Tax Considerations for Land Leases

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For investors looking for new opportunities, land leases are spreading in New York and beyond. A land lease occurs when the landlord sells the land to an investor and then leases it back to the investor.

The transaction is documented in a ground lease, a document that typically lasts 35 to 99 years. Often, during the period the tenant is renting the property, they may decide to build another structure there; this sometimes involves razing an existing structure. Once the lease reaches its expiration date, the tenant transfers ownership of the improvements to the landlord.

Many types of property are leased on the ground, including vacant land, industrial properties, office buildings, multi-family residential properties, and hotel properties. In New York, some co-ops are built on leased property on the ground, which allows owners to price co-ops at very competitive prices. Co-op developers save money by renting the land, instead of buying it, and are able to pass it on to residents. However, they also pass on the cost of paying the ground lease, which contributes to monthly maintenance costs that can exceed those of other apartment types.

Many landowners like land lease because it allows them to extract value from land they may not be using or are underutilizing.

For example, some universities that own vacant land or unused student housing have turned to land leasing, creating a new revenue stream to fund campus programs and initiatives. Family businesses can opt for land leases to keep a property in the family, even if they don’t have the funds or the inclination to develop it. For some landlords, land leases can generate higher returns on a property than they would get from its appreciation over time.

While land leases can offer many benefits to investors, there are also tax considerations. The tenant must pay property taxes when the property is subject to a ground lease.

It is important to get expert advice from knowledgeable commercial real estate professionals on how to take stock of a property the landlord is considering renting land for, what type of transaction best suits the needs of the owner and the level of control the owner will have. have on any construction on the property, among other matters. The landlord will need legal protections in case the tenant fails to take care of the property in the agreed manner. Beyond this, the owner will need to develop a marketing strategy for the property to be made available for land rental.

For insight, Crain Content Studio spoke with Jonathan Stein, Principal at Goulston & Storrs. Stein provides tax advice for business and real estate transactions. His clients include real estate investment trusts, developers, institutional investors and family offices, private companies, family businesses, fund sponsors, holding companies and lenders.

Stein focuses on complex tax issues involving joint ventures, cross-border and tax-exempt structuring, tax-free exchanges, transfer taxes, leasing and financing issues. He also represents investment fund sponsors and holding companies in taxable and non-taxable merger and acquisition transactions.

CRAIN’S: How do land leases work and why are they becoming popular?

STEIN: A new wave of land lease investors is seeking to restructure real estate capital by separating ownership of the land under a commercial building from the building itself. In practice, the way it works is that an investor buys the land from the property owner or developer and then leases it to the seller under a long-term ground lease. Since these land leases can free up additional cash and lower the cost of capital, they are very attractive to landlords and developers.

CRAIN’S: What are the tax issues associated with a ground lease?

STEIN: As with all things real estate, there are important tax considerations involved. First and foremost, the parties must decide whether to treat the sale and leaseback of the land as a “true lease” for tax purposes. . If the lease is respected as such, then the seller may have what is called a “capital gain on sale”. This gain could be deferred by concluding an exchange of the same nature. It is when a good used for business purposes or as an investment is exchanged for another similar good used for the same purpose.

If the tax cost of a sale is high and a like-kind exchange is not possible, then it may be possible to treat a long-term lease as finance or a loan instead of a “true lease”. “. In this scenario, the form of the transaction as a land lease is ignored for income tax purposes. Instead, the property owner is treated as if the “purchase price” he received for the land was a loan, and the “rent” payments are principal and interest payments on this loan. Whether a given lease can be treated as financing depends on the terms of the lease, and in particular how the option to buy back the land is structured.

CRAIN’S: What about depreciation?

STEIN: Sometimes sale-leasebacks include the purchase of buildings and improvements, as well as land. In this case, the buyer-lessor can depreciate the building instead of the seller-tenant. This tax outcome is subject to negotiation, and seller-tenants are often able to retain the benefits of depreciation on improvements. As the land is not depreciable, this question does not arise for a real land lease.

CRAIN’S: Are there transfer rights?

STEIN: This varies by jurisdiction. In New York, the grant of a ground lease is generally subject to New York State transfer taxes, either because the transaction contains an option to purchase or because the term of the lease is greater than 49 years, or both. New York City transfer taxes generally do not apply to a new land lease because “rents” under the city’s commercial rent occupancy tax are excluded from the transfer tax. However, land lease assignments may be taxable in both New York State and New York City. With proper planning, it may be possible to avoid paying twice for transfer tax, once on the sale and once on the leaseback.

CRAIN’S: Are there any other structuring considerations?

STEIN: Leases should be analyzed to determine if there is prepaid or deferred rent. If so, special tax accounting rules may apply so that prepaid or deferred amounts are accounted for on a pro rata basis over the term of the lease.

The references:

Ground Lease – Everything You Need to Know (+ Calculator)

https://www.us.jll.com/en/views/unlock-the-value-of-underutilized-land-with-a-ground-lease

https://www.reit.com/news/reit-magazine/september-october-2018/reinventing-ground-lease-concept

What Is a Land-Lease Building in NYC?

https://www.skylineprp.com/resurgence-of-the-ground-lease

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