Using a 1031 Exchange for Transferrable Development Rights

What are Transferrable Development Rights? 

"Development Rights" are defined as the unused rights to develop a property within the limits set by state or local laws. With states and municipalities increasingly imposing restrictions on new construction, the value of development rights has skyrocketed. Since 1916, more than 140 state and local governments have introduced regulations allowing unused development rights to be transferred to different parcels. Property owners can consult with a local land use professional to determine whether they can benefit from such a program. These rights can then be used to construct improvements, such as buildings with more floor space or height, or to build at higher density than would otherwise be allowed. Consequently, an owner with unused development rights can achieve significant financial gain by selling these Transferable Development Rights (TDRs) to another parcel owner looking to further develop their property.  

The use of TDRs is a planning and preservation tool that is often used to protect agricultural, historic, or environmental resources while accommodating the needs of development. TDRs are the creation of state and local laws around the country that permit the owners of “preservation area” land to carve out the development rights of their property and sell them for use in a “receiving area”, usually nearby. Generally, developers purchase “development credits” and apply them to areas designated for growth at higher densities than would otherwise have been permitted. Once the property owner has sold their development rights, their land will be permanently restricted from further development. 

The Internal Revenue Service addressed the issue of Development Rights in 2008 with the release of PLR 200805012. Simply stated, the question asked in that private letter ruling was whether Development Rights are like-kind for the purposes of IRC Section 1031 to a fee interest in Those certain items of real and/or personal property qualifying as “replacement property” within the meaning of Treasury Regulations Section 1.1031(k)‑1(a) and either: (a) received by the taxpayer within the designation period in accordance with Treasury Regulations Section 1.1031(k)‑1(c)(1) or (b) identified in a written designation notice signed by the taxpayer and hand delivered, mailed, telecopied or otherwise sent to the qualified intermediary before the end of the designation period in accordance with Treasury Regulations Sections 1.1031(k)‑1(b) and (c). The definition of “replacement property” shall not include property the identification of which has been revoked by the taxpayer in accordance with Treasury Regulations Section 1.1031(k)‑1(c)(6); (“New Asset”) Property or properties properly received by a taxpayer as part of a 1031 exchange. Replacement Property . The IRS noted that state law defined an “interest in real property” to include: 

 “title in fee, a leasehold interest, a beneficial interest, an encumbrance, development rights, air space and air rights, or any other interest with the right to use or occupancy of real property or the right to receive rents, profits, or other income derived from real property.”  

The IRS also noted the Treas. Reg. §1.1031(a)-1(b) provides that “like-kind” refers to the nature or character of the property and not to its grade or quality. Thus, real property in one asset class may be exchanged for real property in another asset class under §1031. The IRS concluded that the Development Rights to be acquired in this Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange were like-kind to the fee interest being relinquished in the exchange. 

The IRS addressed a similar issue a year later with the release of PLR 200901020. The specific question to be resolved in this PLR was whether residential density development rights are like-kind to other interests in real estate. As with the earlier PLR, the IRS pointed out that Development Rights constitute interests in real estate under state law. The Exchanger was to dispose of development rights within a Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange , and then acquire a fee interest in real estate, an additional leasehold interest in real estate with 30 years or more remaining, and certain land use rights. After a detailed historical analysis of Development Rights and easements in Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange s, the IRS concluded that the Development Rights to be transferred by the Exchanger are of like-kind to the fee interest in real estate, a leasehold interest in real estate with 30 years or more remaining, and the land use rights.

In December 2020, the IRS issued the long anticipated Final Regulations for real property transactions under Section 1031. The Regulations provided many examples of what constitutes real property as well as a framework for analyzing items that were not listed. Relevant to this discussion, Treas. Reg. §1.1031(a)-3(a)(5)(i) specifically identified “land development rights” as real property for the purposes of Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange s. Additionally, property that is real property under state or local law will also be treated as real property for purposes of Section 1031 under Treas. Reg. §1.1031(a)-3(a)(6). 

Based on this guidance from the IRS, Exchangers may sell or purchase Transferable Development Rights within a properly structured Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange . 

To further understand Transferable Development Rights and the utilization of Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange s involving TDRs, let’s walk through a hypothetical scenario involving two property owners and how they both can utilize TDRs. 

Utilization of 1031 Exchange with Transferrable Development Rights 

What does the owner of a three-story brownstone in New York have in common with the owner of a 100-acre farm in New Jersey? They each own something that they’re unaware of: Transferable Development Rights. 

Our New York City brownstone is owned by a widow who lives comfortably, though with little money left over each month. She has considered selling her home and moving but is reluctant to do so given the sentimental value of the home and high interest rates. She recently consulted with one of her trusted advisors who suggested that she consider TDRs. Her home is approximately 3,000 square feet on a lot that would allow for a home of up to 6,000 square feet. Because her home is in a ‘special purpose district’, she could sell those unused 3,000 square feet to a developer of a ‘designated receiving zone’, and still retain full ownership of her home and land. While the values of TDRs vary widely across the state, for purposes of this illustration we will assume an incredibly modest $200 per square foot (NYC TDRs ranged from $51 to $223 per square foot in 2013.) Thus, multiplying $200 by 3,000 square feet, our homeowner will receive $600,000 for her TDRs. 

The owner of Cherry Hill Farm is a third-generation farmer, raising a variety of crops on the last remaining active farm in the town that was once three-quarters farmland. Development has steadily encroached upon the family farm. Residential subdivisions border the farm on three sides and a county road runs through the middle. Developers have long targeted this property for the potential to build 75 or more homes. At the same time, the family farm, and its farmers market business face increasing pressure from supermarkets and warehouse clubs that sell corn, tomatoes, strawberries, and other competing products for lower prices. As with New York, prices of TDRs in New Jersey vary widely, so we will assume $10,000 per housing credit. (Nearby TDRs ranged from $10,000 to $50,000+ in recent years.) Thus, multiplying $10,000 by 75 housing units, our farming family will receive $750,000 for their TDRs. As in New York, the farming family will retain full ownership of the farm, with a deed restriction prohibiting future non-agricultural development. 

For both transactions, the result is exposure to significant capital gains on the value of the TDRs. The top tax bracket in New York is 10.9%, and in New Jersey it is 10.75%. 

The Benefits to Our Property Owners 

Our New York widow generated approximately $600,000 from the sale of TDRs associated with her brownstone. Absent a Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange , she faced a potential tax bill of over $208,000 ($65,400 to the state, $120,000 in federal capital gains, and $22,800 in NIIT). Our New Jersey farmer garnered $750,000 from the sale of TDRs associated with their farm. Without the benefit of a Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange , they faced a potential tax bill of nearly $260,000 ($80,625 to the state, $150,000 in federal capital gains, and $28,500 in NIIT). However, because we now know that they can utilize the benefits of a Internal Revenue Code Section 1031 states that "no gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held for productive use in a trade or business or for investment." 1031 Exchange , they can defer associated taxes by deploying those funds toward the purchase of qualifying real estate, including management-free options like Delaware Statutory Trusts.

The Benefits of TDRs to Developers  

Developers who acquire TDRs from other properties benefit by being able to add height or density to their projects. In the case of our New York City brownstone, for example, the developer may have been able to build a 9,000 square foot duplex instead of a 6,000 square foot single family home. This effectively allows him 50% more density on the lot than he may have had without the TDRs. For the developer who acquired the TDRs from our farm family, perhaps he can now build 150 homes in his new subdivision rather than 75, because he bought that additional density from the farm family.  

The Benefits to the Community at Large  

The TDR system is considered to be a mechanism for controlling urban sprawl by concentrating or encouraging development in a specific direction. The use of TDRs is generally viewed more favorably than imposing harsh zoning restrictions on one area, which could cause landowners in that area to claim that there was an unconstitutional “taking” of their property rights. Instead, TDRs offer those property owners a financial incentive to participate in the conservation of their properties for environment, agricultural, or heritage purposes.  

As always, (“Exchangor” or “Taxpayer”) Person intending to conduct a 1031 tax deferred exchange, who transfers a relinquished property and thereafter receives a replacement property. Exchanger s are reminded to consult with their tax and legal advisors, as state and local laws differ around the country. Further, under the terms of every Private Letter Ruling, (“Exchangor” or “Taxpayer”) Person intending to conduct a 1031 tax deferred exchange, who transfers a relinquished property and thereafter receives a replacement property. Exchanger s are advised that each PLR applies only to that (“Exchangor” or “Taxpayer”) Person intending to conduct a 1031 tax deferred exchange, who transfers a relinquished property and thereafter receives a replacement property. Exchanger on that set of facts. Thus, this blog is not a substitute for the advice of competent tax and legal advisors.  

The material in this blog is presented for informational purposes only. The information presented is not investment, legal, tax or compliance advice. Accruit performs the duties of a Qualified A person acting to facilitate an exchange under section 1031 and the regulations. This person may not be the taxpayer or a disqualified person. Section 1.1031(k)-1(g)(4)(iii) requires that, for an intermediary to be a qualified intermediary, the intermediary must enter into a written "exchange" agreement with the taxpayer and, as required by the exchange agreement, acquire the relinquished property from the taxpayer, transfer the relinquished property, acquire the replacement property, and transfer the replacement property to the taxpayer. Intermediary , and as such does not offer or sell investments or provide investment, legal, or tax advice.