Many real property owners lease out a portion

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1 March April 2012 Like-Kind Exchange Corner By Mary B. Foster Exchanging Out of an Income Stream: New Ruling May Be Useful for Code Sec Exchanges of Cell Phone Tower Leases Mary B. Foster is President of 1031 Services Inc. in Bellevue, Washington. Many real property owners lease out a portion of their land or building rooftops for the installation and operation of a cell phone tower. The rental income stream can be sold by the property owner for a lump-sum payment. Several different companies have investment funds that are used to purchase the cell phone tower leases. Some of the websites of these companies represent that a property owner can sell the income stream to the company and not only convert ordinary rental income into capital gain, but also defer the tax on that capital gain through a Code Sec exchange. This can be attractive to a landowner who may want to sell the income stream from a cell phone tower lease on his land and use the proceeds from the sale to acquire new land. Similarly, a building owner may want to sell the income stream from a rooftop lease for a cell phone tower and use the proceeds to exchange into other real property. This article examines whether a property owner can structure the sale of income from a cell phone tower lease as an exchange under Code Sec Note that the same analysis applies to similar special-use leases, such as those for sites for antennas, billboards or even wind or solar farms. Note also that this article will not specifically address capital gain treatment on the sale, but if a transaction would qualify under Code Sec. 1031, it would also be eligible for capital gain rates. The article first briefly examines the taxation of leasehold interests under Code Sec It then reviews a new private letter ruling in which an easement of property subject to a cell phone tower lease was held to be real property for REIT purposes. JOURNAL OF PASSTHROUGH ENTITIES 11

2 Like-Kind Exchange Corner 12 Lastly, the article examines if the structure used by the REIT in the new ruling can provide a blueprint for a property owner, such as the landowner or the building owner, to convert the rental income stream from such a lease into real property that is exchangeable under Code Sec Code Sec and Leaseholds Code Sec is favorable to tenants with respect to the disposition of their leasehold interests. A tenant may exchange into or out of a leasehold, 1 and the leasehold is like-kind to a fee interest if the lease has a term of 30 years or more remaining, including options to extend. 2 A landlord, by contrast, is not so favored under Code Sec A landlord cannot exchange out of the grant of a new lease, even if the term is 30 years or more. Any consideration received by the landlord for the lease is treated as rent. 3 Under the same reasoning, a landlord cannot exchange out of the income stream from a lease. The assignment of the rental income would be taxable as rent to the landlord under assignment of income principles. 4 As rent, it would not be eligible for exchange treatment (or capital gain rates). To take advantage of Code Sec. 1031, the landlord must convey an interest in the real property itself, and not just the rental income. Thus, if a landowner with a ground lease for a cell phone tower wants to convert the present value of his or her income stream into funds to buy more land, he or she must sell an interest in the land that includes his interest in the rental income. The same is true for the building owner who wants to sell the income stream from a rooftop lease. It must convey an interest in real property that includes the right to the rental income. It will not want to convey a full fee interest in the land or building, so a lesser interest must be used. Use of Easements in Private Letter Ruling A new private letter ruling may offer a method to both create an exchangeable asset and to allow a property owner, such as the landowner or the building owner, A new private letter ruling may offer a method to both create an exchangeable asset and to allow a property owner, such as the landowner or the building owner, to convey less than a fee interest CCH. All Rights Reserved. to convey less than a fee interest. The taxpayer in LTR (the LTR ) was a new corporation that intended to elect treatment as a REIT. The taxpayer wanted to acquire and own easements over both land and building rooftops, with such easements being subject to cell phone tower leases. The taxpayer therefore wanted to confirm that the easements would qualify as real estate assets and interests in real property for REIT purposes so that the taxpayer would meet the requirements for REIT treatment. 6 A typical easement was structured in the following manner. First, before the easement was created, the property owner, as landlord, entered into a lease agreement with a wireless communication provider, as tenant. The leased site included a certain amount of square footage of property, including the air space above and access to the nearest public road. The tenant was permitted to use the leased site for the transmission and reception of communications signals and the installation, maintenance and operation, repair and replacement of cell towers and related equipment. This was the only permitted use under the lease. It appears as though the tenant was the tax owner of the cell phone tower and related equipment, although the LTR does not explicitly state this. The property owner then sold an exclusive easement to the easement holder over the portion of the property that included the lease site and the cell phone tower. The purchase price was fixed with some contingent elements. The property owner also granted nonexclusive easements over areas that were necessary for: (a) ingress to and egress from the exclusive easement and a publicly dedicated roadway; (b) installation, repair, replacement, improvement, maintenance and removal of utilities providing service to the exclusive easement and the cell phone tower; and (c) if the leased site were located on building rooftops, access to building risers, conduits, shafts, raceways or other designated space to connect the tenant s equipment to other locations in the building. The easement was perpetual in duration as long as the easement remained in use. The easement would expire if it were abandoned for more than an unspecified period of years for reasons other than casualty, condemnation, or act of God. The LTR does

3 March April 2012 state that some of the easements to be obtained by the taxpayer were long-term but not perpetual in duration, but the LTR does not specify the duration of these easements. In addition to the grant of the easement, the property owner assigned its landlord s interest in the cell phone tower lease to the easement holder. Thus, the easement holder became the landlord under the cell phone tower lease and received the rental income. The easement holder also assumed responsibility under the cell phone tower lease for the obligations of the property owner, other than the obligations relating to the ownership, operation and use of the property. The easement holder had the unrestricted right to lease, license, transfer or assign its rights under the easement, in whole or in part. Upon the expiration of the cell phone tower lease, the easement holder could enter into a new lease with any third party. Further, the easement holder also could enter into a new lease of any unleased portion of the easement. For example, a tenant with a cell phone tower would often sublease a portion of the lease site. If the sublessee needed additional space in addition to that subleased from the tenant, the easement holder could lease the sublessee a portion of the easement outside of the lease site. REIT v. Code Sec Analysis The LTR held that the easement was an interest in real property and a real estate asset for REIT purposes. If an easement like the one in the LTR was also considered real property for Code Sec purposes, a property owner could convert the present value of the income stream from a cell phone tower lease into an exchangeable real property asset. Real property is generally like-kind to all other real property under Code Sec. 1031, so the property owner could defer the gain by reinvesting the proceeds into other real property. 7 Statute and Regulations The LTR relied in part on Code Sec. 856(c)(5)(C), which provides that the term interests in real property includes fee ownership and co-ownership of land or improvements thereon, leaseholds of land or improvements thereon, options to acquire land or improvements thereon, and options to acquire leaseholds of land or improvements thereon, but does not include mineral, oil, or gas royalty interests. The definition of real property under Code Sec. 1031, as derived from cases and rulings, is similar to that in Code Sec. 856(c)(5)(C). However, there are several differences. For example, mineral, oil or gas royalty interests can be real property for Code Sec purposes. 8 Also, while leaseholds are real property under the REIT rules, a leasehold of real property must have a term of 30 years or more remaining to be like-kind to a fee interest for Code Sec purposes. 9 Further, options are included in the statutory definition of real property for a REIT, but there are no definite rulings finding that options are real property in the Code Sec context. Nevertheless, none of these differences are relevant to an asset like the easement in the LTR, and thus these differences would not seem to affect the applicability of the LTR s analysis to Code Sec The LTR next cited Reg (d) for the definition of real property for REIT purposes, which states as follows: Real property includes land or improvements thereon, such as buildings or other inherently permanent structures thereon (including items which are structural components of such buildings or structures). In addition, the term real property includes interests in real property. Local law definitions will not be controlling for purposes of determining the meaning of real property for purposes of section 856 and the regulations thereunder. Under the regulations, real property includes, for example, the wiring in a building, plumbing systems, central heating or central air-conditioning machinery, pipes or ducts, elevators or escalators installed in a building, or other items which are structural components of a building or other permanent structure. The term does not include assets accessory to the operation of a business, such as machinery, printing press, transportation equipment which is not a structural component of the building, office equipment, refrigerators, individual air-conditioning units, grocery counters, furnishings of a motel, hotel, or office building, etc. even though such items may be termed fixtures under local law. This definition of real property is also similar to the definition under Code Sec The one difference is that Code Sec applies to property held in a trade or business or for investment, and thus there is no exclusion for assets accessory to the operation JOURNAL OF PASSTHROUGH ENTITIES 13

4 Like-Kind Exchange Corner 14 of a business. Nevertheless, this difference between the two definitions does not impact the application of the LTR s analysis to Code Sec because the easement is held for rental purposes and not in an active business. Revenue Rulings The LTR then examined revenue rulings involving other less than fee real estate assets. It cited Rev. Rul , 10 which found that air rights over real property are interests in real property for REIT purposes. Air rights were defined in Rev. Rul as the long-term leasehold or fee simple ownership of the space above the ground that a landowner can occupy or use in connection with the land, plus necessary easements on the surface for support of structures erected in such air space. Air rights should also be real property under Code Sec if the air rights are perpetual. There is no specific ruling on air rights under Code Sec. 1031, but there is a ruling that found that perpetual water rights were real property. 11 Also, air rights have been found to be an interest in land under the predecessor to Code Sec. 1033, 12 and the definitions of real property for Code Sec and 1033 are generally the same. The LTR next cited Rev. Rul , 13 which found that various components of a microwave transmission system are real estate assets for REIT purposes. It is not clear why this ruling is cited because the REIT was acquiring an easement in the land and buildings owned by the property owner. The actual cell phone towers were apparently owned by the wireless communication provider, as tenant. The IRS did find that cell phone towers were interests in real property in another private letter ruling when the taxpayer actually owned the cell phone towers and related equipment. 14 Finally, the LTR discussed Rev. Rul , 15 which provided that the consideration received by an individual for the granting of an easement in his farmland constituted the proceeds from the sale of an interest in real property. The LTR also cited Rev. Rul with no discussion. Rev. Rul found that an easement was real property for Code Sec purposes. In Rev. Rul. Property owners who are landlords with cell phone tower leases are being actively marketed by businesses looking to purchase the income streams from theses leases CCH. All Rights Reserved , not cited in the LTR, an easement was held to be like-kind to a fee interest under Code Sec. 1033(g). 17 Rev. Rul has been cited as authority in several private letter rulings that found that perpetual conservation easements were real property for Code Sec purposes and could be exchanged for a fee interest. 18 There are no rulings under Code Sec.1031 involving less than perpetual easements. As noted above, the definition of an interest in real property for REIT purposes is similar to, but not identical, to the definition for Code Sec The differences in the definitions do not appear relevant to the easements described in the LTR. Furthermore, the revenue rulings relied upon by the IRS in the LTR all should apply to Code Sec Therefore, a strong argument can be made that a perpetual easement like the one in the LTR should be real property for Code Sec purposes. Possible Counter Arguments The IRS might be troubled by the fact that the property owner has converted ordinary rental income into a real property right that can be exchanged. Therefore, the IRS might put forth a few counter arguments that should be considered before structuring such an easement. The Easement Is a Carved-Out Interest Like-kind refers to the nature or character of the property and not to its grade or quality. 19 Differences between interests in real property under Code Sec have generally been found to be differences in grade or quality and not nature of character. However, property that is otherwise characterized as real property for state law purposes may still be personal property for Code Sec purposes (and therefore not like-kind to real property) if it is a carved-out interest. Courts have found carvedout interests in exchanges that involved standing timber, water rights and mineral rights. All of the interests involved were of limited duration or quantity, rather than perpetual or to exhaustion or as long as production lasted. 20

5 March April 2012 The real property interest in the LTR was an easement that was stated to be perpetual. However, the easement would expire if the use were abandoned for more than an unspecified number of years for reasons other than casualty, condemnation or an act of God. Therefore, IRS might argue that an easement like the one in the LTR is of limited duration and differs in nature and character from a fee interest for Code Sec purposes. As discussed earlier in this article, the IRS has issued revenue rulings and private letter rulings that found that the easements in question in the rulings were interests in the land for Code Sec purposes. These other rulings did not state if the easements involved would be considered abandoned after a certain period of nonuse, so they cannot be compared to the LTR on this issue. The property owner might consider granting an easement without expiration provisions to avoid an IRS argument that the easement is of limited duration and therefore not like-kind to real property. However, if these provisions are not included in the grant of an easement, then the easement generally may not be terminated simply for nonuse. The property owner must also show the easement holder had the intent to abandon the easement, and this may be difficult to prove. 21 The property owner should consider this carefully and examine the relevant state law on terminating easements. When property interests have been found to be carved-out interests of limited duration, they have been property interests that only lasted a specific number of years. While the easement in the LTR did have expiration provisions, it was perpetual if the easement holder continued to use it. It would not expire at the time of the expiration of the existing cell phone tower lease if the easement holder renewed the existing lease or entered into a new lease. At some point in the future, it seems likely that the need for a cell phone tower on a site might end due to lack of market demand, changes in technology, mergers or other factors that affect the demand for cell phone tower sites. At that point, the easement holder would likely abandon the easement through nonuse. The easement holder in the LTR also obtained other unrestricted rights over the easement in addition to the right to act as the landlord under the cell phone tower lease. The easement holder could generate additional revenue by leasing a portion of the easement to the extent that portion was not already subject to a lease. 22 The easement holder could also sell the easement because it had the unrestricted right to lease, license, transfer or assign its rights under the easement, in whole or in part. Perhaps these characteristics are enough to overcome any argument that the easement is more in the nature of a carved-out interest for Code Sec purposes. They do seem to provide the easement holder with rights beyond the holder of a mere assignment of rental income. A property owner contemplating granting an easement in lieu of an assignment of the rental income from the lease will have to weigh the tax benefits of the easement against the requirement of giving up additional rights to the property, including rental income from future leases. Rental Stream in Separate Asset from the Easement The IRS might assert that the cell phone tower lease is a separate asset from the easement and that the taxpayer is selling an income stream for tax purposes, and not an asset that is like-kind to real property under Code Sec For this argument to succeed, the lease and the rent payments would have to be considered separate from the bundle of rights represented by the real property ownership. The IRS lost a similar argument in Peabody Natural Resources Co. 23 In that case, the taxpayer exchanged a coal mine, including the supply contracts, for a gold mine. The IRS argued that the coal supply contracts were an intangible asset separate from the real estate assets. The Tax Court held for the taxpayer and found that the coal supply contracts were part of the bundle of rights incident to the ownership of the coal mine and not separable from the ownership of the land and the coal reserves. The Tax Court in Peabody Natural Resources, Co. relied on the earlier decision in C.E. Koch. 24 The taxpayer in Koch acquired replacement property in an exchange consisting of a fee interest subject to 99-year condominium leases. The IRS argued that the taxpayer was receiving a reversionary interest in land with a nominal value and an income stream represented by the rent under the condominium leases. The Tax Court refused to separate the rental income stream from the bundle of rights incident to, and inherent in, the ownership of the fee. Based on the holdings in these two cases, it would seem that a cell phone tower lease and the rental income derived from it would be considered part of the bundle of rights incident to an easement. The IRS would have to argue that the holdings in the two JOURNAL OF PASSTHROUGH ENTITIES 15

6 Like-Kind Exchange Corner cases only apply to a fee interest and not an easement. But if the easement were found to be real property for Code Sec purposes and not a carved-out interest, a court could well apply the holding in Koch and Peabody Natural Recourses, Co. to find that the lease income is part of the easement. Conclusion Property owners who are landlords with cell phone tower leases are being actively marketed by businesses looking to purchase the income streams from theses leases. These property owners may desire to realize the present value of the rental income stream and use the proceeds to acquire other real property assets. The LTR offers a possible structure to convert the leasehold and rental stream into an exchangeable real property asset under Code Sec However, the property owner must convey a perpetual interest in the real property along with the rental income stream, thereby giving up substantial property rights. In addition, no rulings analogous to the LTR have been issued under Code Sec While the authorities cited in the LTR also seem to apply to Code Sec. 1031, some counter arguments do exist and the property owner should consider this when granting such an easement. 1 LTR (Oct. 17, 2008); Rev. Rul , CB Reg (a)-1(c)(2). 3 R.W. Crooks, 92 TC 816, Dec. 45,614; A.J. Pembroke, 23 BTA 1176, Dec Aff d, CA-DC, 4 USTC 1274, 70 F2d 850. Rev. Rul ; CB Reg (a); P.R.G Horst, SCt, 40-2 USTC 9787, 311 US 112, 61 SCt 144; P.G. Lake, Inc., SCt, 58-1 USTC 9428, 356 US 260, 78 SCt LTR (Dec. 9, 2011). 6 Code Sec. 856 requires that a certain percentage of a REIT s gross income must be derived from, among other sources, rents from real property, which include rents from interests in real property. It also requires that a certain percentage of the value of a REIT s total assets be represented by real estate assets, among other assets. 7 K.J. Crichton, CA-5, 41-2 USTC 9638, 122 ENDNOTES F2d 181, aff g. BTA, 42 BTA 490, Dec. 11, Rev. Rul , CB Reg (a)-1(c)(2). 10 Rev. Rul , CB Rev. Rul , CB Rev. Rul , CB 145, as modified by Rev. Rul , CB Rev. Rul , CB LTR (July 22, 2011). 15 Rev. Rul , CB 351, clarifying Rev. Rul , CB Rev. Rul , CB 145; see also LTR (Nov. 12, 2010). 17 Rev. Rul , CB LTR (Dec. 8, 2006), LTR (Jan. 4, 2002) and LTR (Jan. 18, 2002). 19 Reg (a)-1(b). 20 Oregon Lumber Co., 20 TC 192, Dec. 19,614 (1953); D.G. Smalley, 116 TC 450, Dec. 54,367 (2001); D. Wiechens, DC-AZ, USTC 50,708, 228 FSupp2d 1080; W. Fleming, 24 TC 818, , Dec. 21,166 (1955), aff d sub nom., P.G. Lake, Inc., SCt, 58-1 USTC 9428, 356 US 260, 78 SCt 691, rev g W. Fleming, CA-5, 57-1 USTC 9363, 241 F2d Gerbig v. Zumpano, 7 NY 2d 327 (1960). 22 Some of the websites offering to purchase leases or easements provide that the property owner will share in a portion of the revenue from the additional leases. This may create a tax partnership between the property owner and the easement holder, or perhaps it is akin to a retained royalty interest that results in the sale proceeds (and any replacement property) being treated as rent to the property owner. See R.W. Crooks, 92 TC 816, Dec. 45, Peabody Natural Resources Company, 126 TC 261, Dec. 56,508 (2006). 24 C.E. Koch, 71 TC 54, Dec. 35,480 (1978) CCH. All Rights Reserved.