What To Know About The Definition Of 'Real Property' For 1031 Purposes

In a time of great uncertainty, it is a relief to be sure about one thing: the meaning of “real” — at least as it applies to commercial real estate transactions.

What qualifies as real property, particularly in the case of property exchanged under Internal Revenue Code Section 1031, has been clarified by the federal government in recent years. This is a welcome change for parties involved in certain CRE transactions, such as those involving the exchange of like-kind properties. 

Before the passage of the Tax Cuts and Jobs Act of 2017 and the issuance of new IRS regulations in 2020, the definition of real property was ambiguous. This could slow down transactions as parties debated whether things like natural gas-gathering pipelines or wind turbines counted as real or personal property.

“Prior to TCJA, real property wasn’t defined for 1031 purposes, resulting in a void in what could be considered real versus personal,” said Chris Newton, executive vice president of Chicago Deferred Exchange Co. “Post-TCJA, there is clear guidance through tests that sellers and buyers can now apply.”

The IRS allows some forms of property within a building that previously might have been considered personal property to be categorized as real property, provided the properties meet the specific criteria under one of three definitions. In general, this means structural components or machinery could be considered real property.

“The new definitions give us insight into figuring out whether what our clients are selling and buying is real property, such as fixtures and equipment,” CDEC CEO Mary Cunningham said. “If you think about someone purchasing a hotel, there is a lot of personal property that transfers along with the real property. The question for investors is, ‘Can we spend proceeds from the sale of real property to pay for personal property like furniture, washers and dryers, refrigerators and stoves?’”

But while the regulations bring greater certainty to CRE deals, there are still lingering questions about the new definitions. Cunningham said CDEC, a qualified intermediary and exchange accommodation titleholder that has facilitated thousands of 1031 commercial property transactions, continues to field calls from clients looking for clarification. 

A crucial point to understand is that the IRS now allows state law to take precedence over federal law in the classification of real property. 

“For 1031 exchange purposes, there was always a push and pull regarding whether real property was defined by state or federal law,” Cunningham said. “Now, there are several ways to define real property without ambiguity.”

The IRS lists three different methods to define a property as real:

• The state law test: Property is considered real if, on the date the property is transferred in a 1031 exchange, the property is considered real under relevant state or local law.
• The listed assets test: An improvement to land is deemed real property if it involves an inherently permanent structure or is a structural component of an inherently permanent structure. Examples can include electrical, plumbing or HVAC systems.
• The factors test: Property that isn't a listed asset may be considered real property if, for example, it was installed during construction of the structure or its removal would cause structural damage.

“With these new definitions, you're relying on state law to determine what is real property, not federal,” Newton said. “This is meaningful in that it's less open for interpretation than it was.”

Although the definitions have brought clarity to real property transactions, Newton said confusion about another definition can arise during a 1031 exchange. IRC Section 1031 allows a seller to delay paying taxes on a gain if the proceeds are reinvested in a like-kind property. 

Newton said property sellers can get hung up on what constitutes like-kind property. They might interpret it to mean they must purchase a property that is very similar to what they are selling — that it must be of the same asset class or located in the same state, for example.

“People can have a very narrow focus of what qualifies as like-kind,” he said. “They might assume that if they are selling a six-unit building in Illinois, they have to purchase another six-unit building in Illinois.”

That isn't the case, he said. Under the definition of like-kind, the property to be purchased could be an industrial building in a different state, for instance. What matters is that the two properties have equivalent valuations.

Cunningham said it is important that sellers seek the advice of both tax and property exchange experts. What they don’t know or understand about certain IRS definitions might prevent them from benefiting from 1031 property exchanges. 

“We play a critical role to the party that's doing the exchange, but as a qualified intermediary, we're forbidden from giving tax advice,” Newton said. “However, we can make sure people understand the things that they need to talk to their tax advisers about. Our job is to make sure they do a 1031 exchange the right way if they decide that it's the right thing for them, but they need to make that decision with good information.”

This article was produced in collaboration between Chicago Deferred Exchange Co. and Studio B. Bisnow news staff was not involved in the production of this content.

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