Leasehold improvement exchanges allow an Exchangor to improve property already owned. There are many complicated steps to ensure that an exchange is executed correctly; however, we’ll take care to explain the background and attempt to simplify them.
The Internal Revenue Service (IRS) does not view improvements to land owned by the Exchangor as like-kind property for two reasons. First, improvements consist of materials and labor; both are not real property until affixed to the real property (land or structure). Second, an Exchangor cannot purchase property from oneself but rather receive like-kind property from another party. The 1031 exchange rules must also be followed. With the IRS holding this view, it is essential that a related party takes ownership of one of the properties at least 180 calendar days prior to the exchange or relinquished property closing.
In Revenue Procedure 2004-51, the IRS provides that Revenue Procedure 2000-37 does not apply to replacement property held in a Qualified Exchange Accommodation Agreement if the property is owned by the Exchangor within the 180-day period prior to the transfer of the burden of ownership of the parked property. Consequently, an Exchangor cannot exchange into property if owned by the Exchangor within 180 calendar day period prior to parking the property with an Exchange Accommodator Titleholder (EAT). The EAT is a single member limited liability company created for the exchange.
Thirty-Year Leasehold Interest is Real Property
At least six months prior to starting the exchange, the land owned by the Exchangor is conveyed to a related party. The related party leases the land to the EAT for a period greater than 30 years and 180 days. The improvements are constructed by the EAT with funds provided from the sale of the relinquished or old property. Towards the end of the 180 calendar days the EAT’s interest in the ground lease and improvements are assigned to the Exchangor as the replacement property, completing the exchange requirements.
The lessor or related party charges a fair market rent for at least two years to the Exchangor and terminates the ground lease at the end of the second year, satisfying the related party rules of Code Section 1031(f). A thirty-year leasehold interest is recognized as real property.
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:
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.
Six Steps of a Leasehold Improvement Exchange
The process of a leasehold exchange are as follows:
- The Exchangor transfers fee interest to a related party more than 180 calendar days prior to entering lease with EAT.
- The EAT enters into a 30 year and 180-day ground lease with the related party and constructs the improvements with either funds provided by the Exchangor or the exchange proceeds from the sale of the relinquished property.
- The relinquished property sells within 180 calendar days of construction start date.
- The Exchangor is assigned to the lease with the improvements.
- The related party continues to own fee interest subject to the ground lease and terminates the lease after two years.
- The related party should collect fair market ground rent during lease.
Tax Court Outcome and Guidance on Leasehold Improvement Exchanges
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, the taxpayer constructed a motel on the property. The leasehold improvements to the property cost the taxpayer approximately $2.5 million.
In 2006, the 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 one 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.
In 2006, the IRS announced that it continues to study leasehold improvement exchanges. Currently, this type of exchange continues to be scrutinized by the IRS and should not be entered without the counsel of the Exchangor’s attorney or CPA.
Next Steps
If you’re considering a Leasehold Improvement Exchange, contact us via our consultation form below or call our office any time at 800-227-1031. We look forward to hearing from you and assisting you with your leasehold improvement exchange.
