Real Estate, or Not? Beware of Personal Property Masquerading as Real Property

Section 1031 of the Internal Revenue Code facilitates a tax-deferred exchange of investment properties, provided the properties exchanged are real property, and of like-kind with one another. As of the enactment of the 2017 Tax Cuts and Jobs Act, personal property has been eliminated from eligibility for a 1031 exchange. However, real property can be exchanged broadly for many other types of real property (for example, residential for commercial, or industrial for farmland). The term “like-kind” does not refer to the property use, but rather, to the type of property interest being exchanged. Many property ownership types are considered like-kind with one another, such as fee interests, perpetual easements, and leasehold interests with a remaining term of thirty or more years. However, certain property that superficially appears to be real estate may be legally classified as personal property, thus ineligible for like-kind exchanges. This distinction is crucial for investors to recognize to navigate their exchange options effectively.

What Constitutes Personal Property?

Personal property refers to movable items that are not permanently affixed to the land. Fixation to a foundation or structure is the major distinguishing factor between personal and real property. However, from state to state, there are nuances. For example, in some states (such as Florida and South Carolina) ownership of a boat slip (a designated space for docking or mooring a boat) is typically considered real property – in others, such as North Carolina and Missouri, it is generally considered personal property. In 1031 exchanges, it’s critical to differentiate between real and personal property as the latter does not qualify for like-kind exchange benefits. This classification impacts the eligibility of certain assets that may be owned together with real estate; when an investor is selling property comprised of a combination of real and personal property, they must have an allocation of the overall purchase price prepared, with the respective values assigned to the real versus personal property. Another way investors could be affected is when they try to exchange an asset (such as a boat slip) that appears to be real estate, but does not meet the requisite criteria upon further inspection or inquiry.

Real-Estate Adjacent Personal Property Interests

An example of property that appears to be real property, but is actually considered personal property, is a mobile home. An investor might wish to purchase or sell a mobile home park or vacant lot, along with ownership of the mobile home(s) on that property, which are rented out. While the underlying fee interest to the land being transferred would qualify as real property, the mobile homes themselves would not. It would be important to determine what portion of the purchase price for the property should be allocated to the mobile homes; this provides clarity on which portion of the property and corresponding proceeds are connected to the exchange. To qualify as real property in a 1031 exchange, manufactured housing units must be permanently affixed to a chassis or foundation. If they are not, they are deemed personal property and therefore not eligible for a like-kind exchange.

Airplane hangars also surprisingly fall into the category of personal property due to their mobility and the typical lack of land ownership by the hangar holders. However, their acquisition in connection with the acquisition of a ground lease or perpetual easement in the underlying real property may qualify for 1031 exchange purposes. Easements that are perpetual in nature are typically classified as real property and can be like-kind to other real estate interests. Acquisition and operation of many investment assets, such as cell towers, is often achieved through acquisition of an underlying perpetual easement, which qualifies that acquisition for a 1031 exchange.

Additional Clarifications on Real Property and the Like-Kind Requirement

In 2020, the IRS released Final Regulations to provide further clarification on what constitutes real property for the purposes of a 1031 exchange. The Regulations focused on the priority of state and local law treatment of an asset in determining whether it is considered real property, provided a purpose or use test for analysis, as well as provided a defined list of interests considered real property, along with long sought-after guidance on exchange treatment when incidental personal property is purchased with real property. For more information, visit: td_9935.pdf (irs.gov). Note that the Regulations do not provide guidance on what real property interests are considered like-kind with one another.

As a reminder, whether or not property is considered real property does not determine whether that particular interest is exchangeable with another real property interest. There are circumstances where the nature of the property must be examined to determine whether it can be exchanged for, say, a fee interest. For example, certain riparian rights are considered real property but may not always be like-kind to a fee interest in land. In Revenue Ruling 55-749, the IRS clarified that water rights may be recognized as like kind to a fee interest in land provided they are held for productive use in a trade or business or for investment, and that the right is perpetual in nature, not limited in time or duration. An investor interested in exchanging riparian rights in some form, or a similar interest, would need to work closely with their tax advisor to determine what property interests are like-kind, and suitable as relinquished or replacement property in their exchange.

Conclusion

The intricacies are numerous when it comes to less straightforward assets and their eligibility for a 1031 exchange. Determining whether an interest in property can be exchanged, and for what, can sometimes require a nuanced understanding of both statutory definitions and IRS interpretations. As demonstrated, while many real estate types are interchangeable, exceptions based on the property’s legal status or physical attachment to the land can determine exchange eligibility. Investors are advised to consult with their independent tax and legal professionals to ensure their transactions comply with IRS regulations, and encouraged to contact First American Exchange with any questions.

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