In the normal course of business, a taxpayer is subject to capital gains tax when gain is realized on the sale of real property. The rate at which capital gains are taxed depends on factors such as the type of gain (short-term or long-term) and the taxpayer’s tax bracket but can be rather high. One way to avoid payment of capital gains tax is to enter into a Section 1031 Exchange instead of a traditional sale. If a transaction qualifies for Section 1031 treatment the capital gains tax that would be due is deferred.
For a transaction to be eligible for Section 1031 treatment it must meet a number of requirements. For example, the property involved in the transaction must be held for use in a trade or business or for investment. In addition, the property relinquished and the replacement property must be of “like-kind”. Both personal and real property can potentially qualify for a Section 1031 Exchange; however, real property cannot be exchanged for personal property and vice versa.
In many cases, it is apparent to the parties involved that a potential transaction qualifies for 1031 Exchange treatment; however, in other situations it is far from clear that a transaction will qualify. When there is a question regarding how a transaction will be treated for tax purposes, a taxpayer has the option to ask the Internal Revenue Service for an opinion ahead of time. The IRS will then respond with a Private Letter Ruling, or PLR. A 2011 PLR has led to some confusion with regard to a taxpayer’s ability to restructure an asset so that the asset qualifies for a Section 1031 Exchange.
Private Letter Ruling 201149003
In PLR 201149003 taxpayer was a corporation that proposed to engage in the business of acquiring, owning, and leasing certain easements in, to, under, and over certain real property. To facilitate the business of taxpayer, taxpayer planned to enter into lease agreements with property owners and then acquire easements on the leased property. The easements would then be used to construct and operate cell phone towers on the property. The actual question in PLR 201149003 was related to treatment under § 856(c)(4)(A) of the Internal Revenue Code of easements over real property acquired subject to existing leases and the treatment under §§ 856(d) and 856(c)(3)(A) of rent accrued and paid pursuant to such existing leases; however, the ruling could also be used to analyze the potential Section 1031 eligibility of situations where a lease is turned into an easement.
The ruling in PLR 201149003 concluded that “an Easement acquired by Taxpayer under an Easement Agreement” is “an interest in real property”. That ruling, in turn, could be used to make the argument that if a lease is turned into an easement the resulting easement, which qualifies as real property, could be eligible for Section 1031 Exchange treatment. Caution, however, should be used in reaching this conclusion as the IRS could challenge that interpretation and, instead, treat the lease and the easement as separate assets. Furthermore, the IRS could also challenge the newly created lease under the “qualified use test”. The “qualified use test”, in essence, requires a taxpayer to prove that the taxpayer had the intent to hold the property used in a Section 1031 Exchange for investment purposes. While the length of time taxpayer has owned the property is not the only consideration in an analysis of the “intent to hold” element of the “qualified use test”, a property that was acquired or “restructured” immediately prior to a Section 1031 Exchange is more likely to be challenged by the IRS on the “intent to hold” element of the test.
Thirty Year Leasehold Interest
A thirty year lease or more is considered real property and can be exchanged for a fee interest in real property. The taxpayer’s landlord interest in a lease is not exchangeable and does not qualify for 1031 consideration, rather is treated as “the receipt of advance rental income by the taxpayer-lessor in an amount equal to the equity value of the property received” per Pembroke v. C.I.R. (B.T.A. 1931) and Crooks v. C.I.R. (1989).
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Atlas 1031 Exchange has been accommodating tax-deferred exchanges of all kinds for more than 17 years. We are fluent in the rules and regulations of IRC Section 1031 and able to help you navigate your exchange.
Contact us today to discuss any questions you may have. Call our office at 1-800-227-1031, email us at info@atlas1031.com, or submit your question through the online form at the top of this page.
