The IRS, in PLR 201408019 (Feb. 21, 2014), has ruled that a Taxpayer may engage in a like-kind exchange where the replacement property constitutes a long-term sub-leasehold in real estate that a related person of the Taxpayer already owns.

In this ruling, the Taxpayer disposed of real property that it had owned for investment or use in its trade or business (the “Relinquished Property”) to an unrelated buyer.  The Taxpayer caused the proceeds from the disposition of the Relinquished Property to be held by a qualified intermediary under a standard “deferred” like-kind exchange arrangement.  Nothing unusual to this point.

However, in this case, the Taxpayer desired to acquire replacement property which would be comprised of a more-than-30-year sub-leasehold interest in real estate together with to-be-constructed improvements to the real property (the “Replacement Property”).  It was noted that the 30+ year sub-leasehold was of a duration that would be longer than the useful life of the newly constructed improvements.  The fee simple interest in the real estate to which the Replacement Property relates was owned by an affiliate of the Taxpayer.  Moreover, the real estate was already subject to a long-term lease in favor of another affiliate of the Taxpayer.

In connection with the like-kind exchange, the Taxpayer proposed that the existing structure situated on the real estate to which the Replacement Property relates would be demolished, the Taxpayer would enter into a more-than-30 year sublease and would, within the 180-day exchange period, construct a new building on the property.  To the extent that proceeds from the disposition of the Relinquished Property were not used in the improvements completed as of the 180-day exchange period, such excess would constitute taxable gain to the Taxpayer.

The IRS ruled that this transaction would constitute a like-kind exchange, even though the Taxpayer was effectively acquiring Replacement Property which was situated on real estate owned by a related party.  The IRS determined that the related party exchange limitations of Section 1031(f) would not apply, so long as neither the related party who owned the fee simple real estate or the related party who subleased the property to the Taxpayer does not dispose of their interests in the property for at least two (2) years following the exchange.

This ruling is interesting because the law has long been that a taxpayer may not acquire as eligible replacement property in a like-kind exchange improvements on property the taxpayer already owns.  See, e.g.Bloomington Coca-Cola Bottling Co. v. Commissioner, 189 F.2d 14 (7th Cir. 1951); see also Rev. Proc. 2004-51 (concluding that the Bloomington Coca-Cola principle will apply to an improvement exchange if the fee simple to the real estate on which the replacement property will be constructed had been owned by the taxpayer within 12 months of the exchange transaction).  However, under PLR 201408019, it appears that this limitation can be avoided if the replacement property is constructed on property owned, not by the taxpayer, but by a person who is a related party to the taxpayer.

Like-kind exchanges involving the construction of improvements during the 180-day exchange period are very complex and require the assistance of experienced advisors in order to structure and complete properly.  This ruling offers a potential way of structuring a “build-to-suit” exchange transaction involving property owned by affiliates of a taxpayer.