In December of 2020, the US Internal Revenue Service (the "IRS") issued final regulations (T.D. 9935) (the "Final Regulations") on like-kind exchanges under Section 1031 of the Internal Revenue Code of 1986, as amended. The Final Regulations, which generally apply to exchanges beginning after December 2, 2020, provide much-needed clarity for natural resource-related assets. In addition to various forms of economic interests in minerals in place (i.e., operating or working interests, royalty interests, and overriding royalty interests), oil and gas pipelines (whether above- or below-ground), offshore platforms (whether for drilling or production), derricks, and oil and gas storage tanks generally ought to be treated real property for Section 1031 purposes.

Additionally, the Final Regulations (a) revise the definition of "real property" for Section 1031 purposes, (b) eliminate the "Purpose or Use Test" (as described below) for both tangible and intangible assets, and (c) provide for certain other clarifications, including adapting an existing incidental property exception. The Final Regulations also expressly state that the rules of the Final Regulations apply only for purposes of Section 1031.

Section 1031 generally

Section 1031 generally provides that no gain or loss is recognized in connection with an exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is also to be held either for productive use in a trade or business or for investment.1 Section 1031 was amended by Section 13303 of the Tax Cuts and Jobs Act to limit its application to exchanges of real property for those exchanges completed after December 31, 2017 (subject to a limited transition rule for certain assets). Prior to such amendment, Section 1031 could be effected on a broader array of assets (broader than merely "real property").

On June 12, 2020, the Department of the Treasury ("Treasury") and the IRS published proposed regulations in the Federal Register containing proposed Section 1031 regulations. After consideration of public comments, the Final Regulations adopt certain portions of the proposed regulations, with modifications.

Final Regulations

a. Impact of state or local law definitions on the determination of what is "real property"

Under the Final Regulations, property is considered real property for Section 1031 purposes if, on the date of the exchange, such property is classified as real property under the law of the State or local jurisdiction in which that property is located (the "State or Local Law Test"). The State or Local Law Test is applicable to both tangible and intangible property classifications.

Under the Final Regulations, a three-pronged approach applies to the determination of whether property is real property for Section 1031 purposes. Property is classified as real property for Section 1031 purposes if the property is:

(1) Classified as real property under the State or Local Law Test (subject to certain exceptions);

(2) Specifically listed as real property in the Final Regulations; or

(3) Considered real property based on a facts and circumstances analysis using the factors provided for in the Final Regulations.

Thus, even if property is not classified as real property under the State or Local Law Test, such determination does not preclude the property from being considered real property for Section 1031 purposes.

b. Purpose or Use Test eliminated

Under the proposed regulations, the function of property was considered in determining whether such property is real property for Section 1031 purposes (the "Purpose or Use Test"). As an example, under the proposed regulations, machinery could not generally be classified as real property if the machinery contributes to the production of income unrelated to the use or occupancy of space.

Based on input from commentators, Treasury and the IRS eliminated the Purpose or Use Test for tangible property in the Final Regulations. Thus, if tangible property is permanently affixed to real property and will ordinarily remain affixed, such property is generally considered an inherently permanent structure and thus real property for Section 1031, irrespective of whether the property contributes to the production of income. Under the Final Regulations, items of machinery and equipment are classified as real property if they comprise an inherently permanent structure, a structural component, or are real property under the State or Local Law Test.

c. Certain intangible assets included as real property

Under the Final Regulations, intangible assets that are real property for Section 1031 purposes include, in part, (i) fee ownership, (ii) co-ownership, (iii) a leasehold interest, (iv) an option to acquire real property, (v) an easement, and (vi) certain other interests.

d. Inherently permanent structure definition revised

Under the proposed regulations, an inherently permanent structure (which would thus generally be treated as real property for Section 1031 purposes) includes, in part, an asset that is permanently affixed to real property and that will remain affixed for an indefinite period of time. However, the proposed regulations did not define the phrase "permanently affixed." In an attempt to provide additional clarity, the Final Regulations contain additional language regarding the meaning of "permanently affixed," by noting that "[a]ffixation is considered permanent if it is reasonably expected to last indefinitely based on all the facts and circumstances."2

e. Offshore platforms and pipelines (and certain other natural resource-related assets)

The proposed regulations specifically listed offshore drilling platforms and oil and gas pipelines as inherently permanent structures, and therefore such property was defined as real property for Section 1031 purposes. One commentator aptly noted that the adjective "drilling" ought to be removed from "offshore drilling platform," as an offshore platform used for production is structurally similar to an offshore drilling platform. Taking the comments into account, the Final Regulations clarify that "offshore platforms" are considered inherently permanent structures for Section 1031 purposes,3 as opposed to merely "offshore drilling platforms." Further, the preamble to the Final Regulations notes that an oil and gas pipeline is listed as inherently permanent and therefore real property for Section 1031 purposes, regardless of whether above or below ground.

In addition, under the Final Regulations, the term real property continues to include unsevered natural products of the land.4 Unsevered natural products of the land includes, in part, timber, mines, wells, and other natural deposits. Natural products and deposits (such as ores and minerals) cease to be real property, however, once they are severed, extracted (e.g., produced), or removed from the land. Further, inherently permanent structures (which are considered qualifying improvements to land, and thus real property for Section 1031 purposes) include, in addition to the oil and gas pipelines and the offshore platforms described above, derricks and oil and gas storage tanks.

For natural resource-related assets that are neither classified as real property under the State or Local Law Test or specifically listed in the Final Regulations, such property may still be treated as real property based on the factors described in Treas. Reg. § 1.1031(a)-3(a)(2)(ii)(C). Whether particular meters or compressors affixed or connected to pipelines or other natural resource property is considered real property for Section 1031 purposes must be determined by their unique facts and circumstances.

In any exchange related to natural resource-related properties, taxpayers ought to continue to analyze the impact of Sections 1245 and 1254 (as an example), which have separate and distinct gain-recognition rules that may apply depending on the facts of the transfer or exchange.


1. Under Section 1031(b), however, a taxpayer must recognize gain on an exchange to the extent of money and non-like-kind property (i.e., personal property) received in the exchange.

2. Treas. Reg. § 1.1031(a)-3(a)(2)(ii)(A).

3. Treas. Reg. § 1.1031(a)-3(a)(2)(ii)(C).

4. Treas. Reg. § 1.1031(a)-3(a)(1).

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This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.