Real Estate ‘Put’ Option Could Help Defer Taxes

In a clarification issued by the IRS, development rights constitute "real property," and in some cases will allow companies to defer taxes when exc...
Robert WillensApril 27, 2009

For quite some time, the Internal Revenue Code has allowed companies and individuals to defer tax payments if property of like kind is exchanged. To be sure, Section 1031(a) of Code states that no gain or loss is recognized on the exchange of property held for productive use in a trade or business, or for investment, if the property is exchanged solely for property of like kind – which is to be held.

What’s more, the words ‘like kind’ refer only to “nature or character” of property and not to its grade or quality.

Accordingly, real property can be freely exchanged, on a tax-deferred basis, for other real property even if, for example, an improved parcel of realty is exchanged for an unimproved parcel. The improved or unimproved status of the realty goes only to the issue of its grade or quality, but the nature or character of each item of property to be exchanged is the same.

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Also, it is clear that certain intangible rights pertaining to realty can be viewed as real property that can be exchanged under the aegis of Section 1031(a), for more “conventional” real property interests.

The Internal Revenue Service released guidance on the subject in a private letter ruling issued in October (LTR 200901020). In the example, the taxpayer, which we will call Alpha Corporation, enters into a contract to sell certain parcels of land to a buyer — Omega Inc, for our purposes. Further, the land use entitlement has been determined for both the properties being sold, as well as some other properties retained by Alpha but not included in the sale. Those entitlements are identified in a Phased Development Site Plan (PDSP) that has been approved by the County Board within whose jurisdiction the land is situated.

The PDSP permits the parcels of land to be developed as residential housing units and hotel units. In addition, the contract gives Alpha a put option, entitling Alpha to transfer to Omega some or all of the residential development rights for the parcels it retains. The contract also provides that if Alpha exercises the put option, Omega is required to transfer to Alpha the right to construct some or all of the hotel units now approved for the parcel sold to Omega.

Bob Willens 2Then in 1972 [a] Revenue Ruling held that an easement and right-of-way are properties of like kind to both real property with nominal improvements and real property improved with an apartment building.— Robert Willens.

Under state law, the “development rights” constitute interests in real property. The contract sets a purchase for the transfer of the development rights. In addition, Alpha says it intends to exercise the put option and use the sales proceeds to acquire like-kind replacement property. Alpha’s replacement property will be comprised of: (1) a fee interest in real estate; (2) a leasehold interest in real estate with 30 years or more to run; and (3) land use rights for hotel units. The form of the transaction will be a so-called “deferred like-kind exchange”.

In Perpetuity

The ruling notes that not all interests defined as “real property interests” for state law purposes are of like kind. For example, even if a short-term lease (one with less than 30 years to run) is an interest in real property under state law, it is not of like kind to a fee interest in real estate for federal income tax purposes. However, a 1955 Revenue Ruling1 determined that land could be exchanged for perpetual water rights: The ruling held that the fee interest in the land and a “water right in perpetuity” are of like kind.

Four years later, in 1959, another IRS Revenue Ruling2 noted that a tax paying entity was granted an easement of indefinite duration over specified portions of its land: The ruling concludes that the easement constitutes “an interest in real property.” Then in 1972, yet another Revenue Ruling3 held that an easement and right-of-way are properties of like kind to both real property with nominal improvements and real property improved with an apartment building.

This trio of precedents persuaded the IRS to grant Alpha’s recent ruling request.

Indeed, in the 2008 Revenue Ruling, Alpha proposes to exchange development rights for a fee interest in real estate, a leasehold interest in real estate of 30 years or more remaining, and land use rights for hotel units. Significantly, the development rights to be conveyed will be “in perpetuity” and are “directly related and requisite to [Alpha’s] interest, use, and enjoyment of the underlying land.”

Moreover, although this was not dispositive, these development rights are, for state law purposes, characterized as interests in real property. Accordingly, the intangible development rights to be transferred by Alpha were found to be of like kind to a fee interest in realty, a leasehold interest in real estate with 30 years or more remaining, and land use rights for hotel units. As a result, Alpha will not recognize any gain or loss on the exchange of these development rights for the package of conventional real estate interests and land use rights it is scheduled to receive in the deferred like kind exchange.

Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for

1 Rev. Rul. 55-749, 1955-2 C.B. 295.
2 Rev. Rul. 59-121, 1959-1 C.B. 212.
3 Rev. Rul. 72-549, 1972-2 C.B. 472.