By: Daniel Pessar
Commercial real estate landlords and tenants can create tax value for investors and tenants through creative lease structures.
I. Section 1031 Exchanges are Not Easy to Accomplish
One of the tax benefits unique to real estate investors is § 1031 of the Internal Revenue Code (IRC), which allows real estate investors to defer capital gains taxes when they (1) complete the sale of their investment property and (2) purchase other property, all while (3) following certain rules, mostly found in regulations.[1] Section 1031 is a powerful tool for tax savings and wealth preservation because it allows a complete deferral of gains for decades and the exchange of investment property of one type into investment property of a very different nature. For example, a tax-deferred exchange can be accomplished by an investor using the proceeds from the sale of an apartment building in Texas to purchase undeveloped land in California.
But these tax-advantaged exchanges are not easy to accomplish. The main reason more investors do not benefit from this tax provision is because the investor needs to identify the investment property to be purchased (the “replacement property”) within forty-five days of the sale of the property being sold (the “relinquished property”).[2] Very often, investors sell because they have a pressing personal reason or receive an attractive unsolicited offer; in both cases, they rarely know which specific property they want to purchase with the proceeds of the sale. Even if investors know which property they would want to purchase, perhaps that seller would not want to sell, or perhaps there could be delays in the sale process that would not allow the buyer to complete the acquisition within the required 180 days from the sale of the relinquished property.[3]
Often, the time limits within § 1031 create stress for investors who must race to find new investment properties and pay more than they would otherwise in order to enjoy the tax benefits. After all the time and money spent identifying new properties and negotiating purchase agreements, the acquisitions might not happen within the required window, if at all. These situations are more common when there is less inventory in the market and prices are high. In those cases, investors may be stuck paying the capital gains tax that arises from the investment property sale.
II. Lease with Purchase Option Structures: A Strategic Solution
One tool I have used for both landlord and tenant clients is structuring a lease that gives the tenant the option to buy the property. Using certain mechanisms, the parties can create flexibility, so they can each make the sale of the property tax-advantaged. Three proposed solutions are below:
(1) Delayed Closing: Give one or both parties the ability to delay the closing in order to identify a replacement property.
For example, the seller may want to delay the closing by a period of weeks or months if necessary to identify the investment property that it will use as replacement property in the exchange. A buyer might also receive rights to trigger the option-to-buy but delay the closing if necessary to sell the investment property it owns to use those proceeds to buy the subject property.
(2) Speedy Closing: Require a speedy closing schedule or face penalties.
Closing within a certain time frame might be essential to satisfy the § 1031 requirements. As a result, the parties could demand that the other side incur a financial penalty if the closing is not accomplished on time. These provisions incentivize the parties to move swiftly towards closing.
(3) Due Diligence: Anticipate due diligence at lease negotiation and in advance of purchase-rights.
Purchase options are sometimes only available a few months or years after a lease commencement, but the buyer-tenant might not fully understand the property it is purchasing. For example, are there any environmental or zoning complications? The tenant should be advised to review certain due diligence items in advance of signing the lease itself, or structure due diligence review rights in the months or years preceding the purchase-right.
III. A Simple Example
Levi owns a commercial building and is open to selling in the coming years. He expects the value to be in the $2–3 million range at the time of sale, and his accountant advises that Levi could face $600,000 in capital gains taxes. He starts looking at potential replacement properties but doubts he will be able to coordinate a successful sale at acceptable terms and pricing, and purchase an appropriate replacement, within the timelines set for a successful § 1031 exchange.
He negotiates a lease with a purchase option for most of the space in the property, but includes two options to delay closing, each giving him an additional 100 days to close. As a result, if the tenant exercises the purchase option, he will be able to find and negotiate the purchase of replacement property for the period of time until closing, plus the 200-day extension period, plus the 45-day post-closing allowed by the regulations.
These lease terms can help tenants as well. For example, a tenant who owns an investment property and decides to exercise the purchase option in the lease may want to extend the closing date, if needed, to facilitate a § 1031 exchange by allowing time for the successful sale of the relinquished property.
IV. Bringing § 1031 Within Reach
Since 2017, the only type of property that can benefit from IRC § 1031 is real estate.[4] Although the rich benefits available to real estate investors are not easy to obtain, creative contracting can make the benefits more accessible. Because parties to a lease with option to buy are in a good position to plan for a potential purchase months or years in advance, they can structure a transaction that gives one or both parties an easier pathway to a successful exchange. If the lease terms, for example, effectively turn a seller’s 45-day identification period into a much longer period, it can bring the significant benefits of IRC § 1031 within reach.
[1] See Treas. Reg. § 1.1031(a)-1 (1991); 2024 Instructions for Form 8824, IRS, CAT. NO. 12597K (Oct. 18, 2024), https://www.irs.gov/pub/irs-pdf/i8824.pdf.
[2] IRS, Fact Sheet: Like-Kind Exchanges Under IRC Section 1031 (2008), https://www.irs.gov/pub/irs-news/fs-08-18.pdf.
[3] Id.
[4] See Tax Cuts and Jobs Act, Pub. L. No. 115-97, § 13303, 131 Stat. 2054, 2123 (2017).
