Beyond Fee Simple: Non-Fee Interests and Statutory Exclusions in 1031 Exchanges
Most investors think of a 1031 exchange as selling one building and buying another. Fee simple in, fee simple out. That understanding is correct as far as it goes — but it stops well short of the full picture.
The final regulations under Treasury Regulation §1.1031(a)-3, effective December 2, 2020, define "real property" for Section 1031 purposes in terms that are considerably broader than fee simple ownership — and simultaneously draw a hard line around certain interests that can never qualify, regardless of what state law says.
Understanding where that line falls is critical for any investor or advisor structuring a 1031 exchange involving non-traditional property interests. This article examines both sides: the non-fee interests that qualify and the statutory exclusions that don't.
Why This Matters Now
The Tax Cuts and Jobs Act of 2017 eliminated like-kind exchanges for personal property, limiting Section 1031 exclusively to "real property." But the statute itself doesn't define the term. That left a gap — one that the IRS and Treasury filled with T.D. 9935, the final regulations that added §1.1031(a)-3 to the Code of Federal Regulations.
The regulations matter because they establish a federal definition of real property for 1031 purposes that operates independently of state law classifications. An interest can qualify as real property for Section 1031 even if state law treats it as personal property — and conversely, an interest can be excluded from Section 1031 even if state law calls it real property.
For investors in the Tacoma and Puget Sound region, where cell tower leases, conservation easements, timber interests, and development rights are common transaction elements, the distinction between qualifying and non-qualifying interests is not academic. It determines whether a 1031 exchange is available at all.
Part I: Non-Fee Interests That Qualify
Treasury Regulation §1.1031(a)-3(a)(5) identifies specific intangible interests that constitute real property for Section 1031 purposes. These include fee ownership, co-ownership, and the following non-fee interests:
Leasehold Interests
A leasehold is explicitly listed as real property under the regulations. The 30-year rule — which treats a leasehold with 30 or more years remaining (including renewal options) as equivalent to a fee interest for like-kind purposes — predates the 2020 regulations and remains operative.
Practical significance: A ground lease with 35 years remaining is exchangeable real property. The lessee can sell the leasehold interest and acquire replacement real property — whether that replacement is another leasehold, a fee interest in an apartment building, or farmland. The interests need not be structurally identical; they need only be "like kind," and all real property is like kind to all other real property under the post-TCJA framework.
The short-lease problem: A leasehold with fewer than 30 years remaining may still qualify as real property under the regulations, but it may not be "like kind" to a fee interest. The like-kind analysis is separate from the real-property-definition analysis. Investors holding shorter-term leaseholds should evaluate this distinction carefully before committing to an exchange.
Easements
Both appurtenant easements (which benefit a dominant estate) and easements in gross (which benefit a person or entity rather than a parcel) qualify as real property. Conservation easements, utility easements, access easements, and agricultural preservation easements all fall within this category.
The sale-of-easement opportunity: When a landowner sells a conservation easement — granting permanent development restrictions in exchange for a payment — that payment represents proceeds from the disposition of a real property interest. Those proceeds are eligible for 1031 exchange treatment. The landowner can defer the gain by acquiring replacement real property within the standard 45-day identification and 180-day exchange periods.
This is particularly relevant in Washington's agricultural and timber regions, where conservation easement transactions are increasingly common. The gain on a $500,000 conservation easement sale can be fully deferred through a 1031 exchange into income-producing property.
Land Development Rights
The regulations specifically list "land development rights" as qualifying real property. This encompasses transferable development rights (TDRs), density credits, and similar entitlements that derive their value from the underlying real property.
In jurisdictions that permit TDR transfers — including several municipalities in King and Pierce County — a developer who sells development rights from one parcel can exchange into other real property, deferring the entire gain. This is a powerful planning tool for developers who are monetizing entitlements rather than building.
Options to Acquire Real Property
An option to purchase land or improvements is real property for Section 1031 purposes. If a taxpayer sells an option to acquire real property and realizes gain, that gain is eligible for deferral through a 1031 exchange.
"Similar Interests"
Beyond the specifically enumerated categories, the regulations include a catch-all: any intangible interest that "is in the nature of any of the intangible assets" listed, and that "derives its value from real property or an inherently permanent structure" and "is inseparable from that real property or inherently permanent structure," qualifies as real property.
This language provides flexibility for non-standard interests that share the essential character of leaseholds, easements, or development rights. The key analytical questions are:
1. Does the interest derive its value from specific real property? 2. Is the interest inseparable from that real property — meaning it cannot exist independently of the underlying land or structure? 3. Is the interest in the nature of a leasehold, easement, or similar right?
If all three answers are yes, the interest qualifies — even if it doesn't fit neatly into any of the enumerated categories.
The License and Permit Distinction
This is where the regulations draw their most nuanced line — and where investors most frequently make errors.
Treasury Regulation §1.1031(a)-3(a)(5)(ii) provides that a license, permit, or other similar right is real property if:
- It is solely for the use, enjoyment, or occupation of land or an inherently permanent structure, and
- It is in the nature of a leasehold, easement, or similar right.
But a license or permit to engage in or operate a business on real property is not real property — regardless of its classification under state or local law.
The cell tower example: A land use permit authorizing placement of a telecommunications tower on government-owned land qualifies as real property. The permit grants the right to use and occupy a specific portion of land — it is in the nature of an easement. The holder can exchange this permit through a 1031 exchange.
The casino example: A state license to operate a casino in a specific building does not qualify as real property — even though the license is specific to that building, even though it cannot be transferred to another location, and even though state law might classify it as a property interest. It is a license to operate a business, not a right to use or occupy real property. The proceeds from selling such a license cannot be deferred through a 1031 exchange.
The analytical test: Does the license or permit produce income from the use or occupancy of space (like a lease would), or does it produce income from the operation of a business that happens to be conducted on real property? The former qualifies. The latter does not.
This distinction matters for:
- Liquor licenses tied to a specific premises — generally not real property
- Billboard permits authorizing placement on specific land — likely real property (in the nature of an easement)
- Marina slip permits authorizing use of specific waterfront space — likely real property (in the nature of a leasehold)
- Franchise authorizations to operate at a specific location — not real property (business operation license)
When the characterization is ambiguous, the regulations require examining the nature of the right granted, not the label applied by the issuing authority.
Part II: The Statutory Exclusions — What Can Never Qualify
Before the TCJA, former IRC §1031(a)(2) explicitly excluded certain asset categories from like-kind exchange treatment. When the TCJA repealed §1031(a)(2) as part of limiting exchanges to real property, a question arose: did the repeal of §1031(a)(2) mean that these previously excluded assets could now qualify, if they happened to be classified as "real property" under state law?
The answer is no.
Treasury Regulation §1.1031(a)-3(a)(5)(i) preserves every exclusion from the repealed statute. The following intangible assets are not real property for Section 1031 purposes, regardless of their classification under state or local law:
Stock
Stock in a corporation is excluded — with two narrow exceptions:
1. Stock in a cooperative housing corporation (where the stockholder is entitled to occupy a dwelling) 2. Shares in a mutual ditch, reservoir, or irrigation company described in IRC §501(c)(12)(A), if recognized as real property by state law or a court of competent jurisdiction
All other corporate stock is permanently excluded. An investor cannot sell shares in a REIT and exchange into an apartment building under Section 1031, even though the REIT itself holds real property. The REIT shares are stock — and stock is excluded.
Bonds or Notes
Debt instruments are excluded, including municipal bonds, corporate bonds, and promissory notes. A seller-financed note received on the sale of real property is not itself exchangeable real property — it is an evidence of indebtedness.
Other Securities or Evidences of Indebtedness or Interest
This catch-all sweeps in any financial instrument that represents a claim against another party rather than a direct interest in real property. Debentures, commercial paper, and structured instruments are excluded regardless of what underlies them.
Interests in a Partnership
Partnership interests are excluded — even if the partnership's only assets are real property. You cannot exchange a 50% interest in a real estate partnership for an apartment building under Section 1031.
The §761(a) exception: If a partnership has made a valid election under IRC §761(a) to be excluded from all of subchapter K, then an interest in that partnership is treated as an interest in each of the partnership's underlying assets rather than as a "partnership interest." In that case — and only in that case — the interest can qualify for 1031 treatment if the underlying assets are real property. This exception is narrow and requires the election to be in place before the exchange.
Practical note for LLC owners: Most multi-member LLCs default to partnership treatment for tax purposes. An investor who holds a membership interest in a real estate LLC cannot exchange that interest under Section 1031 unless the LLC has a §761(a) election in place. The workaround — dissolving the LLC and distributing the property to the members before the exchange — is available but must be properly structured and timed.
Certificates of Trust or Beneficial Interests
A beneficial interest in a trust is excluded — with limited exceptions for trusts that are treated as direct ownership under applicable tax rules (such as a grantor trust or a Delaware statutory trust that qualifies under Revenue Ruling 2004-86).
Choses in Action
A chose in action — a right to recover money or property through legal action — is not real property. Litigation claims, contract rights to receive payments, and similar contingent rights are excluded even if they arise from real property transactions.
The Interplay with State Law
The regulations establish a dual-track classification system:
Track 1 — State law can expand the definition: If property is classified as real property under the law of the state where it is located, it is generally treated as real property for Section 1031 purposes — even if it doesn't fit the federal categories of land, improvements, or enumerated intangibles. This is the "state law plus" approach that the final regulations adopted (expanding on the narrower proposed regulations).
Track 2 — But state law cannot override the exclusions: The intangible assets listed in §1.1031(a)-3(a)(5)(i) — stock, bonds, notes, partnership interests, certificates of trust, beneficial interests, and choses in action — are excluded from Section 1031 treatment regardless of state law classification. If Washington state treats a particular partnership interest as "real property" for property tax or recording purposes, that classification is irrelevant for Section 1031.
Similarly, a license to operate a business is not real property for Section 1031 purposes even if state law treats it as a property interest.
This asymmetry is intentional. The regulations preserve the congressional policy that certain categories of assets should never receive exchange treatment — a policy that predates the TCJA and survives the repeal of §1031(a)(2).
Practical Applications
Reverse and Improvement Exchanges
The non-fee interest rules apply equally in reverse exchanges under Revenue Procedure 2000-37 and improvement exchanges. If a taxpayer acquires a leasehold interest or easement through an Exchange Accommodation Titleholder (EAT), the same classification rules apply. The interest must qualify as real property under §1.1031(a)-3 — and if it does, the exchange can proceed through the reverse exchange safe harbor.
For improvement exchanges, where construction is performed on the replacement property while held by the EAT, the completed improvements must constitute real property (inherently permanent structures and structural components). The non-fee interest analysis becomes relevant when the improved property is held under a ground lease rather than fee ownership.
Mixed-Interest Transactions
When a single transaction involves both qualifying and non-qualifying interests — for example, a sale of real property that includes an assignment of a business license — the non-qualifying interest must be separated and treated as "boot." Gain attributable to the boot is recognized immediately, while gain attributable to the qualifying real property interest is deferred.
Proper allocation between qualifying and non-qualifying components requires appraisal evidence and should be documented in the purchase and sale agreement before closing.
The 15% Incidental Personal Property Rule
Treasury Regulation §1.1031(k)-1(g)(7)(iii) provides that personal property incidental to real property — if its value does not exceed 15% of the replacement property's value — will not violate the safe harbor restrictions on access to exchange funds. But this is an identification and safe harbor rule only. The incidental personal property is still boot and still triggers gain recognition. The 15% rule does not convert personal property into real property.
Key Takeaways
1. The real property definition for Section 1031 is broader than fee simple. Leaseholds, easements, land development rights, options, and similar interests all qualify — creating exchange opportunities that many investors overlook.
2. The license and permit distinction is the most frequently misapplied rule. A permit for the use of real property (like a cell tower placement permit) qualifies. A license to operate a business on real property (like a casino license) does not. Examine the nature of the right, not the label.
3. The statutory exclusions from repealed §1031(a)(2) survive in the regulations. Stock, bonds, partnership interests, and choses in action can never qualify for Section 1031 treatment, regardless of state law classification.
4. State law expands but cannot override. State law can qualify an interest as real property if it satisfies the general definition. But state law cannot qualify an interest that falls within the enumerated exclusions.
5. Proper structuring and documentation are essential. When a transaction involves non-fee interests, the classification analysis should be completed before closing — not after. The exchange agreement, purchase contract, and identification notice should all reflect the correct characterization.
At Olympic Exchange Accommodators, we regularly facilitate 1031 exchanges involving non-traditional property interests throughout the Tacoma area and western Washington. If you're considering an exchange involving a leasehold, easement, development rights, or any interest that doesn't fit the standard "sell one building, buy another" framework, contact us for a no-obligation consultation. The analysis starts with the regulations — and the regulations are more favorable than most investors realize.
Jeff Helsdon, CES® Certified Exchange Specialist since 2003
Disclaimer: This article is for informational purposes only and does not constitute legal, tax, or financial advice. Consult your own attorney, CPA, and financial advisor before making decisions about your 1031 exchange.
