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Leasehold Interest and 1031 Exchanges
It is generally understood that in order to take advantage of the tax deferral benefits of a 1031 exchange the guideline to be adhered to is that an investor must replace the relinquished property with one that is considered “like kind.” Like kind is defined as “any other real estate held for productive use in a trade or business investment” and refers to the nature or character and not the grade or quality of the property. For example a vacant lot held for investment can be exchanged for a class A medical office building.
A less well known fact is that Regulation 1.1031(a)-1(c)(2) allows the investor to exchange conventionally owned real estate for a leasehold interest. A leasehold interest is one where the investor does not own the ground but rather has a right to a stream of income for a prescribed period of time. Generally, the reason an investor would consider a leasehold interest is a higher level of income than could not otherwise be realized from the same tenant.
The requirement to acquire a leasehold interest as replacement property when doing a 1031 exchange is that there be at least thirty (30) years remaining in the lease term. It is interesting to note that the term(s) of renewal options may be included when determining whether the leasehold interest has a remaining term of 30 years or more or not. In one case the court held that the initial term of 5 years with 10 optional renewal periods of 5 years each was considered “like kind.”
The benefits of exchanging into a long term net lease investments (be it an outright purchase or a leasehold interest) is that they provide stable, predictable income and generally minimize if not eliminate the management headaches associated with investment property. Frequently net leased properties are secured by well-recognized national companies who have been rated by Standard & Poors and Moody’s.
When considering a 1031 exchange and investing in net lease or leasehold properties the investor should seek out expert guidance from their CPA and/or real estate attorney prior to finalizing any investment decisions.
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