Since Eisenhower occupied the Oval Office, owners of business and income property have been able to exchange “like kind” real property and benefit from deferred tax treatment on gains. The Internal Revenue Service rules are relatively straightforward about what qualifies as like-kind property. The classification is a function of the nature or character of the property, as opposed to its grade or quality.
Indeed, under Section 1031(a)(1) of the tax code, an office building generally can be exchanged for another office building, and a fleet of trucks can be swapped out for another fleet, without triggering an immediate tax hit when the newly acquired property is worth more than the old. This permissive approach means that virtually any variety of real estate can be exchanged, on a tax-free basis, for any other interest in real estate.
Other caveats apply, including that the newly acquired property has to be used in a trade or business, or for investment. But in general, the types of property rights and interests that constitute interests in real property — and may be considered like kind to real property for purposes of the tax code are, if nothing else, exceedingly broad.
Accordingly, it is well-settled that unimproved land can be exchanged tax-free for improved land. That is, the properties, in this case, may differ in terms of their grade or quality but, nonetheless, are of the same kind or class. In addition, a fee or ownership interest in realty can be exchanged, on a tax-free basis, for a leasehold interest with respect to real estate that has a remaining term, taking into account renewal options of at least 30 years.
What is less apparent, however, is whether a property right represents an interest in real estate — and provides owners with a Section 1031 tax deferral.
Local Law Controls
The IRS acknowledges that local law generally determines whether assets are considered real property or personal property. For example, in an October letter issued by the service, (LTR 200805012, October 30, 2007) it provides an example of a C corporation that owned a fee interest — one that is free and clear of all ownership conditions — in two properties, each located in the same city. For clarity’s sake, let’s call the C corporation ZedCo, the two properties Alpha Complex and Beta Complex, and the city Plainsboro.
In the scenario, ZedCo intends to transfer its fee interest in Alpha to a qualified intermediary — an independent company that facilitates Section 1031 exchanges — who will then sell Alpha to a third party purchaser. The intermediary, in turn, uses the sales proceeds to purchase Alpha developments rights. Plainsboro law defines development rights as the “rights granted to a parcel of land under a zoning ordinance respecting permissible use, area, bulk, or height of improvements executed thereon.” Finally, the intermediary transfers the development rights to ZedCo.
Owning the development rights allows ZedCo to develop Beta Property with “greater floor space” than would otherwise be allowed while retaining tax-deferred status. Why? The IRS ruling notes that local law tax statutes define an “interest in real property” to include development rights. Moreover, the ruling notes that a transfer of development rights is subject to local gains tax as a “transfer of real property.”