Real Estate ‘Put’ Option Could Help Defer Taxes

In a clarification issued by the IRS, development rights constitute "real property," and in some cases will allow companies to defer taxes when exchanging property.

For quite some time, the Internal Revenue Code has allowed companies and individuals to defer tax payments if property of like kind is exchanged. To be sure, Section 1031(a) of Code states that no gain or loss is recognized on the exchange of property held for productive use in a trade or business, or for investment, if the property is exchanged solely for property of like kind – which is to be held.

What’s more, the words ‘like kind’ refer only to “nature or character” of property and not to its grade or quality.

Accordingly, real property can be freely exchanged, on a tax-deferred basis, for other real property even if, for example, an improved parcel of realty is exchanged for an unimproved parcel. The improved or unimproved status of the realty goes only to the issue of its grade or quality, but the nature or character of each item of property to be exchanged is the same.

Also, it is clear that certain intangible rights pertaining to realty can be viewed as real property that can be exchanged under the aegis of Section 1031(a), for more “conventional” real property interests.

The Internal Revenue Service released guidance on the subject in a private letter ruling issued in October (LTR 200901020). In the example, the taxpayer, which we will call Alpha Corporation, enters into a contract to sell certain parcels of land to a buyer — Omega Inc, for our purposes. Further, the land use entitlement has been determined for both the properties being sold, as well as some other properties retained by Alpha but not included in the sale. Those entitlements are identified in a Phased Development Site Plan (PDSP) that has been approved by the County Board within whose jurisdiction the land is situated.

The PDSP permits the parcels of land to be developed as residential housing units and hotel units. In addition, the contract gives Alpha a put option, entitling Alpha to transfer to Omega some or all of the residential development rights for the parcels it retains. The contract also provides that if Alpha exercises the put option, Omega is required to transfer to Alpha the right to construct some or all of the hotel units now approved for the parcel sold to Omega.

Bob Willens 2Then in 1972 [a] Revenue Ruling held that an easement and right-of-way are properties of like kind to both real property with nominal improvements and real property improved with an apartment building.— Robert Willens.

Under state law, the “development rights” constitute interests in real property. The contract sets a purchase for the transfer of the development rights. In addition, Alpha says it intends to exercise the put option and use the sales proceeds to acquire like-kind replacement property. Alpha’s replacement property will be comprised of: (1) a fee interest in real estate; (2) a leasehold interest in real estate with 30 years or more to run; and (3) land use rights for hotel units. The form of the transaction will be a so-called ”deferred like-kind exchange”.

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