Can You Use a 1031 Exchange With a Sale-Leaseback?

This guide summarizes IRS guidance, Treasury regulations and law firm commentary. Like-kind exchanges are technical and deadline-driven, so treat it as background for a conversation with your tax advisor, not as advice.

According to the IRS, Section 1031 now applies only to exchanges of real property. The property given up and the property received must both be held for use in a business or for investment, and must be of like kind, meaning of the same nature or character even if they differ in grade or quality. Real property held primarily for sale does not qualify, and US real property is not like-kind to real property outside the United States.

Two more IRS points matter for everything that follows. If you receive money or other property in the exchange, you must recognize gain to the extent of the money and other property received. And you cannot recognize a loss in a like-kind exchange. Exchanges are reported on Form 8824.

Many purchasers of leased buildings are completing exchanges of their own. They have sold a property and need to buy a replacement, and a building with a long-term tenant in place suits that purpose. A law firm article on the subject notes that either party to a sale-leaseback may use a 1031 exchange, and that the seller is not directly involved in the purchaser's exchange process.

What the seller does feel is the buyer's calendar. An exchanging buyer must identify replacement property in writing within 45 days after its own sale and complete the purchase within 180 days. Those deadlines can make an exchange buyer highly motivated to close, which is useful, and unable to grant extensions if your side runs late, which is a risk to plan for. If the buyer misses its deadlines, the consequence is the loss of its own tax deferral, not a penalty that falls on you. The purchase agreement will usually ask you to cooperate with the buyer's exchange. That is normally reasonable provided it adds no cost, liability or delay for you.

A seller can treat the sale half of a sale-leaseback as the first leg of an exchange. The mechanics are the standard ones. Because the property sold and the property bought involve different counterparties, the exchange is run through a qualified intermediary. The sale proceeds are held by the intermediary, and the seller cannot have access to them. The 45-day identification period and the 180-day completion period run from the sale.

The difficulty is obvious once it is laid out. Most owners do a sale-leaseback to put cash into the business or to pay down debt. An exchange requires the opposite: the proceeds must go into other qualifying real property, and under the IRS rule any money you take out is taxable to the extent of your gain. An exchange and a cash raise pull in different directions.

There are situations where a seller-side exchange fits the goal:

• The company is using the proceeds to buy another facility, for example a second plant or a larger building in a new market, and wants to stay in the current one under a lease.
• The real estate is held by the owners in a separate entity, and they would rather trade one concentrated building for different investment real estate than cash out.
• The sale is one step in a planned repositioning of a real estate portfolio.

A partial exchange is also possible in concept, with some proceeds reinvested and some taken as taxable cash. Whether that produces a worthwhile result depends on your basis, your gain and the cost of the replacement property, and it has to be modeled by your CPA before the sale closes. An exchange cannot be arranged after you have received the money.

This is the part of the subject that is specific to sale-leasebacks. Treasury Regulation 1.1031(a)-1(c) lists, as an example of a like-kind exchange, a taxpayer who is not a dealer in real estate exchanging a leasehold of a fee with 30 years or more to run for real estate. In other words, a long enough lease is treated as the same kind of property as ownership.

In a sale-leaseback the seller gives up ownership and receives cash plus a lease. If that lease runs 30 years or more, the question arises whether the seller has really made a like-kind exchange of the building for a leasehold, with the cash as additional consideration. A law firm summary of the cases explains what follows from that:

• The key element is the length of the leasehold including renewals. On that reading, a base term under 30 years can still cross the line once renewal options are added.
• In Century Electric, a federal appeals court held that a sale with a leaseback of 95 years including renewals was a like-kind exchange with additional consideration, so the seller's loss could not be recognized.
• In Jordan Marsh, a different appeals court reached the opposite result for a leaseback of just over 30 years where the cash received equaled the property's fair market value, holding that the transaction was a sale. The same summary reports that the IRS said it would not follow that decision.

The practical exposure is mainly on the loss side. An owner selling for less than adjusted basis who expects to deduct the loss could find it disallowed if the leaseback is long enough to be like-kind property. For an owner selling at a gain, the general IRS rule is that gain is recognized to the extent of money received, so treating the deal as an exchange would not by that rule shelter the cash. The law in this area comes from older cases that do not all agree, which is a reason for a tax advisor to look at the lease term and options before the letter of intent is signed.

Lease term and renewal options are usually negotiated for business reasons: price, flexibility and how long you need the site. If a loss deduction is part of your plan, add the 30-year question to that negotiation before the term is fixed.

• ✓Do we expect a gain or a loss on the sale, measured against adjusted basis?
• ✓Counting every renewal option, does the leaseback run 30 years or more?
• ✓If we expect a loss, does the lease term put the deduction at risk, and should the term or options be restructured?
• ✓Is any part of the proceeds going into other real property, and if so, should that purchase be set up as an exchange with a qualified intermediary before closing?
• ✓Which entity owns the building, and is it the same taxpayer that would acquire the replacement property?
• ✓If the buyer is in an exchange, what cooperation language is acceptable, and what happens to our schedule if the buyer cannot extend?
• ✓How does our state treat the gain and the exchange?

Our part in this is the real estate side: finding buyers, including exchange buyers working against a deadline, and negotiating lease term and renewals with your tax advisor's guidance in hand so that the business terms and the tax plan do not work against each other.