IRS Allows Exchange of Leasehold Interests in a 1031

There are different kinds of things that can be exchanged in a 1031 exchange without the payment of tax. Real estate (typically land and buildings) can be easily exchanged for almost any other type of real estate. However, ‘movable things’ like planes, boats, construction equipment, etc. (called personal property by the IRS), have exchange rules that are much more rigid and narrow. For example, an airplane hangar can be exchanged for a fish market or a ski-condo, but the airplane itself can only be exchanged for another airplane.

There’s a third, more unusual kind of 1031 exchange that falls somewhere in between real estate and personal property called a leasehold. A leasehold is the right to use someone else’s property. For exchange purposes, some leaseholds are treated the same as if they were real estate. For example, if you own a building that is built on land leased for 99 years, which is not uncommon, both the building and land lease are considered real estate and can be sold together and exchanged into other real estate, leased or otherwise.

To be considered real estate, the lease must have at least 30 years of remaining life, including all possible extensions. Suppose you have an investment property with 20 years of remaining life, but it also has the possibility of three 5-year lease extensions after that. Your lease has a potential remaining life of 35 years. Therefore it’s considered the same as real estate and can be exchanged for any other type of real estate.

Why might someone want to sell a lease? In addition to buildings on leased land, we’ve had clients who’ve sold the lease of an entire building to a developer who wanted to redevelop the property. We’ve also handled quite a few exchanges involving leases of cell phone towers. Why would someone buy a lease from someone else? It might be because the lease is at below-fair-market-value rents; possibly to get possession of the property so that they can change the usage.

One of the debates within the exchange community has been the question of how to handle exchanges involving leases of less than 30 years. While leases of more than 30 years are treated as real estate (and with that comes the benefit of great flexibility), leases less than 30 years are subjected to the same rigid rules as personal property.

Unanswered questions abound. For example, what if you sell a warehouse lease with 10 years left on it? Can you only exchange it for another 10-year warehouse lease? Or can you exchange it for a 10-year lease on a retail space? How about a 5-year warehouse lease, or a 5-year retail lease? Until lately there was no guidance from the IRS on these questions, and it created a lot of uncertainty in the industry.

In a recent private letter ruling (PLR200842019) the IRS answered part of this question in a situation where a taxpayer sold a lease on a space in an office building and did a 1031 exchange into a lease in a different office building. In their ruling the IRS said that the fact that the two leases vary in their terms and value do not affect the taxpayer’s ability to do an exchange. In other words, the fact that the leases were for different lengths of time, different amounts per month, and the spaces were of different sizes did not impact the exchange.

There was one unfortunate aspect of this: they did not address the issue of whether or not the type of property had to be the same for both leases. In this case, both leases were for office space, so we still don’t know if you can sell an office lease and exchange into a retail lease. But at least some of the questions plaguing the industry have been satisfied in a small way with this private letter ruling.