This More More Monday post discusses various examples of “real property” that can be exchanged with real estate. When we think of a 1031 tax-deferred exchange or “like-kind” exchange, we first think of exchanging real estate for real estate. And that is typically what is done. However, have you considered what the definition of “real property” is in a 1031 exchange or what types of property can be exchanged?
We know that a fee interest in any type of investment or business use real estate, whether residential, commercial, agricultural or industrial can be exchanged for a fee interest in any other residential, commercial, agricultural or industrial real estate. Have you ever considered that property interests other than a fee interest may also qualify for an exchange?
Some examples of property that may be defined as “real property” for 1031 purposes:
30 Year Leases: You can exchange a fee interest for a lease of 30 years or more, including options. If the lease includes optional periods for renewing the lease, these renewal options are included in the term of the lease. For example, a lease of 20 years with two five-year options will qualify under the 30 year lease requirement. A lease of five years with ten 5-year renewal options will also qualify since the taxpayer will have the option to lease the property for 55 years. It is not clear if a lease term of less than 30 years is like-kind to a fee interest.
Easements: An easement is a right in real property. The granting of a perpetual conservation easement may be like-kind to a fee interest in real estate, since the purpose of a conservation easement is to keep the land in its natural or historical state forever. A taxpayer may be able to exchange a conservation easement for improved real estate and begin generating a new cash flow.
Cell Phone Towers/Billboards: A cell phone tower easement or billboard easement works much in the same way as a as a long-term lease. The telecommunication phone company or billboard company will negotiate a long term lease with the landowner for a lump sum payment. This payment may be used for acquiring a fee interest in investment or business use real estate.
Tenant-in-Common Interest: A tenant-in-common interest is a form of co-ownership in which each co-owner has an undivided interest in the real estate. If two individuals own real estate each with a 50 percent undivided interest, when the property is sold, they may be able to take their 50 percent of the sale and exchange into other real estate. The co-owners can exchange into the same replacement property or go their separate ways and reinvest into completely different properties.
Mineral, Gas & Oil Interests: Mineral, gas and oil interests may be exchangeable for a fee interest depending on the type of interest being conveyed. There are several different types of interests. A mineral estate is the perpetual interest in all minerals running with the land and this type of estate can be separated from the surface rights to the property. A taxpayer can separate the mineral estate from the surface real estate and just exchange the mineral estate into a fee interest in any other type of real estate. A mineral lease gives the lessee the right to extract minerals for a period of time or until exhaustion and the lessee incurs all the costs of exploration and extraction. The exchange of this type of a mineral lease into a real estate interest is allowed under federal regulations. A mineral royalty entitles the holder to the right to receive a percentage of the mineral produced until exhaustion which also qualifies under federal regulations to be exchanged for real estate. However, a mineral lease in which the lessor retains a royalty interest cannot be exchanged for real estate.
Life estate: If the life expectancy of the life tenant is 30+ years, a life estate can be exchanged for other real property.
Option to Purchase Real Estate: While the exchange of options is not quite as popular as it was a few years ago, an option to purchase may be exchanged for real property if the option is considered real property under state law.
While these types of “interests” are not usually thought of as real estate to most taxpayers, federal and state laws do allow these types of transactions to qualify for a 1031 exchange. If you are contemplating any of these types of property in an exchange, you should obtain the advice of a tax or legal advisor familiar with what constitutes real property in your state and perhaps you will be able to use Section 1031 to accomplish your investment objective.
Your 1031 CORP. Exchange Officer can help you get started.