Acquiring a Leasehold Interest as Replacement Property

Section 1031 defines a leasehold interest with a term of 30 years or more as "like kind" to a fee interest in real estate. Renewal options under the lease are counted for purposes of determining if the lease has 30 years or more to run. Accordingly, a 30 year leasehold interest can be exchanged for a fee interest in real estate or vice versa, a fee interest in real estate can be exchanged for a 30 year leasehold interest.

Usually when a leasehold interest is sold or exchanged, the lease is an existing lease and there is significant value in the lease because of leasehold improvements which are present on the leasehold. When a leasehold interest is purchased as replacement property for an exchange, the value of the leasehold would normally be attributed to the value of the improvements which are on the leasehold. For income tax reporting, the taxpayer-lessee would continue paying rents after acquiring the leasehold including improvements. The purchase cost (or tax basis in an exchange) of the lease would be amortized over the period of the lease.

What if the lease is a newly created lease into which the taxpayer is entering? A taxpayer can transfer a fee interest for the receipt of a newly created 30 year lease. But in this case, it is important that the purchase price appear to be for the acquisition of a leasehold and related improvements and not merely as an advance payment of rent over the term of the lease. If the newly created lease was perceived to be an advance payment of rent 1031 exchange treatment has been denied under case law for the seller of the lease. But there have been exceptions under IRS Rulings.

If the IRS viewed the purchase of the lease to be an advance payment of rent to the lessor (and the rental agreements required rents of more than $250,000), the Internal Revenue Code would require that the lessor and lessee both treat the payment as rent income and rent expense over the period of the lease and this would not be viewed as a “purchase” by the lessor. Accordingly, the possible application of this provision is an issue that taxpayers entering into a purchase of a newly-created lease should be concerned about in drafting the terms of the purchase.

As one can see, it is important that the purchase appear to be in the nature of the purchase of real estate vs. an advance payment of rent. For more information on Leasehold Interests as Replacement Property, please visit our website or call 1031 Corporation Exchange Professionals at 888-367-1031.