Traditionally, the sale of real property exposes a taxpayer to a capital gains tax obligation if a gain was realized from the sale. Given the fact that capital gains tax rates have historically been high, taxpayers frequently look for ways to decrease or avoid paying capital gains taxes. One option allowable under the Internal Revenue Service Code is to enter into a Section 1031 Exchange in lieu of a traditional sale which results in a deferral of capital gains taxes. Section 1031 of the IRS Code provides that “no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business, or for investment.” For an exchange to qualify, the properties involved must be of “like-kind”. Not surprisingly, the definition of “like-kind” has been debated, argued, and expanded on by the Tax Court over the last 100 years in an attempt to decide whether the various transactions taxpayers have presented as Section 1031 Exchanges actually qualify. One variant of an Exchange that continues to result in confusion and litigation is the “leasehold Improvement” exchange.
Leasehold Improvements
A leasehold improvement involves modifications or renovations made to an existing building or piece of land that are made specifically to accommodate a business. Often, a taxpayer purchases a building or tract of land and then builds on the land or renovates the building to suit the taxpayer’s business purposes. If leasehold improvements are part of a proposed Section 1031 Exchange, they can complicate the analysis. This is particularly true if the taxpayer already owns the land on which taxpayer wishes to make the improvements prior to entering into the Section 1031 Exchange.
As a general rule, the I.R.S. has specifically disallowed attempts to use improvements of land already owned by taxpayer in a Section 1031 Exchange because a taxpayer cannot own both the property to be relinquished and the property used to replace it. Rev. Proc. 2004-51 Section 4.05 states “An exchange of real estate owned by a taxpayer for improvement on land owned by the same taxpayer does not meet the requirements of Code Section 1031.”
Relevant Tax Court Cases
In Bloomington Coca-Cola Bottling Company v. Commissioner, 189 F.2d 14 (1951) the Court held that taxpayer could not exchange one piece of property owned by taxpayer to another party in exchange for improvements completed by the other party made on second property owned by taxpayer.
More recently, in DeCleene v. Commissioner, 115 T.C. 457 (2000) taxpayer attempted to qualify a transaction for Section 1031 treatment wherein taxpayer originally owned both properties. Taxpayer conveyed a property to another party via Quitclaim deed. The other party then held the property while leasehold improvements were completed over a three month period. Taxpayer then relinquished a second property owned by taxpayer to the other party in exchange for the original property which had been improved upon. The Tax Court focused on the fact that the other party involved in the transaction never really acquired the benefits and burdens of ownership of the property and, therefore, the transaction did not qualify.
This does not mean, however, that leasehold improvements cannot be structured in a way that will qualify for Section 1031 Exchange treatment. Both case law and the I.R.S. Code indicate that if a qualified intermediary, or QI, is used along with a Qualified Exchange Accommodation Agreement, or QEAA, a transaction that includes leasehold improvements may qualify for Section 1031 treatment. According to the “Limitations” section of Rev. Proc. 2004-51 Section 4.05 “This revenue procedure does not apply to replacement property held in a 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.” Moreover, the Court in DeCleene specifically mentions that taxpayer did not use a third party facilitator (QI) resulting in the conclusion that the party to whom the property was conveyed never actually owned the property. Had taxpayer “parked” the property with a QI and entered into a QEAA the transaction might have qualified for Section 1031 treatment.
If you or your client is considering a leasehold improvement exchange and would like to engage Atlas 1031 Exchange as the accommodator and have questions regarding the characteristics of the transaction, request a consultation.
