One of the more complex topics in 1031 exchanges is the so-called “leasehold improvement exchange,” which have been the source of some controversy.
Corporations have used these exchanges to improve real estate owned by a related corporation (i.e. a corporation with a certain level of common ownership). If you have an individual or corporate client who is contemplating one of these exchanges, you can increase your professional stature by offering guidance on how they work.
Clients need to understand not only the mechanics of these exchanges, but also the risks and potential legal issues which can arise out of them. In this post, we will go over these mechanics, highlight the benefits of these exchanges and then cover some of the issues involved.
Basic Mechanics of Leasehold Improvement Exchanges
In a traditional improvement exchange, the target replacement property is acquired by the facilitator and then leased back to the taxpayer. The taxpayer then proceeds to use the funds from the sale of the relinquished property (and outside funds if desired) to finance improvements. There can be many benefits to this exchange variation.
The leasehold improvement exchange adds a layer of complexity by conveying a leasehold interest rather than a fee simple absolute interest. In this new variation, the owner of the replacement real estate transfers a leasehold interest to the facilitator. In most cases, the facilitator establishes a special purpose entity (single member LLC) to temporarily hold the leasehold interest throughout the duration of the exchange. Or, the SPE can maintain the leasehold interest for the entire duration of the lease and sublease the property to the taxpayer.
In any case, the taxpayer funds the improvements which are made prior to the end of the exchange period (which is still 180 days). Then, at the end of the exchange, the facilitator transfers the leasehold interest to the taxpayer.
The taxpayer is then in possession of a “real property interest” provided that the leasehold interest is of sufficient length (i.e. minimally 30 years including renewal options). As long as all the exchange proceeds were spent, and there be no other forms of boot, the taxpayer will not incur any immediate tax consequences.
Benefits of Leasehold Improvement Exchanges
In many cases, these exchanges are performed using raw land owned by a related corporation. Consider this example:
- Corporation A wants to construct a hotel on an unimproved lot which is owned by Corporation B
- Corporations A and B are considered related parties under the applicable rules in Section 1031.
- Instead of selling the raw land, Corporation B agrees to convey a leasehold interest to Corporation A so that the hotel project can be constructed.
- Corporation A engages a facilitator, sells its relinquished property, funds the construction and then receives the leasehold interest.
In this case, the benefits of this exchange variation are very clear. Corporation A has been able to fund its construction project without having to purchase the underlying land. This means that all the exchange proceeds can contribute toward the construction.
Corporation A can achieve full tax deferral by simply channeling funds toward the construction. This is a huge benefit, as otherwise the taxpayer would only be able to partially fund its construction project with exchange proceeds.
Understanding the Potential Issues
In cases in which there is no related party owner, the potential issues of this variation are essentially the same as those for ordinary improvement exchanges. The taxpayer has to comply with the specialized regulations found in the Treasury Regulations. However, if the case involves a related party owner, then there can be multiple potential issues. The transaction would be governed by the related party rules under subsection 1031(f).
This means that the taxpayer would be subject to the two-year holding requirement under paragraph 1031(f)(1)(C). The taxpayer would not be allowed to convey the leasehold interest until at least two years have passed since the end of the exchange.
Moreover, the transaction would be subject to the “purpose requirement” of the related party rules. This means that the transaction could be collapsed if it were found that the avoidance of federal income tax was a principal purpose underlying the exchange. This requirement can only be determined on a case-by-case basis.
Depending on the specifics of the case, a court could rule that the taxpayer is in violation of the purpose requirement. Let’s look at a hypothetical:
Suppose a taxpayer, Corporation A, owns a property with a low adjusted basis and wishes to avoid paying income tax following a sale. The taxpayer engages with a related corporation, Corporation B, to conduct a leasehold improvement exchange to build a commercial property on an unimproved lot.
The term of the lease – 30 years – is enough to satisfy the like-kind requirement. Given that this will produce a favorable situation for Corporation B upon the conclusion of the lease, a court may decide that this transaction runs afoul of the purpose requirement of subsection 1031(f). Of course, this decision would depend on all the relevant factors of the case. But the fact that the relinquished property had a low basis would be highly significant.
The IRS has issued numerous opinions and documents on this type of transaction. It may be helpful for you to familiarize yourself with this material. Reading this all of it will be time-consuming and difficult, however, and so this usually isn’t an option.
In any event, in most cases it will simply be enough to discuss the mechanics and notify your client that these transactions are more closely scrutinized by the IRS, and that therefore a qualified tax attorney should probably be obtained.