Avoiding 1031 deferred taxes with a land-lease condo?

Question

If I 1031 exchanged into a condo on a land-leased property, once the property reverts to the land owner would I have to pay any deferred taxes on the relinquished property sale? Since there would be no sale of the replacement property and no appreciation, i'm curious if I'd still have to pay those deferred taxes from the sale of the relinquished property. Is this another option, besides death, to avoid those taxes?

Cash flow on the replacement property would be great. I would have to weigh the benefits of great cash flow over the years versus zero appreciation (in fact, 100% depreciation!). But, the condo is in a great location, rental inflation could increase cash flow over years, the condo is much cheaper than other nearby condos because of the land-lease. Given that in 5 years nobody could secure a 30 year mortgage on the place I'll also be out of exit strategies. I'm not sure I'd be comfortable doing it, but I'm just trying to think through different options with my 1031 exchange.

Thanks in advance for any insights!

Bill Exeter · Answer

Hi @Mike Warder,

Yes, it is possible to 1031 Exchange into a land-lease/ground lease investment as long as the ground lease has at least a total of 30 years remaining (remaining term plus any options to extend). You can always negotiate extensions and/or options that would push the remaining term 230 years or more. Ground leases that have a remaining term, including options, of less than 30 years will not qualify for 1031 Exchange treatment.

Dave Foster · Answer

@Mike Warder, One simple answer is to negotiate with the land owner a new series of lease extensions.  The IRS has been fairly consistent in holding that a run time left of at least 30 years on a land lease constitutes the same bundle of rights as a fee simple interest in real estate.

There is also a fairly recent court decision (it took a few years to resolve but I think it was 2013 VIP v. Commissioner) where a lease left of 21 years and a couple months did not qualify as real estate equivalent.  And the IRS won.  So once again, your first step (after getting your war council of atty, acct, and QI together) is to negotiate a lease extension.

Second though you are buying a lease and improvements.  I do believe that you are able to set up a basis and depreciate those improvements.  And if your acct is on board you can probably assign most of the value of that lease to the improvements if it is of a shorter duration.

Third I spose I'd ask the "what if" question.  What if I just decided the price was right and I purchased and hung on to it for the remaining term?  If the cash flow is that good it may be worth it.  And you never know when the land owner changes their mind - 35 years is a long long time.  And if it's cash positive you may not care.