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Leasehold Improvement Exchanges & Taxation

We’ve covered numerous issues related to Section 1031 on our blog in the past. We’ve discussed state tax issues, the use of vacation homes, New York co-ops, reverse 1031 exchanges, all above and beyond the basic principles of 1031 transactions. As we’ve seen, Section 1031 can get a bit tricky when you consider all of the myriad rules and requirements which taxpayers have to be aware of.

When you identify property, you have to obey certain rules.  You have to hold both your relinquished property and your replacement property.  You are subject to specific standards; when you go to acquire replacement property.  There is a rigid timeline, and so on and so forth. Navigating the rules and requirements of Section 1031 can be a daunting task.  Taxpayers should always consult with an experienced tax attorney to ensure a smooth transaction.  In this blog post, we’ll look at another aspect of Section 1031:  Leasehold Improvement Exchanges and their taxation.

Exchanges By Affiliates

As it turns out, there is a related variation of the 1031 improvement exchange which has been discussed on this blog before. This related variation is referred to as “leasehold improvement exchanges by affiliates,” or “leasehold improvement exchanges by related parties.” Depending on the local jurisdiction, leasehold interests may satisfy the like-kind requirement as qualifying real property. Typically, to qualify as real property, the leasehold interest must be of at least 30 years in length.  Leasehold extensions also qualify for consideration.  Accordingly, an interest of 20 years with two options to extend the lease of  five years each likely suffices. In certain cases, taxpayers utilize leasehold improvement exchanges so that they can improve real property owned by a related party. In this post, we will go over the mechanics of leasehold improvement exchanges.  We’ll then discuss one of the key issues surrounding this transaction. 

Basic Overview of Leasehold Improvement Exchanges by Related Entities 

A typical 1031 “improvement exchange,” involves improvements to either a structure or raw land owned by an unrelated party. However, improvements to related person property may also fit the bill. The related person might be a corporation or an individual, for instance.  In that scenario, taxpayers have structured leasehold improvement exchanges as one way to avoid related party risks. A taxpayer can either sell a relinquished property, or acquire a replacement property, from a related party.  Note, though, that such transactions are subject to specific requirements. Structuring a leasehold improvement exchange allows taxpayers to get around related party issues.  That’s because, in this variation, the taxpayer merely acquires a temporary interest, not a fee simple interest. 

In a leasehold improvement exchange, the seller conveys a leasehold interest to an exchange accommodation titleholder (or EAT).  The Seller then makes improvements to the property. The EAT then transfers the leasehold interest to the taxpayer and the taxpayer takes credit for the improvement values. The taxpayer then dissolves the EAT or entirely absorbs it.  Meanwhile, the seller remains on record as the true owner. The taxpayer is, thus, able to improve upon property owned by a related party.  The taxpayer does so without experiencing the usual complications which arise from related party transactions.  

Unique Issues with Leasehold Improvement Exchanges 

If you undertake a leasehold improvement exchange, you need to be conscious of the fact that these transactions are quite sophisticated and present many potential problems. Because of the fact that these transactions involve related parties, they will certainly receive heightened scrutiny from the IRS.  Accordingly, it’s critical that taxpayers structure these transactions properly. One issue with these transactions is whether courts will impose the same rules which normally apply to related-party transactions.  The taxpayer acquires only a leasehold interest. That’s important.

There’s a possibility that courts may apply the “step transaction doctrine” in order to treat these transactions as typical related party exchanges. If courts did this, it makes these transactions considerably riskier.  Think about it.  The entire transaction could fail, for instance, if a court determines that basis shifting exists to avoid federal income taxation. If the seller accepted some amount of cash in the context of the transaction, this may also cause the transaction to fail.  That’s because such acceptance is generally not consistent with related party exchanges. 

Opening For An IRS Challenge

Whenever a taxpayer performs an exchange involving a related party, even one in which a leasehold interest is conferred such as in this unique variation discussed here, that taxpayer opens himself or herself up to objections from the IRS. Related party exchanges have been known to cause unpleasant surprises; a number of related party transactions have unexpectedly failed even when it seemed as though all rules and regulations were accounted for. If you are set on conducting a leasehold improvement exchange, by all means proceed, but understand that you are assuming risks which are absent with traditional exchanges.  

New York City Tax Attorneys For A Better 1031 Exchange

No matter what perspective you take, leasehold improvement exchanges involving affiliates or related parties are highly complex and bring up a number of important issues. If you attempt one of these transactions, you need to obtain a very experienced professional to help guide you through the process and inform you of the many things which can possibly go awry. The professionals at Mackay, Caswell & Callahan, P.C. spend their time mastering these types of issues so that they their clients receive the best possible counsel. If you have a question about an upcoming leasehold improvement exchange, or about any other tax or business issue, please contact this tax attorney in NYC and we will be sure to resolve your case in double quick time! 

Image credit: JD Hancock