Tax Court: Leasehold Interest Exchanged For Fee Interest In Real Estate Does Not Qualify For Section 1031 Treatment
Under the tax law, taxpayers are afforded favorable treatment when instead of selling appreciated property, they “exchange” it for other property; the idea being that the taxpayer has not cashed out its investment in the property, but rather simply changed the form of the investment.
Specifically, Section 1031(a) of the Code 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.”
Stated simply, a taxpayer recognizes no gain if they exchange appreciated property for property that is of “like kind.” And this, as you can imagine, is where issues arise. What is “like kind” property? The regulations offer some guidance.
Section 1.1031(a)-1(b) of the Regulations provides that the words “like kind” have reference to the nature or character of the property and not to its grade or quality. 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.
In general, this like-kind requirement precludes a taxpayer from exchanging real property for personal property, or vice versa. Fair enough. But what if a taxpayer transfers a leasehold interest – rather than a fee interest – in real estate in exchange for a fee interest in real estate? Is the leasehold interest of “like kind” to the fee interest?
Regulation Section 1.1031(a)-1(c) offers the following:
“Examples of exchanges of property of a ‘like kind.’—No gain or loss is recognized if * * * 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.
While enlightening, this example has one major shortcoming: does it mean that a leasehold interest with less than 30 years to run at the time of an exchange cannot qualify for Section 1031 treatment if exchanged for a fee interest in real estate?
Earlier today, the Tax Court offered its opinion on the matter.
In VIP’s Industries Inc. & Subsidiaries v. Commissioner, T.C. Memo 2013-357, the taxpayer owned a ground lease with respect to real property. The ground lease was originally entered into in 1993 with a nonrenewable and nonextendable lease with an original term of 33 years. In 1994, the taxpayer constructed a motel on the property at a cost of $2,509,398 and operated the motel until 2006.
On March 30, 2006, the taxpayer sold its leasehold interest in the property to a Wall Street investment firm and deposited the proceeds with a qualified intermediary (QI). When the leasehold interest was assigned, a term of 21 years and four months remained under the ground lease.
The taxpayer used the sale proceeds deposited with the QI to purchase fee interests in two real properties with a combined fair market value of $4,319,705: an existing motel and an existing office building. The taxpayer held both replacement properties for productive use in its trade or business.
On the taxpayer’s federal income tax return for its TYE September 30, 2006, the taxpayer realized gain of $4,320,618 from the exchange of the leasehold interest. On its return the taxpayer claimed that it recognized gain of $2,104,632 – the cash and debt relief received — and did not recognize the remaining $2,215,986 of the realized gain pursuant to Section 1031.
The IRS denied the deferral of gain under Section 1031, arguing that the leasehold interest with a remaining life of 21 years was not of “like kind” to the two fee interests it received in exchange.
In defending its position, the taxpayer argued that the regulations do not preclude an exchange of a leasehold with a life less than 30 years; rather, they provide a safe harbor by stating that an exchange of a leasehold with a remaining life in excess of 30 years will qualify for Section 1031 treatment.
The Tax Court sided with the IRS and denied the like-kind exchange. Looking to previous decisions, the court stated the following:
Petitioner exchanged its leasehold interest in the Eugene property with a remaining term of 21 years and 4 months for fee interests in the Bridgeport and Salem properties. We previously have held that leasehold interests with similar or even longer terms than the one at issue here are not equivalent to fee interests. In May Dep’t Stores Co. v. Commissioner, 16 T.C. at 556, we held that a 20-year leasehold was not equivalent to a fee interest. In Standard Envelope Mfg. Co. v. Commissioner, 15 T.C. at 48, we held that a leasehold interest with a term of 1 year and an option to renew for a term of 24 years was not equivalent to a fee interest, and we have held that options to renew are included in determining whether a leasehold interest is equivalent to a fee interest.
Petitioner’s leasehold interest in the Eugene property with a term of 21 years and 4 months remaining is closer in nature to the leasehold interests that we characterized as not equivalent to a fee interest than to the 30-year leasehold interest that section 1.1031(a)-1(c), Income Tax Regs., recognizes as the equivalent of a fee interest. Applying our precedent, we therefore conclude that petitioner’s leasehold interest was not of like kind to a fee interest under section 1031.
Unfortunately, because the Tax Court decided this case in accordance with its existing precedent, it didn’t need to address whether Regulation Section 1.1031(a)-1(c) mechanically excludes all exchanges of leaseholds with terms of less than 30 years for fee interests from receiving like-kind exchange treatment. So the mystery will continue, but be warned: if you plan to exchange a leasehold interest with a remaining life of less than 30 years, you run a significant risk of having the exchange challenged and denied.
California Senate approves $10,000 tax credit for new-home buyers
By Jim Wasserman
// Published: Thursday, Oct. 15, 2009 – 12:00 am | Page 8B
A shattered California home building industry received a boost Wednesday when the state Senate voted to extend a popular $10,000 tax credit that fueled thousands of new-home sales last spring and summer.
The Senate voted 35-1 to reauthorize the use of $30 million in credits not awarded during the first program. That should allow the state to give tax credits to about 4,300 more buyers of new unoccupied homes, many of which are in inland areas of California including the Central Valley. Eligible buyers would get a maximum of $3,333 in credits for each of the next three years.
Senate Bill X3 37 goes now to the Assembly, which is expected to consider it next week. It must pass that legislative body and be signed by Gov. Arnold Schwarzenegger to become law. But the Assembly approved an earlier version of the bill by wide margins and the governor has said he favors the buyer tax credit as a stimulus to the economy.
“This tax credit worked so well that in just four months it was gone,” said Sen. Ray Ashburn, R-Bakersfield, author of SB X3 37. “This is a good program that assisted people in buying homes and sharing in the American dream.”
More than 10,600 buyers of new homes were approved for the tax credit before the state Franchise Tax Board stopped taking applications July 2. Many buyers combined it with a federal $8,000 tax credit for first-time homebuyers to claim up to $18,000.
Since July, the FTB has determined that the average state credit will be $7,000, not the full $10,000. That freed up another potential $30 million in credits. According to the bill, buyers who close escrow after the credit is reauthorized will be eligible; but not those who closed escrow on new homes between July 2 and the date the bill goes into effect.
Reaction in the building industry Wednesday was swift.
“We’re very pleased,” said Allison Barnett, legislative advocate for the California Building Industry Association, a builder trade group that sponsored the bill. “The credit has been effective in creating jobs, getting people back to work and getting people back in the sales offices, which is essential for recovery in California.”
Builders contend the tax credit has helped them trim excess inventory, selling thousands of finished, but unsold, homes. Critics, including some economists, have argued the tax credit does little to stimulate the larger economy. And others question subsidizing new-home sales when there is a massive glut of existing homes for sale in California.
Brad Diede, executive vice president of the California Association of Specialty Contractors, said his group lobbied lawmakers statewide to extend the credit. Said Diede, “What we saw was employers putting people back to work after they had to lay them off. It’s stimulating the economy all the way around.”
The FTB said Sacramento, Roseville and Fresno were among top cities where residents received tax credits.
An earlier version of the bill, carried most of this year by Assemblywoman Anna Caballero, D-Salinas, failed to pass before a September legislative deadline. Many thought the bill was dead. But it was folded Wednesday into Ashburn’s SB X3 37 as part of a special session on water policies.
Ashburn carried the original bill last February to allocate $100 million for buyer tax credits. That was passed to win key Republican votes for plans to close a then-$42 billion state budget deficit.
New California Law: AB 957
This emergency bill that went into effect immediately when signed by the governor on Sunday, October 11, 2009, enacts the Buyer’s Choice Act, which prohibits a mortgagee or beneficiary under a deed of trust who acquired title to residential real property improved by 1-4 dwelling units at a foreclosure sale (or trustee’s sale) from, requiring, directly or indirectly, as a condition of selling the property, that the buyer purchase title insurance or escrow services in connection with the sale from a particular title insurer or escrow agent. The law does not prohibit a buyer from agreeing to accept a title insurer or an escrow agent recommended by the seller if written notice of the right to make an independent selection is first provided by the seller to the buyer.
A “seller” is defined as a mortgagee or beneficiary under deed of trust who acquired title to residential real property improved by four or fewer dwelling units at a foreclosure sale, including a trustee, agent, officer, or other employee of any such mortgagee or beneficiary. Thus this law applies only to REO transactions. Furthermore, a real estate agent of the REO seller is included under this definition.
A “seller” who violates these provisions will be liable to the buyer for an amount equal to three times all charges made for the title insurance or escrow services. In addition, any person in violation will be deemed to have violated his or her licensing law and will be subject to discipline by the licensing entity (e.g., the DRE). A transaction is not invalidated solely because of the failure of any person to comply with any provision of this law.
(Note: Existing Section 9 of RESPA (federal law) prohibits a seller (in all transactions not only REO transactions) from requiring the home buyer to use a particular title insurance company–no mention of escrow services in Section 9–either directly or indirectly, as a condition of sale. Buyers may sue a seller who violates this provision for an amount equal to three times all charges made for the title insurance. However in a letter from HUD, the agency indicated that it was not a violation of Section 9 to require a buyer to use a particular title insurance company so long as the seller paid for it. This new California law does not clarify this distinction as to whether to law applies or doesn’t apply depending on who pays for the title insurance or escrow services.)
For a copy of the new law, click here.