Furniture in a 1031 Exchange: The 15 Percent Rule

Furniture, free standing appliances and other personal property do not qualify for a 1031 exchange. Since 2018, only real property can be exchanged. When personal property changes hands alongside a building, its value is generally treated as taxable, either as a separate sale on the way out or as boot on the way in. A separate rule lets small amounts of "incidental" personal property be ignored for identification purposes, as long as it stays under 15 percent of the value of the real property it comes with.

This matters most for owners of furnished short term rentals, apartment buildings with laundry equipment, hotels, self storage facilities and anything else that is sold with contents.

Why does personal property no longer qualify?

Before 2018, a 1031 exchange could cover equipment, vehicles, artwork and other personal property, under a separate set of like kind rules. The Tax Cuts and Jobs Act limited Section 1031 to real property for exchanges completed after December 31, 2017. Everything else now falls outside the exchange.

That change did not stop sellers from including contents in a sale. A buyer of a furnished beach rental still expects the beds, sofas and kitchenware. The question is simply how those items are treated for tax, because they are no longer part of the deferral.

What counts as real property and what does not?

Regulations finalized in 2020 set out what real property means for exchange purposes. In broad terms it covers land, buildings and other inherently permanent structures, plus their structural components. Wiring, plumbing, central heating and air conditioning, built in elevators and similar systems are generally treated as part of the real property.

Items that can be picked up and moved are generally personal property. Typical examples include:

• ›Furniture, beds, rugs and decor in a furnished rental
• ›Free standing refrigerators, washers and dryers
• ›Kitchenware, linens and electronics
• ›Golf carts, maintenance equipment and tools
• ›Business equipment in a property sold with an operating business

A depreciation label is not the test. A cost segregation study may classify certain components as five or seven year property for depreciation. The 2020 regulations make clear that this classification does not by itself decide whether the item is real property for a 1031 exchange. Your CPA can tell you how your specific components are likely to be treated.

What is the 15 percent incidental property rule?

The rule comes from the identification regulations. When you identify replacement property within 45 days, you do not have to list incidental personal property separately if two conditions are met:

• ›The items are of a kind typically transferred together with that type of real property in standard commercial transactions
• ›The total fair market value of all the incidental items does not exceed 15 percent of the total fair market value of the real property

The regulations give furniture, laundry machines and similar items in an apartment building as an example. If they meet both tests, they are disregarded for identification, and identifying the building is enough.

The rule is about identification, not about tax. Meeting the 15 percent test keeps your identification clean. It does not turn furniture into like kind property. The value of the personal property you receive is still generally treated as boot, which is taxable to the extent you have gain on the exchange.

The 2020 regulations also confirmed that receiving incidental personal property does not, on its own, knock an exchange out of the Qualified Intermediary safe harbor.

What happens on the sale side?

When you sell a property with contents, part of the price is attributable to the personal property. That part is treated as a sale of personal property, outside the exchange.

If the furniture has been depreciated, its tax basis may be low or zero. Any gain on it is generally taxed as ordinary income under the depreciation recapture rules for personal property, rather than at capital gain rates. That can surprise owners who expected the whole sale to be deferred.

A worked example, for illustration only

The figures below are illustrative and do not describe any real transaction or property.

An owner sells a furnished vacation rental for 800,000 dollars. The purchase agreement allocates 40,000 dollars to furniture and contents. The owner bought those contents years ago and has fully depreciated them, so their basis is zero.

On the sale side, the 40,000 dollars allocated to contents is generally treated as a separate sale of personal property. With a zero basis, the full 40,000 dollars would generally be taxable, likely as ordinary income. The remaining 760,000 dollars is the real property, and that portion can go into the exchange.

On the purchase side, the owner buys a furnished replacement for 900,000 dollars, with 30,000 dollars allocated to furnishings. That is about 3.3 percent of the price, well under 15 percent, so the furnishings do not need separate identification. But the 30,000 dollars of furnishings is still personal property received in the exchange, and is generally treated as boot to the extent of the owner's gain.

In this illustration, contents on both sides create taxable amounts even though the real estate itself is fully reinvested.

How do owners usually handle contents?

Practices vary, and the right approach depends on your facts. Points that commonly come up in conversations with a CPA and a Qualified Intermediary include:

• ›Allocate in writing. A purchase agreement that states a value for personal property gives everyone a clear record.
• ›Use a realistic value. An allocation that is far too low or far too high can be challenged.
• ›Consider buying contents separately. Some buyers purchase furnishings for the replacement property in a separate transaction with their own funds, so exchange proceeds go only to real property. Whether that suits you is a question for your advisers.
• ›Watch the settlement statement. Contents sometimes appear as a credit or a line item that is easy to miss. Your Qualified Intermediary should see the statement before closing.
• ›Report it correctly. Form 8824 and the related schedules need to reflect the personal property portion separately from the exchange.

Does this affect DST or NNN replacement property?

Usually much less. A Delaware Statutory Trust interest or a single tenant net lease property is typically acquired without meaningful personal property, so incidental items are rarely an issue on the replacement side. Owners selling a furnished rental and moving into passive real estate often find that the contents question only arises on the sale.

DST interests are securities, available only to accredited investors through a licensed broker dealer and the definitive offering documents. They carry risk, including possible loss of principal, and nothing here describes any specific offering.

The short version

Personal property is outside the exchange. The 15 percent rule keeps small amounts of it from complicating your identification, but it does not make that property tax deferred. If you are selling or buying anything that comes furnished or equipped, raise the contents early with your CPA and Qualified Intermediary, agree an allocation in writing, and make sure the closing statement matches it.