Does Leasehold Interest Qualify For 1031 Exchange? - Dst Investment

1031 Exchange

The 1031 Exchange is named after the Internal Revenue Code (IRC) Section 1031. Generally, short-term capital gains are taxed as ordinary income according to federal income tax brackets. The long-term capital gains tax rate in 2020 is 15% for the bracket between $53,601 and $469,050, and 20% for $460,050 or more. Under section 1031, an investor enjoys capital gains tax deferral by a like-kind exchange of real estate properties for the purpose of business and investment.

Leasehold v Freehold

Freehold means someone holds ownership of a thing. This thing can be a piece of land or property or other tangible or intangible objects. In an example of a property, it means that he or she has a real right over the property. As the owner, he or she may grant a lease on the property to another person. The person who concludes a lease with the owner has a leasehold interest. It means that he or she can have temporary periods stipulated in the contract to access and occupy the land or the property. In reality, the subjects that the owner can lease are not limited to land or real estate.

Leasehold Interest Qualification for 1031 Exchange: Time

The Code of Federal Regulations provides some essential explanations in relation to property held for productive use in trade or business or for investment. For the benefit of the 1031 Exchange, the critical hurdle to pass is the test of “like-kind” property, which is used in section 1031(a) of 26 U.S.C.A. It states that the word “like-kind” refers to the nature or character of the property and not to its grade or quality. In other words, one kind or class of property may not, under that section, be exchanged for property of a different kind or class. A leasehold interest is one example listed in the statute regarding exchanges of property of a “like-kind”. It reads that a taxpayer who is not a dealer in real estate exchanges a leasehold of a fee with 30 years or more to run for real estate can be categorised as “like-kind” property. In other words, section 1.1031(a)-1(c) of the regulations provides that the length of the leasehold interest plays a role in the test of “like-kind” property, which is 30 or more years with respect to a fee interest in real estate. In the case of R & J Furniture Co. v Commissioner, the Tax Court of the United States held that a lease with an initial term of 5 years and ten renewal options of 5 years each was the property of a like-kind and the equivalent of a fee interest in real estate. The lease was deemed under the regulations because the taxpayers had the right to possess, occupy, and use the leased property for a total of 55 years. This case confirms that the 1031 Exchange allows shorter leases in combination with optional renewal periods, so long as the amount of years in total is greater than 30 years of use.

Leasehold Interest Qualification for 1031 Exchange: Subject

Another test is whether the leasehold interest is derived from real property or personal property because only the real estate is covered by the 1031 Exchange. The legal difference regarding interests between real property and personal property is distinctive. In short, interests arising from real property always tie with the land, whereas the interests of personal property are only linked with the holder of the interests. The case of Peabody Natural Resources Company v Commissioner is a great example to show how the court deals with this test. In this “like-kind” exchange case, the court first regarded a coal supply contract similar to a condominium lease. Then the court intended to make a determination whether the exchange was subject to the 1031 Exchange. The first test the court encountered was whether the coal supply contract implicated an interest of a real property or personal property. Based on the New Mexico Law, the court ruled that the contracts were ‘equitable servitudes’, which obligated the taxpayer and all successive owners to honor the supply contract to the public utilities. In other words, the contractual interests were attached to the land and bound by whoever owns it. Therefore, it was considered as real property interests. As a result, the contracts satisfied the real estate test that is an element required by the 1031 Exchange. Besides, it is worth noting that like other 1031 Exchange properties, the leasehold interest also has to be held for the purpose of productive usage in a trade or business or for investment and all other requirements for deferral under the 1031 Exchange rule.

Value of Leasehold Interest

In the case of Inland Edinburgh Festiva, LLC v County of Hennepin from the Minnesota Tax Court, it explains the assessment of the value of a leasehold interest. The court states that the value of a leasehold interest – that is, the tenant’s right to use and occupy the property – depends on the relationship between the contract rent and market rent. If contract rent is less than market rent, the tenant’s leasehold interest has a positive value. Conversely, if contract rent is more than market rent, the tenant’s leasehold interest has a negative value.

In sum, leasehold interest can qualify for 1031 Exchange, subject to multiple legal requirements laid out in the statute and court cases.