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 must receive like-kind property from another party. The 1031 exchange guidelines 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) or contractor
A strategy that requires advance planning can facilitate a leasehold improvement exchange on land owned by the Exchangor when the fee interest of the land is transferred to a related party more than 180 days before the transfer of ownership to the contractor or EAT (otherwise known as the parking arrangement). Thirty year leasehold interests are considered real property and eligible for 1031 exchanges. The Exchangor leases the land to either the contractor or EAT for a period greater than 30 years. The improvements are constructed with 180 calendar days and then the lessee's interest in the ground lease and ownership of the improvements are transferred to the Exchangor as the replacement property. The lessor may continue charging a fair market rent for the remainder of the 30 plus years or terminate the ground lease.
The leasehold improvement exchange steps are:
1. Exchangor transfers fee interest to related party more than 180 days prior to parking with the EAT.
2. EAT takes a 30 year and 180 day ground lease from the related party and constructs the improvements with either funds provided by the Exchangor or the exchange proceeds.
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 or terminates the lease.
6. Related party should collect fair market ground rent during lease.
This a complex exchange and should not be entered with the counsel of the Exchangor's attorney or CPA.
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