However, in finding that the transaction fits within the non-recognition provisions of Section 1031(a)(1) of the tax code, meaning that the gain will not be immediately recognized for tax purposes, the October IRS letter makes the following observations:
• ZedCo is proposing to acquire development rights and transfer those rights to Beta, which the corporation already owns. This transfer, however, is not an impediment to ZedCo’s claim that the Section 1031(a)(1) tax deferment applies to the exchange. Indeed, the IRS, in citing a 1968 revenue ruling (Rev. Rul. 68-394, 1968-2 C.B. 338) said that it was “immaterial” that development rights will be used merely to enhance the real property that is already owned by the company, which in this case refers to Beta Complex. Furthermore, the ruling indicates that for purposes of Section 1031(a)(1), it is not material that the property acquired, as the replacement property, happens to be on property already owned by the ZedCo.
• Local law treats development rights as an “interest in real property.”
• Development rights are not discretionary, which means that they exist permanently, and therefore are analogous to perpetual rights. This finding brought the case within the safe harbor established in its 1955 revenue rule on water rights (Rev. Rul. 55-749, 1955-2 C.B. 295).
In that ruling, the IRS found that Sec. 1031(a)(1) applied to the exchange of raw land for perpetual water rights which were, under local law, considered real property rights.
So, although a casual observer may not consider development rights to be real estate, the rights involved in this case easily attained that designation. In light of the fact that the development rights at issue here were perpetual and, under local law, represented an interest in real property, the rights were regarded “as of like kind” to the fee interest in Alpha, for which they were exchanged. Perhaps more importantly, ZedCo was able to consummate the exchange on a wholly tax-free basis.
Contributor Robert Willens, founder and principle of Robert Willens LLC, writes a regular tax column for CFO.com.