There is a specific definition of "real property" for tax code Section 1031 purposes. Learn more about how the Tax Cuts and Jobs Act of 2017 impacted this definition below.

With the TCJA change that only real property is eligible for a tax-deferred exchange for federal purposes, the IRS determined that it was necessary to define the term real property for purposes of Sec 1031. So, after issuing proposed regulations in June 2020, the IRS released final regulations (T.D. 9935) on November 23, 2020, that modified the proposed definition to make it more closely track the intent of Congress that real property eligible for like-kind exchange treatment under the law in effect prior to enactment of the TCJA should continue to be eligible for like-kind exchange treatment post-2017. (Conference Report at 396, fn. 726) The final regs are effective and generally apply to exchanges beginning after 2, 2020.

Final Reg. 1.1031(a)-3(a) says that real property includes land and improvements to land, unsevered natural products of land, and water and air space superjacent to land. Further, property that is real property under State or local law is real property for purposes of Sec 1031, as is certain intangible property.

Include inherently permanent structures and the structural components of inherently permanent structures.

Each distinct asset must be analysed separately from any other assets to which the asset relates to determine if the asset is real property, whether as land, an inherently permanent structure, or a structural component of an inherently permanent structure. The determination of whether a particular separately identifiable item of property is a distinct asset is based on all the facts and circumstances, with the following factors taken into account – whether:

If tangible property is permanently affixed to real property and will ordinarily remain affixed for an indefinite period, the property is 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.

The regs include as inherently permanent structures any building or other structure that is a distinct asset that is permanently affixed to real property and that will ordinarily remain affixed for an indefinite period of time. Here, a “building” is defined as any structure or edifice enclosing a space within its walls, and usually covered by a roof, the purpose of which is, for example, to provide shelter or housing, or to provide working, office, parking, display, or sales space. “Buildings” also include the following distinct assets if permanently affixed: houses, apartments, hotels, motels, enclosed stadiums and arenas, enclosed shopping malls, factory and office buildings, warehouses, barns, enclosed garages, enclosed transportation stations and terminals, and stores. (Final Reg §1.1031(a)-3(a)(2)(ii)(B))

The following also qualify as inherently permanent structures, if permanently affixed: in-ground swimming pools; roads; bridges; tunnels; paved parking areas, parking facilities, and other pavements; special foundations; stationary wharves and docks; fences; inherently permanent advertising displays for which an election under section 1033(g)(3) is in effect; inherently permanent outdoor lighting facilities; railroad tracks and signals; telephone poles; power generation and transmission facilities; permanently installed telecommunications cables; microwave transmission, cell, broadcasting, and electric transmission towers; oil and gas pipelines; offshore drilling platforms, derricks, oil and gas storage tanks; and grain storage bins and silos. Affixation to real property may be accomplished by weight alone.

If property is not included in the list above of inherently permanent structures, the following factors must be used to determine whether the property is an inherently permanent structure:

Under the final regulations, items of machinery and equipment are characterized as real property if they comprise an inherently permanent structure, a structural component, or are real property under the State or local law test.

Under the final regulations, structural components of inherently permanent structures are improvements to land and thus real property for purposes of Sec 1031. A structural component is any distinct asset that is a constituent part of, and integrated into, an inherently permanent structure. If interconnected assets work together to serve an inherently permanent structure (for example, systems that provide a building with electricity, heat, or water), the assets are analysed together as one distinct asset that may qualify as a structural component. A structural component may qualify as real property only if the taxpayer holds its interest in the structural component together with a real property interest in the space in the inherently permanent structure served by the structural component. If a distinct asset is customized, the customization does not affect whether the distinct asset is a structural component. Tenant improvements to a building that are inherently permanent are real property under this section.

Examples of structural components include walls; partitions; doors; wiring; plumbing systems; central air conditioning and heating systems; pipes and ducts; elevators and escalators; floors; ceilings; permanent coverings of walls, floors, and ceilings; insulation; chimneys; fire suppression systems, including sprinkler systems and fire alarms; fire escapes; security systems; humidity control systems; and other similar property.

If a component of a building or inherently permanent structure is a distinct asset and is not included in the list above, whether the component is a structural component is a facts and circumstances issue determined on the basis of the following factors:

These generally are treated as real property for purposes of Sec 1031 and include growing crops, plants, and timber; mines; wells; and other natural deposits. Natural products and deposits, such as crops, timber, water, ores, and minerals, cease to be real property when they are severed, extracted, or removed from the land. (Final Reg § 1.1031(a)-3(a)(3))

Intangible assets that are real property for purposes of Sec 1031 include the following items:

The following intangible assets are not real property for purposes of Sec 1031, regardless of the classification of such property under State or local law:

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 other similar right, generally is an interest in real property under this section. However, a license or permit to engage in or operate a business on real property is not real property or an interest in real property, regardless of its classification under State or local law.

Unless otherwise excluded in the final regulations, property is real property under State or local law if, on the date it is transferred in an exchange, the property is real property under the law of the State or local jurisdiction in which that property is located.

The regulations disregard incidental personal property (either residential or non-residential property) that (1) in standard commercial transactions is typically transferred together with the real property, and (2) does not exceed 15% of the aggregate FMV of the replacement real property. Nonetheless, under section 1031(b), a taxpayer must recognize gain on the receipt of the incidental personal property, which is not like-kind property. (Final Reg. §1.1031(k)-1(g)(7)(iii))

The language of the final regulations clarifies that the 15% limitation is calculated by comparing the value of all of the incidental properties to the value of all of the replacement real properties acquired in the same exchange.

Keep in mind that real property as defined in these regulations is only for the purpose of Sec 1031 and not for determining recovery periods for depreciation or for other parts of the tax code.