Leasehold Improvement 1031 Exchange
Leasehold improvement exchanges allow an Exchangor to improve property already owned. A thirty year lease or more is considered real property eligible as a 1031 replacement property. The lease and improvements made by a third party can be conveyed to the Exchangor given the lease is maintained for at least two years and the related party collects fair market ground rent from the Exchangor.
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. Second, an Exchangor cannot purchase property from ones self but rather receive like-kind property from another party. The 1031 exchange rules must also be followed.
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. The single member is non related party to the Exchangor.
Thirty Year Leasehold Interest is Real Property
At lease 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 by the Exchangor or proceeds 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 transferred 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.
The leasehold improvement reverse 1031 exchange steps are:
1. Exchangor transfers fee interest to related party more than 180 days prior to entering lease with EAT.
2. 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.
3. Relinquished property sells within 180 calendar days of construction start date.
4. Exchangor is assigned the lease with the improvements.
5. Related party continues to own fee interest subject to the ground lease and terminates the lease after two years.
6. Related party should collect fair market ground rent during lease.
In 2006, the IRS announced that it continues to study leasehold improvement exchanges. This is a complex exchange and should not be entered without the counsel of the Exchangor's attorney or CPA.
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