Rev. Rul. 78-72

Advice has been requested whether a leasehold interest qualifies, under section 1033(f) of the Internal Revenue Code of 1954, as property that is similar or related in service or use to property converted under the circumstances described below.

A, an individual, was the owner of real property located in state X. The property was unimproved and held by A for investment. In February 1976, A conveyed the property to state X in a transaction that constituted an involuntary conversion into money within the meaning of section 1033 of the Code. A immediately reinvested the proceeds received from the involuntary conversion in the acquisition of a leasehold interest in real property improved by an apartment building which then was and still is held for investment. The leasehold interest had an initial term of 25 years and is subject to three 10-year renewal periods optional to A. In addition to the amount invested in the acquisition of the leasehold interest, A's rental obligation for the initial term and any renewal periods is based on a fixed percentage of the monthly gross receipts to A from apartment rentals, net of fees paid to an independent management company engaged by A to administer the operation of the apartment building.

The specific question is whether optional renewal periods should be added to the initial term of the leasehold for the purpose of determining whether the leasehold interest qualifies as "like kind" property under section 1033(f) of the Code and section 1.1031(a)-1(c) of the Income Tax Regulations.

Section 1033(a)(2) of the Code provides, in effect, that if property is compulsorily converted into money and the taxpayer, during the period specified, purchases other property similar or related in service or use to the property so converted, at the election of the taxpayer the gain shall be recognized only to the extent that the amount realized upon such conversion exceeds the cost of such replacement property.

Section 1033(f) of the Code provides, in part, that if real property held for productive use in trade or business or for investment is compulsorily or involuntarily converted, property of a like kind to be held either for productive use in trade or business or for investment shall be treated as property similar or related in service or use to the property so converted.

Section 1.1033(g)-1(a) of the regulations provides that the principles of section 1.1031(a)-1(b) shall apply in determining whether replacement property is property of a like kind. Section 1.1031(a)-1(b) provides, in part, that the words "like kind" have reference to the nature or character of the property and not to its grade or quality. It also provides that the fact that any real estate involved is improved or unimproved is not material, for that fact relates only to the grade or quality of the property and not to its kind or class.

Section 1.1031(a)-1(c) of the regulations indicates, in part, that a leasehold or a fee with 30 or more years to run is like kind with respect to a fee interest in real estate.

In Century Electric Co. v. Commissioner, 15 T.C. 581, 591 (1950), aff'd 192 F.2d 155 (8th Cir. 1951), cert. denied, 342 U.S. 954 (1952), the Tax Court of the United States, indicated that, for like kind exchange purposes, optional renewal periods are included in determining the length of a lease.

In R & J Furniture Co. v. Commissioner, 20 T.C. 857, 865 (1953), acq., 1954-1 C.B. 6, which involved a lease with an initial term of 5 years and ten renewal options of 5 years each, the Tax Court of the United States stated that the lease was property of a like kind and the equivalent of a fee interest in real estate under the regulations since the taxpayers had the right to possess, occupy, and use the leased property for a total of 55 years.

In the instant situation, A's lease runs for an initial period of 25 years plus three optional 10-year renewal periods under the same rental terms. Thus, A has the right to possess, occupy, and use the leased property for a total of 55 years.

Accordingly, A's optional renewal periods should be added to the initial term of the lease for the purpose of determining whether the leasehold interest qualifies as "like kind" property under section 1033(f) of the Code and section 1.1031(a)-1(c) of the regulations. On this basis, the leasehold interest acquired by A in 1976 is like kind with respect to the property conveyed to state X. Therefore, for purposes of section 1033(a)(2), the leasehold interest is similar or related in service or use to the converted property.