposits in place, so long as they remain unsevered. Severance converts them to personal property, which is why timing matters in transactions involving extraction or harvest.

Water and air space superjacent to land confirms that interests need not be at grade. Air rights and water rights are real property when they take the form the regulation describes.

An inherently permanent structure is one affixed to real property that will ordinarily remain affixed for an indefinite period. After the elimination of the purpose or use test, that inquiry is essentially physical: is the thing attached, and is the attachment meant to last.

14.4 Structural components and the distinct asset analysis

A structural component is any part of an inherently permanent structure that serves the structure in its passive function. Walls, roofs, plumbing, wiring, elevators, and central heating and air conditioning are structural components of a building, and they are real property when transferred with the structure.

The analytical difficulty is that many items are physically attached to a building while being functionally independent of it, and the regulation resolves this through a distinct asset analysis. The question is whether the item is properly treated as a separate asset from the structure it sits in, and the answer turns on factors including whether the item is customarily sold or acquired separately, whether it can be moved and, if so, how much damage moving causes, and whether it was installed during construction of the structure.

The interaction with the depreciation rules deserves attention because it is a trap. The regulation coordinates with the general asset account rules of section 168, and T.D. 9935 amended those rules so that the distinct asset determination under section 1.1031(a)-3(a)(4) does not apply for general asset account purposes.¹¹ A taxpayer who has placed assets into general asset accounts should not assume the section 1031 characterization and the depreciation characterization align. They are computed under different rules and reach different answers by design.

14.5 Intangible interests in real property

The regulation treats intangibles in a dedicated paragraph that runs in two directions at once, and both halves are operative.¹²

Enumerated as real property are fee ownership, co-ownership, a leasehold, an option to acquire real property, an easement, stock in a cooperative housing corporation, shares in a mutual ditch, reservoir, or irrigation company described in section 501(c)(12)(A) where those shares have been recognized as constituting or representing real property by the highest court of the organizing State or by State statute, and land development rights. A catch-all follows: similar interests qualify if the intangible asset "derives its value from real property or an interest in real property and is inseparable from that real property or interest in real property."¹³

Note what the catch-all does not require. It does not ask whether the interest produces income unrelated to the use or occupancy of space. That was the proposed purpose or use test discussed at 14.2, and it did not survive into the final rule.

Excluded, and expressly so "regardless of the classification of such property under State or local law," are stock other than the cooperative housing stock just described, bonds or notes, other securities or evidences of indebtedness or interest, interests in a partnership, certificates of trust or beneficial interests, and choses in action.¹⁴ The partnership exclusion carries one carve-out written into the regulation itself: an interest in a partnership that has in effect a valid election under section 761(a) is not excluded. That is the regulatory counterpart to section 1031(e), discussed at 13.1.

Licenses and permits receive a separate rule that cuts both ways.¹⁵ A license, permit, or 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 other similar right, generally is an interest in real property. But a license or permit to engage in or operate a business on real property is not real property, again regardless of State or local classification. The operative distinction is between a right to occupy space and a right to conduct an enterprise, and it is the line practitioners should test any permit against.

14.6 The State-or-local-law alternative and its ceiling

The regulation supplies a second, independent route to qualification. Except as otherwise provided in paragraph (a)(5), 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 that property is located.¹⁶

Three features govern its application.

It is an alternative, not a limitation. Property qualifying under the federal definitions is real property whether or not State law agrees, and property failing them may still qualify through State law. The taxpayer needs one route, not both.

The relevant jurisdiction is where the property sits, not where the taxpayer resides or where the exchange is documented. In a transaction spanning States, each property is characterized by its own jurisdiction, and the two sides of an exchange may qualify by different routes.

The relevant moment is the date of transfer. A later change in State law characterization does not disturb the analysis.

The ceiling is paragraph (a)(5). The excluded intangibles listed at 14.5 are not real property regardless of State or local characterization, and the licenses-and-permits rule carries the same override.¹⁷ No State can legislate a partnership interest or a business operating permit into section 1031.

For a Maryland practitioner the State law route is more useful than it may appear, because Maryland recognizes interests many jurisdictions do not. The route is also subordinate to the enumerated list, and Maryland ground rent shows why: the occupant's leasehold is personal property under Maryland law but is real property for section 1031 because a leasehold is enumerated, as 16.5 and 61.4 develop.

14.7 No inference beyond section 1031

The regulation closes with a provision whose importance is inversely proportional to its length. The definition applies only for purposes of section 1031, and no inference is intended for the classification of property elsewhere in the Code, "such as depreciation and sections 1245 and 1250."¹⁸

The regulation supplies its own example, and it is the one that matters in practice: a structure or a portion of a structure may be section 1245 property for depreciation purposes and for determining gain under section 1245, notwithstanding that the same structure is real property under this section. The regulation goes further and states the consequence directly. A taxpayer transferring relinquished property that is section 1245 property in a section 1031 exchange remains subject to the gain recognition rules of section 1245, notwithstanding that the relinquished or replacement property is real property under the definitional rules.¹⁹

The planning consequence is direct and frequently overlooked. Qualifying under this chapter resolves eligibility for nonrecognition. It does not resolve character, and it does not switch off recapture. Chapter 37 takes up what remains.