In the exchange business we generally discuss with a client whether they want to choose to exchange a property. However there are also occasions where federal tax law will impose Section 1031 exchange treatment on a transaction, typically where the sale results in a loss. As far as their advisors are concerned, a Section 1031exchange is not a consideration because of the tax loss.

Taxpayers, in an effort to free up cash for their business,  may sell operating assets to a third party, such as a private equity fund, followed by a long term leaseback of the property to the seller. This is particularly true when:

  1. The seller may have acquired the property at a relatively high price at the end of the last economic boom and there is little or no gain potential in the long run;
  2. The seller may have heavily leveraged the property and the seller’s lender may be pressuring the taxpayer to sell;  or
  3. The desirability of the area may have slowed, leaving the seller with relatively little upside in terms of later sale.

However, in cases where the taxpayer has suffered a tax loss on the sale of the property, the tax regulations prohibit recognition of the tax loss to a (non-dealer) taxpayer where the sale of the real estate is followed by an immediate acquisition of a leasehold of 30 years or more for real estate. The tax regulations treat this transaction as a non-taxable exchange of like-kind properties.

In Century Electric Co vs. Commissioner, the Eighth Circuit  stated that the tax regulations have the force of law and held that a sale and a leaseback for 95 years, including renewals, was an exchange of like-kind property with boot, so that loss could not be recognized.

The crucial element has to do with the length of the term of the leasehold estate, including renewals. If the term of the leasehold is 20 years, with two ten year extensions, that qualifies as like-kind property. Conversely, in Jordan Marsh Co vs. Commissioner, the Second Circuit held that Congress did not intend the exchange of like-kind property provision to apply where the property received is a lesser (e.g., a leasehold) interest in property conveyed. Therefore, it refused to hold that a sale and leaseback for a term of 30 years and three days, renewable for a similar term if the lessee erected a new building, was an exchange of like-kind property with boot. The Court emphasized that both the purchase price and the rentals were for fair market value. It held that when real estate is transferred for cash equal to the fair market value, the transaction is a sale and not a like-kind exchange.  Predictably, the IRS would not followthe court’s decision in Jordan Marsh Co vs. Commissioner [Rev Rul 60-43, 1960-1 CB 687].

For more information on 1031 exchanges, contact the tax attorneys at All States 1031 Exchange Facilitator at 877-395-1031.