Real Property Only After TCJA: Advisor Notes on What Still Qualifies

The TCJA Change: Real Property Only

Before 2018, 1031 exchanges were available for a wide range of property: real property, personal property, equipment, vehicles, and more. A business could exchange equipment for other equipment, or intangible assets for intangible assets, all within the 1031 framework.

The Tax Cuts and Jobs Act (2017) narrowed the scope. Beginning in 2018, 1031 exchanges are available only for real property. Personal property exchanges are no longer permitted.

This change affects advisors in two ways:

1. Clients with personal property cannot exchange. If a client owns equipment, vehicles, machinery, or artwork, those are not eligible for 1031 treatment.

2. When real property is bundled with personal property, allocation matters. A furnished rental, a restaurant with equipment, or a commercial property with built-in systems may have mixed real and personal property components. The allocation directly affects the client's boot recognition and tax bill.

The 2020 Final Regulations: Defining Real Property

The IRS issued final regulations (T.D. 9935, December 2020) clarifying what qualifies as real property for post-2017 1031 purposes.

Real property includes:

• Land (unimproved or improved).
• Buildings and other inherently permanent structures (including parking lots, bridges, fences, roads).
• Structural components permanently affixed to buildings (HVAC, plumbing, electrical, roofing, walls, floors).
• Land improvements (landscaping, drainage systems, permanently affixed infrastructure).
• Intangible assets associated with real property (licenses, permits, covenants, easements that run with the land).

Personal property does NOT include:

• Equipment and machinery (not permanently affixed).
• Vehicles, aircraft, vessels.
• Furniture, fixtures that are removable without damage.
• Artwork, collectibles, tangible personal property.
• Business goodwill, customer lists, intellectual property.
• Stock or partnership interests.

Fixtures: The Gray Zone

Fixtures are items that are permanently attached to real property and cannot be removed without substantial damage to the property. Fixtures are real property for 1031 purposes.

Examples of fixtures:

• Permanent HVAC, plumbing, and electrical systems.
• Built-in cabinetry, shelving, or storage.
• Structural flooring, walls, or components.
• Permanently affixed signage or branding elements.
• Installed solar panels (generally qualify as fixtures).

Examples of non-fixtures (even if used in the real estate business):

• Removable appliances (ovens, refrigerators, washers).
• Removable furniture.
• Removable equipment (restaurant equipment, office equipment).
• Vehicles, tools, machinery.
• Artwork, decorations.

The distinction can be subtle. An oven built into a kitchen counter is more likely a fixture than a freestanding oven. Shelving that is bolted to the wall is more likely a fixture than freestanding shelving. The test is: "Could this item be removed without damaging the real property?"

The Incidental Personal Property Rule

The 2020 final regulations introduce a pragmatic "incidental personal property" rule. Personal property transferred with real property is treated as real property (and thus qualifies for 1031 treatment) if:

1. The personal property is incidental to the real property (not the primary purpose of the transfer).
2. The personal property does not exceed 15% of the aggregate fair market value of the real and personal property transferred.

This rule is a significant relief for transactions involving furnished properties, equipped properties, or properties sold with some non-real components.

Example:

• A furnished short-term rental property sells for $500K. The real property value is estimated at $450K; furnishings and equipment are estimated at $50K.
• Percentage of personal property: $50K / $500K = 10%.
• Because the personal property is incidental and does not exceed 15%, the entire $500K qualifies as real property for 1031 purposes.
• No separate allocation of personal property is required; the client can 1031 exchange the full proceeds.

Compared to:

• The same property sells for $500K, but furnishings and equipment are estimated at $100K.
• Percentage of personal property: $100K / $500K = 20%.
• Because the personal property exceeds 15%, only the amount within the 15% threshold qualifies. The excess $25K ($100K − 15% of $500K) must be allocated separately.
• The client receives $25K in boot (non-1031 proceeds) and must reinvest only $475K to achieve a full deferral. Or, the client can take the $25K as taxable boot and recognize gain to that extent.

Practical Gray Areas and Advisor Considerations

Solar Panels and Renewable Equipment

Solar panels are generally treated as real property (fixtures) when they are permanently affixed to a building and designed to provide energy to the building. The IRS has issued guidance treating solar as part of the real property.

However, if solar equipment is portable or removable, or if it is personal property of the buyer (not part of the real property), the classification might be different. Advisors should confirm the treatment with the appraiser and coordinate with tax counsel if the property includes significant solar investment.

Cell Towers and Telecom Equipment

Cell towers present a more complex picture. The tower structure itself (the physical building or steel structure) is real property. However, the communications equipment mounted on the tower (antennas, transceivers, cables) is often personal property and is typically excluded from the real estate sale.

A sale of "cell tower with equipment" requires careful allocation. The real property (tower structure) qualifies for 1031; the personal property (equipment) does not. If the purchase agreement bundles both, the allocation must be separated for 1031 purposes.

Tenant Improvements and Built-in Systems

In a commercial property with significant tenant improvements (built-in HVAC, electrical, plumbing, built-out office spaces), the improvements that are structural and permanent are real property. If improvements are removable (removable partitions, removable flooring, removable lighting), they may be personal property.

The distinction depends on the specific facts. Advisors should coordinate with the appraiser and the building's engineer to determine the real vs. personal classification of improvements.

Furnished Short-Term Rentals

Furnished vacation rentals, furnished apartments, and furnished short-term rental properties often include significant furnishings, artwork, linens, and kitchen equipment. These are personal property.

How to handle:

• Request an allocation from the seller's CPA or through the purchase agreement negotiation.
• Calculate whether furnishings and equipment exceed 15% of the total purchase price.
• If under 15%, the incidental personal property rule allows the entire amount to qualify.
• If over 15%, only 15% of the total can be treated as real property. The excess must be allocated separately and creates boot.

Example:

• Short-term rental property sells for $800K gross.
• Real property estimate: $680K.
• Furnishings, linens, equipment, artwork: $120K.
• Personal property percentage: $120K / $800K = 15%.
• This is exactly at the threshold; the entire $800K qualifies for 1031.
• But if furnishings were estimated at $140K, only $800K × 15% = $120K would qualify, and $20K would be boot.

Equipment in Service Businesses

A service business property might include significant equipment (restaurant kitchen equipment, hair salon equipment, auto shop lifts, etc.). This equipment is personal property, not real property.

How to handle:

• Separate the personal property allocation clearly in the purchase agreement.
• Coordinate with the appraiser to value the building/structure separately from the equipment.
• The equipment portion does NOT qualify for 1031 exchange.
• If the client wishes to 1031 exchange, only the real property proceeds can be reinvested; the equipment proceeds must be taken as cash or reinvested in other (non-1031) ways.

Coordination with Appraisers and Tax Counsel

When a transaction includes mixed real and personal property, advisors should:

1. Request a detailed allocation from the seller's CPA. Ask for a breakdown of the purchase price between real property, personal property, and any other components.

2. Coordinate with the appriser. If the client is obtaining an appraisal for the exchange, request that the appraiser separately value the real property and personal property. Some appraisers will provide a detailed allocation report.

3. Review the purchase agreement. Confirm whether the buyer and seller have already negotiated an allocation. If the allocation is already in the agreement, use that; if not, propose one and have both parties agree.

4. Calculate the personal property percentage. Divide the personal property value by the total purchase price. If the percentage exceeds 15%, calculate the excess, which becomes unintended boot.

5. Advise the client on the impact. If personal property allocation creates boot, the client must reinvest less than the full proceeds to achieve a full deferral. Or, the client can accept the boot as taxable income and recognize gain to that extent.

6. Document everything. Retain the allocation memo, appraisal report, and purchase agreement language for the file and for potential IRS inquiry.

Common Advisor Mistakes and How to Avoid Them

Mistake 1: Not asking about personal property until the purchase agreement is signed.

By the time the purchase agreement is signed, the allocation may already be embedded in the contract. It is better to discuss and agree on allocation during the purchase negotiation so all parties have the same understanding.

Mistake: Assuming all property attached to the building is real property.

Equipment, machinery, and removable items attached to a building are often personal property. Do not assume everything is a fixture. Ask specifically: "Is this item permanently affixed? Could it be removed without damaging the property? Is it equipment or a structural component?"

Mistake: Ignoring the 15% incidental personal property threshold.

The 15% rule is generous and often eliminates the need to allocate small amounts of personal property. But if personal property exceeds 15%, the excess creates real boot. Calculate the percentage carefully.

Mistake: Not flagging the issue early.

If a transaction includes significant personal property and the client is expecting a full 1031 exchange, the surprise that some proceeds cannot be exchanged will come as a shock. Flag the issue as soon as it is apparent (during due diligence, not at closing).

Real Property Examples: What Qualifies

Example 1: Unfurnished commercial building

• Real property: Yes. Building, structure, HVAC, plumbing, electrical, parking lot.
• Personal property: None (or minimal, covered by incidental rule).
• 1031 treatment: Full exchange.

Example 2: Furnished short-term rental

• Real property: Building, structure, built-in appliances, permanent fixtures.
• Personal property: Furnishings, bedding, artwork, removable kitchen equipment.
• If personal property is under 15% of total value: Full exchange qualifies.
• If personal property is over 15% of total value: Only 15% of the total qualifies; excess is boot.

Example 3: Restaurant with equipment

• Real property: Building, structure, HVAC, plumbing, electrical, built-in components.
• Personal property: Kitchen equipment, restaurant furniture, removable fixtures, goodwill.
• Equipment must be allocated separately; it does NOT qualify for 1031.
• If equipment represents $200K of a $500K sale, $200K is boot (or must be taken as non-1031 proceeds).

Example 4: Office building with solar panels

• Real property: Building, structure, HVAC, electrical, permanently affixed solar panels.
• Personal property: Minimal (office furniture would not be included in the real estate sale, typically).
• Solar is generally treated as real property if permanently affixed.
• 1031 treatment: Full exchange.

Example 5: Land with cell tower and equipment

• Real property: Land, tower structure (the physical tower).
• Personal property: Antennas, communications equipment, cables, transceivers (typically leased or owned by the telecom company, not included in the land sale).
• If only the tower structure is sold: Real property qualifies for 1031.
• If equipment is bundled: Must allocate; equipment does NOT qualify.

Closing Checklist for Advisors

When advising a client on a 1031 exchange involving any property with non-structural components, use this checklist:

• Review the purchase agreement for all personal property components.
• Request an allocation memo from the seller's CPA breaking down real vs. personal property.
• Coordinate with the appraiser on valuation and classification of real vs. personal property.
• Calculate whether personal property exceeds 15% of the total purchase price.
• If personal property exceeds 15%, calculate the excess (unintended boot).
• Advise the client of the boot amount and the impact on the exchange structure.
• Retain allocation documentation (purchase agreement language, appraisal report, allocation memo) in the file.
• Confirm with the qualified intermediary that the exchange documentation correctly reflects the allocation and boot treatment.
• Prepare the client for potential IRS inquiry regarding the allocation and real vs. personal property classification.

Summary: Real Property Only, but with Practical Tools

The post-TCJA limitation to real property is straightforward in principle but requires careful execution in practice. Advisors who understand the real vs. personal property distinction, apply the incidental personal property rule correctly, and flag mixed-property transactions early will serve clients far better than those who assume all property components qualify for 1031 treatment.

The 2020 final regulations provide clear guidance, but real-world transactions often include gray areas and require careful valuation and allocation. Early identification, clear documentation, and coordination with appraisers and tax counsel are the hallmarks of good advisory practice in this area.