Part of the 1031 XChange Index - Originally Published 11/1/2006 at STEC

Most IRS Section 1031 exchanges involve the sale of real estate and the acquisition of like-kind replacement property. As we have previously noted, property held for investment, income production or use in a business is qualified as like kind with any other property held for investment, income production or use in a business. Fee simple ownership of investment real estate is the most common form of ownership in property involved in exchanges, but other ownership interests may be used as well. Specifically, leasehold interests can be used in exchange transactions, but special rules apply to various situations. These exchanges are not as common as transfers of the fee interest in real property, but leasehold exchanges have been around for a long time and can provide great flexibility for clients when used appropriately with knowledgeable tax advice.

IRS regulations provide that a leasehold interest of 30 years or longer is treated as like kind with fee simple real estate. Subsequent rulings make it clear that optional renewal periods are included in determining the length of the leasehold interest. For example if the lease has a 10-year initial term and 5 five-year options, the length of the lease is 35 years for 1031 exchange purposes. As long as the lease in this example is in the first five years of the term, there will be more than thirty years left and it will be treated as like kind.

For example, a Taxpayer wishes to use an exchange to swap a $250,000 warehouse for an existing lease on a shopping center out-parcel with a value of $275,000. The 20-year lease has two 10-year extensions and is in its ninth year. Therefore, the leasehold length is 31 years (20 years plus two 10-year extensions equals 40 years minus nine years nets 31 years). Taxpayer can sell the warehouse and buy the 45-year leasehold interest as replacement property to complete a successful exchange as long as the exchange is in compliance with all other IRS guidelines.

Short-term leases are not like kind with fee simple real estate. However, they may be considered like kind with other short-term leasehold interests. Although the IRS has approved some short-term leasehold interest exchanges in private letter rulings, it has offered taxpayers no authoritative guidelines on whether the leasehold interests must be similar in term to be considered like kind. For instance, we do not know whether a 5-year leasehold will be considered like kind with a 10-year leasehold.

Taxpayers wishing to construct replacement property improvements on land owned by other parties can use a leasehold in conjunction with an improvement exchange. A successful tax-deferred exchange can be accomplished if the leasehold improvements equal or exceed the value of the relinquished property before the end of the 180-day exchange period. This will require the services of both a QI and an Exchange Accommodation Titleholder. After the relinquished property closing, the EAT enters into the leasehold agreement on the taxpayer's behalf and uses the sale proceeds to construct the improvements. Once the improvements are complete or the 180-day period has ended, the EAT transfers the leasehold interest, which includes the improvements, to the taxpayer via the QI. Of course, the lease term must exceed 30 years as noted above and the identification rules will require a fairly specific description of the state of the improvements if they will not be anticipated to be substantially complete at the end of the exchange period. Valuation issues add complexity to this identification process and should be undertaken only with expert guidance.

Another possibility is where the taxpayer builds leasehold improvements on ground it already owns or controls through a related party. A recent PLR suggests the IRS may allow such transactions if they are carefully structured. PLR 200251008 involved a construction exchange where the party on the other side of the long-term lease was a "related party". What seemed to be a key factor was the existence of a 30-year or longer leasehold interest on the land. This allowed for two different conveyable elements: the underlying fee interest and the leasehold interest. By creating a separate conveyable leasehold interest, the taxpayer increased the value of the leasehold by building improvements that the IRS allowed to be conveyed as the replacement property.

Rev. Proc. 2004-51, issued two years later, was promulgated by the IRS to avoid a situation where a taxpayer conveys property to an accommodator who completes a build-to-suit exchange then conveyed it back as replacement property in an exchange. This makes it clear that we should expect close scrutiny for these exchanges. Therefore, this type of exchange is extremely complicated and requires expert interpretation of a combination of tax and legal issues. Taxpayers must consult tax and legal professionals before attempting this type of transaction.