When a taxpayer sells property outright, the sale is often subject to the payment of capital gains taxes. To avoid the payment of capital gains taxes, a taxpayer may choose to enter into a Section 1031 Exchange instead of a traditional sale. If the transaction qualifies for Section 1031 treatment any applicable capital gains tax will be deferred. The basic premise of a Section 1031 Exchange is that the taxpayer will relinquish a property and replace it with another property of “like-kind”. While there are a number of other criteria that must be met for a transaction to qualify as a Section 1031 Exchange, the “like-kind” criterion itself has been the subject of much debate over the years. For example, can a leasehold interest exchanged for a fee interest ever be considered a “like-kind” exchange?
Leasehold Interest
A leasehold interest is defined as a “claim or right to enjoy the exclusive possession and use of an asset or property for a stated definite period, as created by a written lease.” A long-term leasehold may typically be transferred, sold, or encumbered, but does not devise to heirs if the owner dies. A fee interest is the absolute ownership of land which can be sold, transferred, encumbered and does devise to heirs upon the death of the owner.
Regulation Section 1.1031(a)-1(c) provides some guidance on the issue of leasehold interests exchanged for fee interests by stating:
“Examples of exchanges of property of a ‘like kind.’—No gain or loss is recognized if …a taxpayer who is not a dealer in real estate exchanges…a leasehold of a fee with 30 years or more to run for real estate.”
In essence, that tells us that a leasehold interest may be exchanged for a fee interest if the leasehold interest has 30 years or more left to run; however, the question remained whether a leasehold interest of less than 30 years would qualify for Section 1031 treatment.
Leasehold improvements are those changes the lessee makes to the real property to fit their business needs. A Subway franchise or CVS Pharmacy will construct improvements to their leased spaced. The leasehold interest enables the leasehold improvements to be 1031 eligible.
Tax Court Outcome
VIP’s Industries Inc. & Subsidiaries v. Commissioner, T.C. Memo 2013-357 answered that precise question in the negative. In that case, the taxpayer originally entered into a leasehold agreement for property in 1993 for a non-renewable and non-extendable term of 33 years. The following year, taxpayer constructed a motel on the property. The leasehold improvements to the property cost taxpayer approximately $2.5 million. In 2006, taxpayer attempted to enter into a Section 1031 Exchange by relinquishing the remaining leasehold interest and replacing it with a fee interest in two similar properties. At the time of the exchange, 21 years and four months remained on the original leasehold agreement. The Internal Revenue Service, or IRS, denied the exchange arguing that the remaining 21 plus years on the leasehold agreement was not “like-kind” to the fee interests it was exchanged for in the transaction.
The Tax Court in VIP Industries Inc. & Subsidiaries agreed with the IRS basing its decision on how similar cases have been treated in the past, including May Dep’t Stores Co. v. Commissioner, 16 T.C. at 556, where the court held that a 20-year leasehold was not equivalent to a fee interest and Standard Envelope Mfg. Co. v. Commissioner, 15 T.C. at 48, where the court held that a leasehold interest with a term of 1 year and an option to renew for a term of 24 years was not equivalent to a fee interest noting that options to renew are included in determining whether a leasehold interest is equivalent to a fee interest.
The Tax Court based its decision in VIP Industries Inc. & Subsidiaries on precedent, meaning that the court did not definitively decide that a leasehold interest of less than 30 years could never be exchanged for a fee interest; however, a taxpayer wishing to enter into a 1031 Exchange using a leasehold interest with less than 30 years remaining should seek professional advice prior to attempting the exchange as there is a very good likelihood that the exchange will not qualify.
Interested in learning “Ten Reasons Why a 1031 Exchange Makes Sense?” Download this three page eGuide, here. Do you have a question?
We Can Help
Atlas 1031 Exchange has been accommodating tax-deferred exchanges of all kinds for more than 17 years. We are fluent in the rules and regulations of IRC Section 1031 and able to help you navigate your exchange.
Contact us today to discuss any questions you may have. Call our office at 1-800-227-1031, email us at info@atlas1031.com, or submit your question through the online form at the top of this page.
