News & Insights

by CGS3 Tax Chair & Partner, Phil Jelsma

In a new Private Letter Ruling, the Internal Revenue Service (IRS) recently held that a taxpayer’s acquisition of transferable development rights (TDRs), which acted as a form of density bonus, constituted tangible real property for purposes of Section 1031, which allows deferral of capital gains taxes on the sale of certain investment properties.

Development rights is defined as unused rights to develop a property to the extent permitted under state or local law, while real property includes land and its improvements, unsevered crops and other natural products of the land and water and air space super adjacent to the land.

What’s interesting about the ruling — Private Letter Ruling 202335002 — is that the taxpayer acquired the transferable development rights to use on its own property as opposed to replacement property as part of an exchange. Typically, transferable development rights are used by property owners who own development rights and with respect to their land can sell and transfer those rights, which can be used on another parcel of property.

In the ruling, the IRS concluded that the transferable development rights are real property for purposes of Section 1031. The transfer was completed when a Certificate of Transfer of Development rights was recorded. What was unusual about the ruling was that the taxpayer intended to use the rights on property it already owned. In reaching this conclusion, the IRS looked at Revenue Ruling 68-394, 1968-2 C.B. 338, which involved not a 1031 transaction but an involuntary conversion. In Revenue Ruling 68-394, the taxpayer held the fee interest in adjacent real estate and used the proceeds from the involuntary conversion to acquire a leasehold interest with 45 years remaining on adjacent land. The ruling concludes that the leasehold interest qualified as real estate even though the taxpayer already owned the fee interest in the adjacent land. In Private Letter Ruling 202335002, the IRS held that the analysis in Revenue Ruling 68-394 applied even though the taxpayer held the fee interest in the property where the development rights would be used. This can be contrasted with Bloomington Coca-Cola v. Commissioner, 189 F.2d 14 (7th Cir. 1951), where the court concluded a taxpayer could not use Section 1031 proceeds to construct a bottling plant on real estate already owned by the taxpayer. The court determined that 1031 proceeds could not be used to improve property already owned by the taxpayer.

The IRS seems to be drawing a difference between development rights and physical improvements. Nevertheless, with the current emphasis on affordable housing and density bonuses, this new Private Letter Ruling is potentially valuable to developers who already own property which would automatically be more valuable with density bonuses or other development rights. Acquiring those rights on a tax-deferred basis, rather than on an after-tax basis, presents an economical and efficient tax solution.

As government agencies press affordable housing alternatives, Section 1031 may play an increasingly important role as a planning alternative.

Phil Jelsma is a partner and chair of the tax practice team at Crosbie Gliner Schiffman Southard & Swanson LLP (CGS3).