IRS: Development Rights Like-Kind to Real Estate

IRS Issues Private Letter Ruling Approving Development Rights as Like-Kind Property to Real Estate

On February 1, 2008 the IRS issued PLR 200805012, which approved the acquisition of development rights in an exchange of real estate under Section 1031.  The following is a summary of the important facts in this Private Letter Ruling.

Taxpayer owns Property 1 and Property 2. Taxpayer intends to transfer Property 1 (“Relinquished Property”) to a QI pursuant to an exchange agreement. QI will sell the Relinquished Property to a third-party purchaser in an arm's-length transaction. QI will use part of the cash proceeds from this sale to purchase Development Rights (“Replacement Property”) from a third-party seller. QI will transfer Development Rights to Taxpayer. Taxpayer will cause Development Rights to be recorded with respect to Property 2, which is eligible for use of Development Rights. Development Rights will permit Taxpayer (or its lessee) to develop Property 2 with greater floor space than would otherwise have been allowed if Property 2 does not have Development Rights. When Development Rights are applied to Property 2, the floor area permitted to be constructed on that property will be increased by the increased floor area carried by Development Rights.

Under Ordinances, Development Rights are as-of-right and not discretionary, meaning that they exist permanently rather than at the discretion of a city agency or other decision-making authority.

Sections of State Z Tax Statute further define an “interest in real property” to include “title in fee, a leasehold interest, a beneficial interest, an encumbrance, development rights, air space and air rights, or any other interest with the right to use or occupancy of real property or the right to receive rents, profits, or other income derived from real property.”

Whether property constitutes real or personal property generally is determined under state or local law. See, e.g., Rev. Rul. 77-414, 1977-2 C.B. 299. The types of property rights and interests that constitute interests in real property and may be considered like kind to real property for purposes of § 1031 are broad. For instance, in Rev. Rul. 55-749, 1955-2 C.B. 295, land was exchanged for perpetual water rights, which are considered real property rights under the applicable state law. The ruling holds that the fee interest in the land and the water rights in perpetuity are sufficiently similar to constitute like kind property for § 1031(a) purposes. In addition, Rev. Rul. 72-549, 1972-2 C.B. 472, holds that an easement and right-of-way, both of which were permanent, are properties of like kind to both real property with nominal improvements and real property improved with an apartment building.

In this case, Taxpayer proposes to acquire Development Rights as its replacement property for purposes of § 1031(a) and to transfer such rights to Property 2, which Taxpayer already owns.

For proposes of determining if Taxpayer's proposed transaction qualifies as a like-kind exchange under § 1031(a), it is thus immaterial that Development Rights to be acquired by Taxpayer will be used merely to enhance the real property already owned by Taxpayer. More important is whether Development Rights constitute interests in real property under the state and local laws of State Z. It is clear that Sections of State Z Tax Statute and the regulations thereunder cited by Taxpayer do treat Development Rights as an interest in real property.

Moreover, the various sections of the local Ordinances provide that Development Rights are as-of-right and not discretionary, meaning that they exist permanently rather than at the discretion of a city agency or other decision-making authority. As such, these rights appear to be analogous to perpetual rights. Similarly, Taxpayer represents that a deed transfer is similar to the perfecting of Development Rights, which involves an actual transfer of rights from one property to another.

[W]e conclude that Development Rights that Taxpayer intends to acquire as replacement property will be considered like kind, for purposes of § 1031, to the fee interest in Relinquished Property.