Gallet Dreyer & Berkey, LLP | Section 1031 Exchanges - Tax Benefits When a Property Owner Exchanges Real Property for Leasehold Improvements on a New (Long-Term) Leased Location
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Section 1031 Exchanges - Tax Benefits When a Property Owner Exchanges Real Property for Leasehold Improvements on a New (Long-Term) Leased Location

04/10/2011 | Spring 2011 Newsletter
While many real estate professionals are familiar with “like kind exchanges” under Internal Revenue Code Section 1031, many are not aware that Section 1031 may provide deferral of gain if the proceeds from the sale of property are used to construct or build-out a new leased location under a long-term lease. Section 1031 only provides this deferral if the lease has a term of 30 years or more, including optional renewal periods.

This deferral of gain under Section 1031 is beneficial because, without such statutory deferral, the seller would be required to pay federal income taxes on the gains from the sale.

For example: A Seller owns an office building used for its trade or business, and the Seller desires to sell the building and enter into or acquire two long-term leases to be used for its trade or business. The Seller plans to construct a new building or build-out space in an existing building at the two locations. The Seller desires to complete a like kind exchange under Section 1031 to defer the gain upon the sale of the office building.

Section 1031 and corresponding IRS Regulations and Rulings allow the Seller to “park” the new (replacement) property with an independent third-party (“Titleholder,” generally a new entity established by a qualified intermediary which facilitates Section 1031 exchanges) for up to 180 days prior to the disposition of the relinquished property, and allows the Titleholder to construct improvements on the replacement property during the 180-day period. Only the amount of construction performed up to the date of transfer to the Seller may qualify as replacement property.

A Safe Harbor allows a maximum 180-day period to complete the exchange, with the period commencing upon the sale of the relinquished property. In the case of a “reverse” exchange (i.e., acquisition of replacement property prior to the sale of the relinquished property), the applicable 180-day period commences upon the Titleholder’s acquisition of the replacement property.

A sample timeline for this example:
 
  • Seller enters into a contract to sell its building on January 1 for closing on July 1.
     
  • Seller arranges for Titleholder to enter into the first lease, the term of which commences on May 1, and Titleholder begins construction of improvements immediately. The lease must be assigned to Seller within 180 days after May 1.
     
  • The sale of the office building is completed on July 1 and the proceeds of the sale are delivered to a qualified intermediary, and Seller timely identifies replacement properties.
     
  • Seller arranges for Titleholder to enter into the second lease (and the term commences) on July 1 immediately after the closing of the sale of the office building and construction of improvements begins. The lease must be assigned to Seller within 180 days after July 1.
     
  • Subject to applicable requirements and exceptions and assuming all net proceeds from the sale of the building are used for qualifying leasehold improvements, by application of Section 1031 no gain is recognized by Seller upon this exchange for federal income tax purposes.

There are many issues to consider in connection with this type of “like kind exchange” transaction, such as (a) the timing of the transactions, some of which may be, at least in part, outside the control of the exchanging taxpayer; (b) the actual costs that will qualify as “like kind” to a fee interest in real estate (“soft costs,” at least certain soft costs, may not), and (c) possible transfer taxes upon the transfer of real property including long-term leases.

With appropriate advice and planning, construction exchanges — including the exchange of real estate owned in “fee” for leasehold improvements under a long-term lease — can be accomplished under Section 1031.