IRS Rules That Development Rights are Real Property for Like-Kind Exchange Purposes

February 6, 2008 | Roger McEowen


Section 1031(a)(1) of the Internal Revenue Code provides for a tax-free exchange of “like-kind” property.  Specifically, no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment if the property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.  To qualify for like-kind exchange treatment, the exchanged properties must be of the same kind or class.

Generally, real property must be exchanged for other real property – the rules are very broad with respect to real estate trades (i.e., real estate is of the same kind or class as other real estate.  But, do development rights in real property qualify as like-kind to real estate?  In a recent IRS Private Letter Ruling, IRS said they do.

Under the facts of the ruling, the taxpayer wanted to exchange real property for development rights in real property that the taxpayer was going to apply to property that the taxpayer already owned, and qualify the transaction as a tax-free exchange.  More specifically, a C corporation owned a fee interest in two properties located in the same city.  The corporation proposed to transfer its fee interest in one of the properties to a qualified intermediary who would then sell the property to a third party.  The intermediary would use the sale proceeds to buy development rights in the same tract, and then would transfer those development rights to the corporation which would, in turn, transfer them to the corporation’s other property.  The idea of the transaction was to allow the corporation to develop the other property with greater floor space than would otherwise be allowed.  The IRS determined that the development rights were the equivalent of real property and tax-free exchange treatment was allowed for the transaction.

  Here’s why the IRS ruled as it did:

  1. The development rights would be applied to other property that the taxpayer owned;
  2. The development rights were treated as real property for some purposes under state and local law, even though they were not treated as real property for all such purposes;
  3. The rights were "as-of-right" and not discretionary.  Thus, they existed permanently (a very important fact);
  4. The transfer of development rights was subject to local transfer taxes like a deed transfer; and
  5. The development rights were perpetual and not temporary (this finding brings the ruling within the safe harbor for water rights (Rev. Rul. 55-749, 1955-2 C.B. 295).  In that ruling, IRS held that tax-free exchange treatment applied to the exchange of raw land for perpetual water rights which were, under local law, considered real property rights. 

Also, the IRS referenced a 1968 revenue ruling (Rev. Rul. 68-394, 1968-2 C.B. 338) to support its rationale that it was "immaterial" that the development rights would be used merely to enhance the real property that the company already owned.  IRS also said it was immaterial that the property acquired as the replacement property happened to be on property already owned by the corporation.  Priv. Ltr. Rul. 200805012 (Oct. 30, 2007).