A leasehold improvement exchange is the application of a leasehold interest with a 1031 tax deferred exchange. A couple of examples includes building on land already owned or exchanging out of leasehold improvements made into another leasehold interest to be improved. Each requires planning, but the first example requires that the property to be improved is owned by a related party at least six months prior to initiating the exchange.
Related Party Definition
A related party is any family member of the taxpayer including siblings, spouse, parents, grandparents or a corporation or partnership where more than 50 percent in stock value is directly or indirectly owned by or for taxpayer, or a corporation or partnership if the taxpayer owns more than 50 percent in outstanding stock value of the corporation and more than 50 percent of the capital or profit interest in the partnership.
Leasehold Improvement Exchange
Revenue Procedure 2004-51, July 20, 2004 states in Section 4.05 Limitations “This revenue procedure does not apply to replacement property held in a Qualified Exchange Accommodation Agreement (QEAA) if the property is owned by the taxpayer within the 180-day period ending on the date of transfer of qualified indicia of ownership of the property to an exchange accommodation titleholder.” Furthermore, it is well recognized that a taxpayer cannot make improvements on property already owned because the taxpayer must receive like-kind property from another party in the exchange and not materials and services per Bloomington Coca-Cola Bottling Co. v. C.I.R., (7th Cir. 1951).
Given a related party owns the property to be improved six months prior to the exchange, the Exchange Accommodator Titleholder enters into thirty year and 180 day or more lease with the related party and allocates the exchange funds either from a taxpayer coordinated loan or proceeds from the sale of the relinquished property to pay the contractors making the improvements. No later than the 180th calendar day or earlier if the improvements are completed, the lease is assigned to the taxpayer who pays fair market ground rent to the related party for two years to satisfy the holding requirement established in subsections (f) and (g) of the Internal Revenue Code Section 1031 to prevent basis shifting between related parties.
Leasehold Interest Exchange
A tenant who owns leasehold improvements may sell and initiate an improvement exchange for leasehold improvements to be constructed in the replacement property. Restaurants, medical practitioners and service professionals may relocate or sell a franchise to start another. Those leasehold improvements sold can be replaced and capital gains tax deferred in an exchange where the exchange accommodator titleholder (EAT) constructs the improvements.
In private letter ruling 200842019, the taxpayer exchanged a leasehold interest for newly acquired leasehold with improvements constructed by the landlord paid from the proceeds received when the relinquished property improvements were sold. In the same PLR, the Service references the exchange of leaseholds, referring to the value or quality of two leasehold locations, inferring less than 30 year leaseholds are like-kind. In Revenue Ruling 76-301, 1976-2 C.B. 241, a less than 30 year leasehold in twenty floors was like-kind to a sublease with the same term in five floors in the same commercial building.
A leasehold term of 30 years or more including optional renewable periods is considered like-kind to a fee interest in land. The taxpayer must have the option to renew the lease to be 1031 eligible. A landlord’s interest in a lease or the granting of a new lease is not 1031 eligible but treated as an advance of rental income per Pembroke v. C.I.R., (1931) and Crooks v. C.I.R., (1989).
When considering selling leasehold improvements, a 1031 exchange should be reviewed to determine whether those improvements are eligible for a capital gain deferral. Click on the button below to ask a question.