1031 Exchanges: The Fee or Not the Fee? That is the Question

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I think most practitioners understand that in order to complete a “like-kind” exchange, the property being sold (the “relinquished” property) and the property being purchased (the “replacement property”) must be of like-kind.  For real estate, that’s pretty simple, since, as we know, all real property is considered “like-kind” to other real property, regardless of its use. So, it’s pretty obvious that one may acquire an apartment building as a replacement property for an office building or a strip mall as a replacement property for an industrial property. But you may not know that the acquisition of other real property interests may qualify for treatment as like-kind for 1031 purposes. If don’t think outside of the box, you may miss out on other exchange opportunities.

I would assume that most like-kind exchanges of real property involve the sale of the fee interest in one property and the purchase of a fee interest in another. But is it limited to only the exchange of fee interests? Have you considered that you don’t need to acquire a fee interest? Would it surprise you to learn that a leasehold interest could qualify as “like-kind” property? In fact, the tax code considers a leasehold interest with at least thirty years remaining at the time of the exchange (inclusive of any remaining renewal terms provided for in the lease) to be akin to a fee interest. So, a taxpayer can sell the fee interest in one property and acquire the tenant’s leasehold interest in another property as part of a like-kind exchange, and vice versa.

Here’s something else you many not have considered. Did you know that if your state treats development rights as real property interests, then you may be able to acquire or sell development rights as part of a like-kind exchange? State law treatment is the first consideration, but not the only consideration the IRS will take into account when determining if one can acquire development rights as party of a like-kind exchange. The IRS will also consider: (a) if the development rights are “in perpetuity”; (b) if the development rights are directly related to the taxpayer’s use and enjoyment of the underlying real property; and (c) if the sale of development rights was done as part of an arms-length transaction. If these conditions are met, then development rights may also be utilized as part of a like-kind exchange of real property.

If you want to avail yourself  of the benefits of a like-kind exchange of real property interests, you should not limit yourself to the exchange of a fee interest for a fee interest. Sure, fee interest for fee interest is probably the most common situation, but it may not always work for you. You should be aware of the other possible avenues for completing a like-kind exchange of real property interests.

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