An exchanger may wish to dispose of real property and use the sale proceeds to construct improvements on other property. This is an improvements exchange. The availability of Code Sec. 1031 nonrecognition depends upon who owns the land on which the improvements will be constructed and how the transaction is structured.

Construction on Replacement Property

An exchanger may obtain like-kind exchange treatment by exchanging relinquished property for replacement property that will have an improvement constructed on it before the exchanger receives the replacement property. Coastal Terminals Inc v. U.S., (1963, CA4) 12 AFTR 2d 5247, 320 F2d 333, 63-2 USTC ¶9623. This can be accomplished either through an exchange accommodation titleholder (EAT) in a reverse exchange or as a deferred exchange. If through an EAT, the EAT will acquire raw land, construct improvements while on title to the raw land, and transfer the land and improvements to the exchanger in exchange for the relinquished property. This transaction will satisfy for the Rev. Proc. 2000-37 safe harbor,  if the exchanger satisfied all of the requirements. If structured as a deferred exchange, the exchanger will transfer relinquished property and direct the buyer to transfer proceeds to a qualified intermediary. The qualified intermediary will use the proceeds to acquire improved property. This requires the seller to construct the improvements.

Construction on Existing Property

An exchanger may not obtain like-kind exchange treatment if property is disposed of and the proceeds are used to improve property the exchanger owns. Bloomington Coca-Cola Bottling Co v. Com., (1951, CA7) 40 AFTR 648, 189 F2d 14, 51-1 USTC ¶9320. At one point, practitioners speculated that exchangers could lease property to an exchange accommodation titleholder (EAT) under a lease of more than 30 years, direct the EAT to construct improvements, and then reacquire the lease and improvements. In Rev. Proc. 2004-51, however, the IRS made clear that Rev. Proc. 2000-37  does not apply to such transactions.

In DeCleene, Donald, (2000) 115 TC 457, the exchanger attempted to do an improvements exchange using property the exchanger already owned. The transaction in DeCleene involved an attempt by the exchanger to sell undeveloped property to an unrelated party, have the unrelated party construct a new building on the property, and have the unrelated party transfer the property and newly constructed building back to the exchanger in exchange for another property the exchanger owned. Because this transaction occurred before Rev. Proc. 2000-37 was published, the exchanger was unable to use that safe harbor. Nonetheless, the exchanger argued that the transaction should qualify for Code Sec. 1031 nonrecognition. The Tax Court disagreed. In holding that the transaction did not qualify for like-kind exchange treatment, the court found that the attempted sale of the undeveloped property to the unrelated party was a sham transaction. Thus, the unrelated party was never deemed to be the beneficial owner of the property on which the building was constructed. Instead, the exchanger was deemed to be the owner of the property at all times. This being the case, the later transfer could not qualify for Code Sec. 1031 nonrecognition.

Construction on Related-Party Property

The IRS allowed an exchanger to structure an improvements exchange involving related-party property using the Rev. Proc. 2000-37 safe harbor.

IRS Letter Ruling 200251008 endorses use of an exchange accommodation titleholder (EAT) under Rev. Proc. 2000-37 in an improvement exchange, thus eliminating the practical problems previously inherent in such transactions. In addition, that ruling endorses improvements exchanges between an exchanger and a related person where the related person does not cash out its investment.

Since publishing IRS Letter Ruling 200251008, the IRS has issued IRS Letter Ruling 200329021, on slightly different facts. IRS Letter Ruling 200329021 involved an exchanger who was the wholly owned subsidiary of Parent. Parent had entered into a long-term lease (a 20-year initial period with four five-year renewal options) before the date the exchanger contemplated disposing of its property (RQ) as part of a Code Sec. 1031 exchange.

In IRS Letter Ruling 200329021, the exchanger wished to dispose of RQ and use the proceeds to construct improvements on the property leased to Parent. The steps of the exchange were as follows:

(1) To structure the transaction as a qualified exchange accommodation arrangement (QEAA). QEAA under Rev. Proc. 2000-37, Parent assigned the leasehold to a limited liability company (LLC) wholly owned by an EAT. At the time of the assignment, the leased property was unimproved, except for demolition of the existing building on the site and rough grading (all performed by the landlord). At the time Parent assigned the lease to LLC, Parent also invoiced LLC for soft costs (i.e., engineering, surveys, etc.) associated with the LLC’s construction of the improvements. Parent did not, however, invoice LLC for other costs incurred to enter into the lease;
(2) Under Parent’s direction, LLC constructed improvements. The exchanger disposed of RQ with the proceeds going to a QI. Those proceeds were then advanced to LLC to fund construction of the improvements. LLC first used a portion of its first advance from the QI to reimburse Parent for the invoiced costs. It also paid the construction contractor for the costs of construction from the advances from the QI; and
(3) Before the earlier of the date that was 180 days after Parent assigned the leasehold to LLC and the date that was 180 days after the exchanger transferred RQ, the LLC assigned the leasehold with improvements to the exchanger.

The IRS ruled that to the extent the improvements were complete when the leasehold was assigned to the exchanger, the transaction qualified for Code Sec. 1031 nonrecognition. In addition, the IRS also ruled that, despite the fact that the exchanger and Parent were related, since both the exchanger and Parent “continue to be invested in exchange properties, both will remain so invested for a period of not less than two years following the exchange, and neither is otherwise cashing out its interests, gain recognition is not triggered under §1031(f)(4).” IRS Letter Ruling 200329021. Thus, the IRS endorsed the use of a lease assignment (in lieu of a sublease) by a related party to an EAT in a related-party improvements transaction. Because these transactions involve leases, they are referred to as leasehold improvements exchanges. They have become quite common in the real estate industry.

PLANNING POINTER: In advising whether to lease property from a related party to an EAT or transfer the property to an EAT, tax advisors must consider whether the property owned by the related party has high basis that would allow a tax-free cashout. Using a long-term lease helps to avoid this possibility.

Categories: Federal Tax Articles, Like Kind (IRC 1031), Tax Articles, Tax Free Exchanges