RECENT CASE RE: LEASEHOLD INTEREST NOT LIKE-KIND TO FEE INTEREST
In order to qualify for tax deferral under Internal Revenue Code §1031, both the property sold as relinquished property and the property acquired as replacement property must be like-kind. Section 1.1031(a)-1(b) of the Treasury Regulations clarifies that the term “like-kind” refers to the nature or character of the property interests involved, but not the grade or quality of the specific property. Under this test, the courts have generally concluded that a fee simple interest in real property is like kind to a wide range of real property interests. Thus, developed land is like kind to undeveloped land and a fee interest is like kind to certain mineral interests, water rights and certain long term leasehold estates. Along those lines, Treasury Regulation §1.1031.(a)-1(c) provides that a tenant’s interest in a leasehold estate with 30 years or more remaining to run, including option extensions, is like kind to a fee simple interest in real property. Given the specificity of the regulation, most tax advisors believe that a taxpayer attempting to exchange a leasehold interest with less than 30 years remaining at the time of the exchange would not be like kind to a fee simple interest in other property.
In VIP Industries Inc. & Subsidiaries v. Commissioner, T.C. Memo 2013-357, the taxpayer exchanged a leasehold interest with a remaining term of 21 years for fee simple interests in 2 Oregon replacement properties. There were no option extensions. After citing regulation §1.1031.(a)-1(c) and reviewing precedent cases, the court concluded that leasehold interests with remaining terms similar to the one at issue are not like kind to fee interests in real property. Precedent cases included May Department Stores Co. v. Commissioner, 16 T.C at 556, (holding that a 20-year leasehold was not like kind to a fee interest); Standard Envelope Mfg. Co. v. Commissioner, 15 T.C. at 48 (holding that leasehold interest with a terms of 1 year and an option to renew for a term of 24 years was not like kind to a fee interest). Thus, in the VIP Industries case, the court found that the taxpayer’s leasehold interest in VIP Industries with a term of 21 years and 4 months remaining is closer in nature to the leasehold interests and not like kind to a fee interest. As such, the exchanger was not entitled to deferral of tax under Section 1031.
In light of the VIP Industries case, taxpayers who wish to exchange a leasehold interest for a fee interest should only proceed if the leasehold interest has more than 30 years remaining, including options to renew that would extend the leasehold interest over the 30 year threshold. As always, consult with your tax and legal advisors about your specific situation well in advance of a contemplated 1031 exchange.