Internal Revenue Code §1031 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 if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment.” Commonly known as “1031 Exchanges” or “Like Kind Exchanges,” taxpayers have taken advantage of this tax code section to defer taxes on the exchange of a variety of properties, including aircraft, collectibles, trucks, restaurant equipment, and even coins. Of course, any property being exchanged must be exchanged for “like kind” property, which in the context of personal property narrowly means restaurant equipment for other restaurant equipment, gold coins for gold coins, etc.
However, most attorneys who have been involved in 1031 exchanges are more familiar with exchanges involving real property. The concept of “like kind” has been much more broadly construed in the context of real property transactions than it has with regard to personal property transactions. For instance, Treasury Regulation 1.1031(a)-1(b) states that:
The fact that any real estate involved is improved or unimproved is not material, for that fact relates only to the grade or quality of the property and not to its kind or class. Treasury Regulation 1.1031(c)(2) states the distinction more plainly: [A] taxpayer who is not a dealer in real estate exchanges city real estate for a ranch or farm, or exchanges a leasehold of a fee with 30 years or more to run for real estate, or exchanges improved real estate for unimproved real estate;…. So when it comes to real estate, we are not limited to properties of the same grade or quality, meaning an office building can be exchanged for vacant land, or an apartment building, or even a warehouse. In viewing these transactions, it is quite simply real estate being exchanged for real estate.
While broadness of the definition of “like kind” with regard to real estate is common knowledge to many practitioners, some are not aware that a fee interest in real property may be exchanged for other types of interests in real property. The Treasury Regulations themselves tacitly state that “real estate” may be exchanged for a leasehold of a fee with 30 years or more remaining.
Additionally, several cases and Revenue Rulings have determined that certain mineral interests could be exchanged for real property, including: o An “overriding royalty interest” in oil, gas and mineral rights for an undivided one-half interest as tenant in common in a parcel of improved real property. [Crichton, 42 BTA 490 (1940), affd 122 F2d 181 (1941, CA5)] o An interest in a producing oil lease extending until the exhaustion of the deposit exchanged for a fee interest in a ranch. [Rev. Rul. 68-331 (1968)] o Perpetual water rights for a fee interest in land [Rev. Rul. 55-749 (1955)] The determination of whether a mineral right will be considered “like kind” to a fee interest in real estate depends on: (i) the specific nature of the rights granted under the mineral contract, (ii) the duration of those rights, and (iii) whether the law of the State in which the mineral interests are located would characterize the mineral rights as an interest in real property rather than an interest in personal property. [Oregon Lumber Co, 20 TC 192 (1953).
Over the last few years, the IRS has also issued several Private Letter Rulings (hereinafter “PLRs”) that held that other interests can be considered “like kind” to a fee interest in real property. Of course, Private Letter Rulings may not be relied upon by a taxpayer, so caution is warranted and competent tax advice should be obtained in connection with any such transaction. Nevertheless, PLRs 200805012 and 200901020 both held that the development rights they were asked to consider were “like kind” to a variety of other real property interests, including both fee interests and 30 year leasehold interests. While the IRS looked to state law in making its determination, the Service noted that the ultimate determination is made under federal, not state law. In both rulings, a key factor seemed to be that the development rights involved in the respective exchanges were perpetual in duration.
Two other PLRs have held that New York cooperative apartments were “like kind” to fee interests. Most recently, several cooperative apartments were held to be “like kind” to “the improved and unimproved real property” that the taxpayers planned to acquire (PLR 200631012). The IRS relied on various New York laws in making this determination, including CPLR §5206(a) (homestead exemption from creditors), RPL §279(5) (mortgage for a cooperative interest) and Tax Law §1402-a(a) (“Mansion” Tax). Earlier, the IRS ruled that that a cooperative apartment was “like kind” to a fee interest in a condominium interest in an apartment in the same building (PLR 200137032). That ruling emphasized that the proprietary lease for the co-op in question had more than 30 years remaining in its term.
The 45 day deadline to identify replacement property in a 1031 exchange often proves problematic for taxpayers, especially in our current economy, where many available properties are distressed assets that require the mortgage holder’s approval before a sale can occur. With this in mind, it pays to be mindful that real estate can include more than dirt!
Michael S. Brady, Esq. is a Vice President for Asset Preservation, Inc., a National Qualified Intermediary for IRC §1031 Tax Deferred Exchanges. He is also a Certified Exchange Specialist®.
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