When exchanging real estate, the exchanger must acquire property that is like-kind to the property that was sold.  Like-kind in connection with real estate is defined as “all other real estate.”  The types of property that qualify are very broad.  For example, raw land will be like-kind with improved real estate.  An office building is like-kind with an apartment building.  Real estate in Massachusetts or Rhode Island is like-kind with real estate in Florida, Texas or Arizona.

Further, a partial or fractional interest in real estate is like-kind to a full or fee simple interest in real estate.  So, an exchanger could sell a fee simple interest in real estate and purchase a tenant-in-common interest in real estate.

Recently, a series of rulings have been issued by the IRS which confirms that certain intangible interests in real estate are like-kind to fee simple interests in real estate.

Conservation Easements

In Private Letter Ruling (PLR) 9621012, the IRS ruled that the exchange of a “perpetual scenic conservation easement” (PSCE) for a fee simple interest in land that was either timberland, a ranch, or a farm qualifies for tax-free treatment under section 1031.  A PSCE means any limitation in a deed in the form of an easement, restriction, covenant, or condition, the purpose of which is to retain land predominantly in its natural, scenic, historical, agricultural, forested, or open-space condition.  Under a PSCE, the subject property remains as scenic open space in perpetuity, and its owner is not able to develop the property.  The ruling is based on a state’s civil code, which provides that a conservation easement is an interest in real property voluntarily created and freely transferable in whole or in part.  Assuming the PSCE is, by virtue of state law, an interest in real property, the exchange of the PSCE for the proposed replacement property qualifies as an exchange of like-kind property for purposes of Section 1031.

In PLR 9232030, the IRS ruled that an agricultural conservation easement on a farm is of like kind to a fee simple interest in real estate.

In PLR 200201007, the IRS ruled that a taxpayer’s exchange of a perpetual conservation easement (PCE) on a ranch for other ranch property that would be subject to a PCE upon receipt by the taxpayer qualifies for like-kind exchange treatment under Section 1031.

In PLR 200651018, the IRS ruled that a perpetual stewardship easement as described in the ruling is of like-kind to fee interest in other real property, and use of proceeds from relinquished perpetual stewardship to purchase one or more fee interests in real property to be held by taxpayer for productive use in trade or business or for investment will not disqualify transaction from tax deferred exchange treatment.

Development Rights

The IRS ruled in PLR 200901020 that residential density development rights to be transferred by taxpayer as relinquished property were for Section 1031 purposes of a like-kind to a fee interest in real estate, leasehold interest in real estate with 30 years or more remaining at time of the exchange, and land use rights for hotel units. The land use rights that were a part of the put option addressed in this PLR and the restrictive covenant (collectively referred to as Development Rights) constituted interests in real estate under state law. Taxpayer intended to exercise the put option and use the sales proceeds from the Development Rights (the relinquished property) to acquire like kind replacement property. Taxpayer’s replacement property included a fee interest in real estate, a leasehold interest in real estate with 30 years or more remaining, and land use rights for hotel units.  The IRS ruled that the Development Rights to be transferred by Taxpayer as relinquished property were of like kind, for purposes of Code Sec. 1031, to a fee interest in real estate, a leasehold interest in real estate with 30 years or more remaining at the time of the exchange and land use rights for hotel units (which Taxpayer would receive if the Development Rights it transferred were for more than a certain number of residential units). The new rights for hotel units were to be applied to property Taxpayer already owned. The Development Rights were in perpetuity and were directly related and requisite to Taxpayer’s interest, use and enjoyment of the underlying land. The Development Rights were also interests in real property under state law. In effect, Taxpayer exchanged one set of Development Rights (pertaining to residential density) for other development rights (pertaining to hotel development). Some of the Development Rights were also to be exchanged for another fee interest in land, and another long-term leasehold interest in additional real property.

IRS has also ruled recently that development rights were like kind to the fee interest in property that a taxpayer relinquished in the exchange. The swap involved a complex exchange set up through a qualified intermediary (QI). In the PLR, Taxpayer was a C corporation that owned Property 1 and Property 2 located in City, State Z. It intended to transfer its fee interest in Property 1 (”Relinquished Property”) to a QI under an exchange agreement. QI wwould sell the Relinquished Property to a third-party purchaser in an arm’s-length transaction. QI would use part of the cash proceeds from this sale to buy Development Rights (”Replacement Property”) from a third-party seller. QI would transfer Development Rights to Taxpayer, who would cause Development Rights to be recorded with respect to Property 2. They would permit Taxpayer (or its lessee) to develop Property 2 with greater floor space than would otherwise have been allowed if Property 2 did not have Development Rights. Sections of State Z Tax Statute (and the corresponding sections of State Z regulations), defined “real property” to include “every estate or right, legal or equitable, present or future, vested or contingent, in lands, tenements or hereditaments, including buildings, structures and other improvements thereon, which are located in whole or in part within [State Z].” Sections of State Z Tax Statute further defined an “interest in real property” to include “title in fee, a leasehold interest, a beneficial interest, an encumbrance, development rights, air space and air rights, or any other interest with the right to use or occupancy of real property or the right to receive rents, profits, or other income derived from real property.” Whether property constitutes real or personal property generally is determined under state or local law.  In this case, Taxpayer proposed to acquire Development Rights as its replacement property and to transfer such rights to Property 2, which Taxpayer already owns. The IRS has previously noted that for purposes of Code Sec. 1031(a), it is not material that the property acquired by the taxpayer as the replacement property is on property already owned by that taxpayer so long as it is acquired in an arm’s-length transaction. For purposes of determining if Taxpayer’s proposed transaction qualifies as a like-kind exchange, IRS said it is thus immaterial that Development Rights to be acquired by Taxpayer will be used merely to enhance the real property already owned by it. More important is whether Development Rights constitute interests in real property under the state and local laws of State Z.  Although it is unclear whether Development Rights were treated as interests in real property for all purposes of State Z law, it is clear that Sections of State Z Tax Statute and the regulations thereunder did treat Development Rights as an interest in real property. Moreover, the various sections of the local Ordinances provided that Development Rights are as-of-right and not discretionary, meaning that they exist permanently rather than at the discretion of a city agency or other decision-making authority. As such, these rights appear to be analogous to perpetual rights. In addition, a deed transfer is similar to the perfecting of Development Rights, which involves an actual transfer of rights from one property to another. Thus, while the Tax Statutes of State Z do not explicitly state that Development Rights are granted in perpetuity, IRS concluded that such rights do arise out of an interest in the underlying real estate. Moreover, City Ordinances did not set an expiration date for Development Rights, and thus they were effectively perpetual in nature. Thus, IRS concluded that Development Rights that Taxpayer intended to acquire as replacement property were like kind to the fee interest in Relinquished Property.

The point of this discussion is to alert all potential exchangers to the borad definition of real estate and what will qualify under Section 1031.  For more information or questions about specific scenarios, please contact Moore McLaughlin, Esq., CPA, CES, owner of All States 1031 Exchange Facilitator, LLC at fmm@AllStates1031.com or Alexandra L. Hart, CES at AHart@AllStates1031.com.