Andy Gustafson

A taxpayer frequently incurs capital gains taxes as the result of gain realized in a traditional sale of property. Given the often high rate at which capital gains are often taxed, taxpayers look to legal strategies that allow them to limit their exposure to capital gains taxes. One option is to enter into a Section 1031 exchange instead of a conventional sale. A 1031 exchange allows a taxpayer to relinquish one property and replace it with another “like-kind” property. A transaction that satisfies all of the requirements for a Section 1031 exchange will allow the taxpayer to defer any capital gains that would otherwise be due on gain realized in a traditional sale. To qualify, the property involved must be held by the taxpayer for productive use in a trade or business or be held for investment purposes. In addition, a 1031 exchange must be completed within a 180 day time frame and a qualified intermediary, or QI, must be used to facilitate the exchange.

While many 1031 exchanges are straightforward, textbook examples, others are not. Since taxpayers began taking advantage of 1031 exchanges almost a century ago, the variety and diversity of transactions that taxpayers have attempted to qualify as an exchange has caused the Internal Revenue Service to continuously review and refine the Section 1031 requirements. One type of 1031 exchange that has been the cause of confusion and litigation over the years is the use of an easement as either the relinquished property or the replacement property. The issue, when an easement is part of a 1031 exchange, is whether an easement qualifies as “like-kind” property if the other property involved in the exchange is real property.

Easement

In legal terms, an easement is a right to cross or use someone else’s property. A utility company, for example, may have an easement on your property that allows them to cross over a portion of your property. Just as real property has value, so does an easement. Therefore, an easement can be bought, sold, or exchanged. The issue, however, is whether an easement can be exchanged for real property.

Revenue Ruling and Tax Court

In Rev. Rul. 72-549 (1972) Taxpayer granted an easement to an electric power company over property used in the taxpayer’s trade or business. Taxpayer was compensated for the easement. Taxpayer subsequently purchased real property for an amount that exceeded the compensation received from the electric company. Taxpayer attempted to defer capital gains on the compensation received from the electric company on the grounds that the transactions qualified for Section 1031 exchange treatment. The issue became whether or not the exchange was for “like-kind” properties. The ruling pointed to previous rulings in similar fact scenarios where the focus was on the “nature or character of the property and not its grade or quality”. The ruling held that the easement and the real property are “both continuing interests in real property and of the same nature and character, and as such qualify as “like kind” property under section 1031 of the Code.” A reverse exchange of two easements was also found to qualify in PLR 9814019.

More recently, in PLR 200649028 (2006), taxpayer owned a significant amount of land that the county wished to designate a portion of as a “stewardship area.” In essence, this would grant the county a special type of conservation easement on taxpayer’s land. In return, taxpayer would be compensated with “credits” for the reduction in value of the land as a result of the loss of use caused by the easement. Taxpayer would then be able to use those “credits” to purchase a suitable replacement property. Pursuant to a contract drafted between all parties involved, taxpayer wished to structure the transactions as a Section 1031 exchange. Again, the issue was whether an easement exchanged for real property qualified as a “like-kind” exchange. The ruling once again focused on the grade or quality of the property and not its kind or class. The ruling also focused on the fact that the right to grant an easement stems from taxpayer’s interest in the underlying land as well as that easements are frequently considered to be an interest in real property under state law (as was this case in the instant case) and, therefore, should be treated as such for purposes of a Section 1031 exchange.

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