You think of yourself as a shrewd real estate investor.  You own two (2) four-unit apartment buildings in Oakland which perform well and a well-positioned strip mall in Modesto with six (6) small retail premises.  You also own a valuable albatross – a one-acre parcel with a 45,000 RSF building in downtown Fremont which you purchased in 1985 and leased to K-Mart under a 30-year lease before K-Mart’s demise.  You have not been able to successfully re-lease your Fremont Property.  You paid $1,700,000 for the Property in 1985 and have depreciated the Property.  It now has a tax basis of $500,000 and an appraised value of $6,500,000, even though vacant, primarily because of its excellent location.

A sale of the Property would produce an approximate $6,000,000 capital gain for you and your wife, which you wish to avoid.  Your real estate broker has been searching 18 months for a suitable “Like-Kind Replacement Property” which you can acquire in exchange for your Fremont Property and defer taxable gain on the “sale and “transfer” of your Fremont Property under Section 1031 of the Internal Revenue Code (a “1031 Exchange”).  Your problem:  it seems impossible to locate a suitable Like-Kind Replacement Property anywhere in California for your 1031 Exchange.  Every potential Replacement Property is expensive, very much over-valued with a very low investment return to you and your wife.  And you do not want to exchange into new investment property in Indiana, 2,100 miles from home.

This author would like you to consider an alternative to a 1031 Exchange for your Fremont Property.  The alternative is a Ground Lease with a term not to exceed 34 years where you continue to own the underlying fee title to your Property but relinquish control over the redevelopment, operation, leasing and management of the Property for the term of the Ground Lease to the Ground Lessee in return for a steady, hopefully ample, monthly ground lease rent and the reversion of all improvements constructed by the Ground Lessee to you and your family upon the expiration of the Ground Lease Term.  After 34 years, you still own a piece of valuable property in the Bay Area.  Let’s take a quick overview of the advantages and disadvantages of a 1031 Exchange compared with the advantages and disadvantages of a Ground Lease.

A 1031 Exchange involves the trading/exchanging by the same Taxpayer of Relinquished Real Property held by the Taxpayer for business or investment purposes into a new piece of Replacement Real Property of equal or greater value where the Replacement Property is identified and designated by the Taxpayer within 45 days of the date of sale/transfer of the Relinquished Property and the Taxpayer acquires title to the Replacement Property within 180 days of the date of sale/transfer of the Relinquished Property.

The primary advantage of a 1031 Exchange is Tax Deferral.  The Property Owner can rollover or defer gain from her Relinquished Real Property into her newly acquired Like-Kind Replacement Property.  Ideally, you can trade greatly-appreciated Real Property into Like-Kind Real Property with a greater potential for appreciation and present income.  “Like-Kind” means real property held by the same taxpayer for business or investment purposes.  For example, you can trade a restaurant into apartments, an office into a warehouse, or a motel into vacant land which you intend to develop.  Transfers within all 50 U.S. States are permitted.  Foreign real property and your personal residence do not qualify as Like-Kind.  Generally, your depreciated tax basis in your Relinquished Real Property transfers to the Replacement Property – your purchase price does not establish your tax basis.

A major disadvantage to a 1031 Exchange is the increasing inability to find a suitable investment property with promising investment returns.  Some more disadvantages:  (1) if you exchange into out-of-state Replacement Property you can encounter severe management and operational issues; (2) the IRS imposes strict time requirements on 1031 Exchanges – the Property Owner must identify Replacement Properties (generally up to three) in writing within 45 days of the Relinquished Property transfer date and she must close on the Replacement Property within 180 days of the Relinquished Property transfer date; (3) the taxpayer cannot receive the funds herself in escrow in her name.  Instead, she must proceed through a neutral, unrelated third party Exchange Accommodator; and (4) our taxpayer will have to pay taxes on any non-like-kind property (e.g., “cash” or “Boot”) received in the 1031 Exchange.

A viable alternative to a 1031 Exchange is the property owner groundleasing the Property to a Ground Lessee under a 34-Year Ground Lease.  A word of caution – a Ground Lease with a term of 35 years or more constitutes a “Prop 13” Change in Ownership which may result in a large increase in real property taxes which in turn can cause a marked decrease in the Ground Lease Rent, which the Ground Lessee is able to pay to our Property Owner.  Options to extend the Term of the Ground Lease are counted in determining the length of the Term.  An obvious risk in a Ground Lease situation is locating a sophisticated, experienced and reputable developer/ground lessee to redevelop, operate, manage and lease the Property.  The true “worth” of a Ground Lease Transaction depends on (1) the Ground Lessee’s ability to redevelop a first-class office, retail and/or residential project which will revert to the Property Owner upon the expiration the Term of the Ground Lease and (2) the Ground Lessee’s ability to attract and lease to reputable first-class tenants who will timely pay their rent and ensure a stable and profitable Ground Lease rental stream to the Property Owner.  We at Carr McClellan are fortunate to have worked with reputable and experienced developer/ground lessees who we can recommend to our clients wishing to consider a Ground Lease.

The three (3) primary advantages to the Ground Lease alternative are (1) you and your family continue to own fee simple title to prime Bay Area real estate and all improvements on the real estate revert to you upon the Ground Lease expiration at the end of 34 years; (2) you are relieved of all ownership responsibilities of developing, operating, maintaining, repairing and leasing the Property (these all pass to the Ground Lessee); and (3) you have a built-in income stream of Ground Lease Rent over the term of the Ground Lease.  Depending on the nature of the Ground Lease, you can negotiate a Fixed Annual Ground Rent, subject to set incremental rent increases (e.g., 15% every five years) or tie your Ground Rent to a percentage of the rentals received by your Ground Lessee on its underlying space lease rents.  The latter alternative of percentage rent can be particularly attractive to you as the Ground Lessor where the real property has substantial upside development potential.

A primary disadvantage to the Ground Lessor-Owner under the Ground Lease (which to some investors may in fact be viewed as a benefit) is loss of control over your Property.  The Ground Lessee will generally require substantial control over (1) entitlements, development, construction and alterations to the Property, (2) the leasing plan and rental goals for the completed redeveloped Property and (3) all management and operation of the Property during the Term.  The Ground Lessee will also require the ability to mortgage its leasehold interest in the Property to obtain a construction loan for development and construction of its improvements to the Property.

Another disadvantage is the potential default of the Ground Lessee under the Ground Lease itself and your property potentially lying fallow for years while the litigation progresses.  Care must be taken in selecting an experienced, reputable, and solvent Ground Lessee.  A further risk is the potential default by the Ground Lessee as borrower under its Leasehold Mortgage.  In this event, the Leasehold Mortgagee/Lender could foreclose out your Ground Lessee and put a Ground Lessee of its choosing into your Property as the new Ground Lessee.  Careful drafting can protect you as the Ground Lessor in this scenario.  And you must always ensure that the Leasehold Mortgage is subject and subordinate to your fee interest in the Property so that foreclosure of the Leasehold Mortgage does not impair your fee interest.  Of course, your Ground Lease may be far more complex than outlined above.  For example, the Ground Lessee may insist upon an option to purchase your fee interest in the Property in a right of first refusal should you elect to sell the Property subject to the Ground Lease.

Carr McClellan’s experience and involvement with Ground Leases dates back more than fifty (50) years to the initial build-out of Foster City.  Most of the homes built in Foster City were initially on long-term ground leases from affiliates of the Foster Family, a long-term client of our law firm.

If you would like to learn more about the Ground Lease Alternative to 1031 Tax Deferred Exchanges, please register for our webinar, scheduled for Thursday, April 23, 2020 at 12:00 – 1:00 pm. To register and for more information, please click here.