“Development Rights” As “Like-Kind” Property As Part of a 1031 Tax-Deferred Exchange

Upon the sale of business or investment property, taxes are payable on any gain realized. However, under Section 1031 of the Internal Revenue Code, payment of the tax is deferred if you reinvest the sale proceeds in a property that is a “like-kind” property using what is commonly referred to as a “1031 like-kind exchange.” In the context of a “like-kind” exchange, “sold” and “bought” are called “relinquished” and “replaced,” respectively. To qualify for such tax-deferred treatment, the property being “sold” (actually, being “relinquished”) must be of “like-kind” to the property being “bought” (actually, being the “replacement”).

For 1031 purposes, most real property will be considered “like-kind” to other real property, regardless of its use. For example, one may acquire an office building or a retail center as a replacement property for an industrial property that is being relinquished. In addition, one need not acquire a fee interest. A leasehold interest would qualify as “like-kind” property if there is at least thirty years remaining on the lease at the time of the exchange (inclusive of any remaining renewal terms provided for in the lease). Until now, it was questioned whether other “rights” in real property, such as development rights, can be used part of a 1031 like-kind exchange.

A recent private ruling by the Internal Revenue Service (“IRS”) allowed this. In PLR 200901020, a property owner contracted to sell (relinquish) certain parcels of property. The contract contained a “put” option. This entitled the seller to transfer some or all of its residential development rights under a phased development site plan. If the seller exercised the put option, the buyer was required to sell certain hotel development rights back to the seller. In determining whether the use of development rights qualified for 1031 like-kind exchange purposes, the IRS first looked to applicable state law to determine if the development rights were treated as real property interests. In this case, the IRS concluded that under the actual state’s law, development rights constituted a real property interest. However, the IRS noted that state law is not necessarily dispositive because there are other factors to be considered in determining whether the development rights qualified for 1031 like-kind exchange purposes. According to the IRS, development rights would qualify as real property interests in a “like-kind” exchange if: (a) the development rights were “in perpetuity”; (b) the development rights were directly related to the taxpayer’s use and enjoyment of the underlying real property; and (c) the sale of development rights was done as part of an arms-length transaction. It concluded that the taxpayer had met these criteria, and thus it sanctioned the seller’s exchange of its residential development rights for hotel development rights as part of a like-kind exchange. In addition, the seller was permitted to exchange some of its development rights for a fee interest or long-term lease interest in other property.