Internal Revenue Service (IRS)
Field Service Advisory (FSA)
2002 [Date Illegible on copy received from the IRS]
26 USC § 1031 — Exchange of Property Held for Productive Use or Investment
Analysis Section 430 Georgia District
District Counsel – Georgia District
Subject: Taxpayer: *** TIN: ***
This document may contain taxpayer information subject to I.R.C. Section 6103. This document may also contain confidential information subject to the attorney-client and deliberative process privileges, and may have been prepared in anticipation of litigation. Therefore, this document shall not be disclosed beyond the office or individual(s) to whom it is addressed and in no event shall it be disclosed to the taxpayer and its representatives.
This memorandum responds to your request for advice received in this office on October 21, 1997.
1. Whether a franchise agreement between a municipality and a private party qualifies as a real property interest under Georgia law for the purposes of I.R.C. Section 1031 (“like-kind” exchange).
2. Whether a franchise agreement between a municipality and a private party subject to a provision of renewal every four years upon the election of a new mayor and city council qualifies under I.R.C. Section 1031, as a “like-kind” exchange where the taxpayer exchanges the franchise agreement for undeveloped land.
1. Georgia law considers the franchise agreement a real property interest as the taxpayer has the right to possess land for a period greater than five years.
2. We find that the exchange of the franchise agreement for undeveloped land qualifies as a like-kind exchange under I.R.C. Section 1031 as the franchise agreement has a stated term greater than 30 years including renewals despite the renewal clause upon the election of a new mayor and city council.
At this time, we recommend that the Examination Division not pursue the like-kind exchange issue with this taxpayer.
This office obtained the facts as stated below from your original memorandum and the attached exhibits dated October 10, 1997, and received in this office on October 21, 1997, and the supplemental information you provided on November 18, 1997. According to the facts in your memorandum, *** entered into a Concession and Development Agreement (the “Agreement”) with the *** to develop and operate a ***. The parties executed the original Agreement in ***, and amended it in ***. The Amendment stipulates that “the initial term of this agreement shall commence on the date hereof (***) and shall end on ***.” The Amendment provided that after ***, *** had “the right and option” to extend the initial term. The Amendment stipulated that *** could extend the term of the Agreement from *** to ***, again from *** through ***, and finally from *** through ***. After ***, *** then has the right of first refusal to continue to operate the ***. In the Amendment, *** agreed to pay the City an increasing concession fee plus a percentage of the *** receipts over the life of the Agreement. The Amendment contains the same limitation under paragraph 2(e) as did the Agreement in paragraph 2(b) which provides that:
It is intended and contemplated by the parties that this Agreement will be renewed in *** of each year which begins a new term of office of the Mayor and the Council for the duration of that term of the office. It is understood and agreed between the parties that the City does not have the legal right to bind itself for the obligations set out in this Agreement beyond the current term of the Mayor and Council, ….
In ***, *** filed a declaratory judgment action against the City of *** to determine the City’s authority to enter into the Agreement, its Amendment and its length. In its order, the *** County Superior Court decided three issues that affect ***, the Agreement and its Amendment. The Court held that the ***, allowed the City to grant a franchise regarding activities in its public parks for up to a 50-year term. The Court then held that the parties contracted to establish property rights in the Agreement and its Amendment and therefore declared the Agreement and its Amendment a franchise agreement. Finally the Court held that given the law at the time the parties originally entered into the Agreement and the Amendment, the parties could have entered into a franchise agreement for up to 50 years. The Agreement and Amendment as drafted and signed by the parties must be renewed with each new term of office for the Mayor and Council. The Court then concluded that the Order resolving this declaratory judgment action did not preclude *** and the City from entering into a franchise agreement at any time in the future for a period of up to 50 years.
The franchise agreement granted the taxpayer the right to possess and use certain described property for the development and operation of a *** and the related facilities. The agreement provided for an initial term of *** years with optional renewals for another *** years and the right of first refusal at the end of the stated term.
In ***, *** exchanged the franchise Agreement through a qualified intermediary for *** tracts of undeveloped land with the intent to develop and operate a ***. *** exchanged the franchise Agreement valued at $ *** for $ *** in undeveloped land. *** then reported a capital gain of $ ***, sales price less basis less the reinvestment costs for the undeveloped land.
*** contends that the Agreement granted the taxpayer a real property interest and the exchange meets the like-kind exchange requirements under I.R.C. Section 1031 as it exchanged at least a 30-year leasehold in real property for fee simple property.
State law creates property rights. Federal law does not create property rights; it only defines priority. United States v. Nat’l Bank of Commerce, 472 U.S. 713, 727 (1985). Once state law determines the property rights, federal law determines the tax consequences. United States v. Bess, 357 U.S. 51, 56 (1958).
The Code allows nonrecognition of a gain or loss under I.R.C. Section 1031, the like-kind exchange rules, when the taxpayer exchanges property held for productive use in a trade or business or for investment for property of a like-kind held either for productive use in a trade or business or for investment. I.R.C. Section 1031(a)(1) and Treas. Reg. 1.1031(a)-1(a)(1).
The regulations define “like-kind” property as a “reference to the nature or character of the property and not to its grade or quality.” Treas. Reg. Section 1.1031(a)-1(b). The taxpayer cannot exchange one kind or class of property for a different kind or class of property. Id. The regulation continues with regard to real estate as follows:
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. Unproductive real estate held by one other than a dealer for future use or future realization of the increment in value is held for investment and not primarily for sale. Treas. Reg. Section 1.1031(a)-1(b).
The Code provides that a leasehold interest of a fee with 30 years or more to run is of like kind to a fee simple interest in real property. Treas. Reg. Section 1.1031(a)-1(c)(2). The Tax Court held that, for like-kind exchange purposes, optional renewal periods are included in determining the length of a lease. Century Electric Company v. Commissioner, 15 T.C. 581, 591 (1950), aff’d 192 F.2d 155 (8th Cir. 1951), cert. denied, 342 U.S. 954 (1952) and Rev. Rul. 78-72, 1978-1 C.B. 258.
The Service decided in PLR 9110007 (November 26, 1990) that a 51-year lease with an option to terminate by the lessor on the occurrence of specified conditions did not affect the nature or character of the lease or the characterization of the lease as like kind to a fee simple interest in real estate under Treas. Reg. Section 1.1031(a)-1(c). This ruling concentrated on the overall lease term of 51 years and concluded that it fit within the meaning of Treas. Reg. Section 1.1031(a)-1(c) regardless of the options of the lessor.
Georgia law defines a lease as a “grant by one person to another of an estate for years of his own estate, with a reversion to himself…” OCGA Section 44-6- 102. Georgia law also defines an “estate for years” as one which passes an interest for a limited period of time in property. OCGA Section 44-6-100(a). An estate for years in land passes as real property. OCGA Section 44-6-100(b).
The Georgia Supreme Court held that a contract for the possession of lands with rights of possession for a term of 60 years was considered a lease of the lands described within the contract. Superior Pine Products Co. v. Williams, 106 S.E.2d, 214 Ga. 485 (1958); OCGA Sections 44-6-100 and 44-6-102.
The Georgia Court of Appeals held that a lease of lands for 5 years or more creates an estate for years and an interest in real property. OCGA Sections 44-6- 100, 44-6-102, and 44-7-1; Shell Petroleum Corp. v. Jackson, 47 Ga. App. 667, 669, 171 S.E. 171 (1933), and Paces Partnership v. Grant, 212 Ga. App. 621, 442 S.E.2d 826 (1994).
The Georgia Code provides that “one council may not, by an ordinance, bind itself or its successors so as to prevent free legislation in matters of municipal government.” O.C.G.A. 36-30-3(a) (1993). Governing authorities of Georgia’s municipal corporations are prohibited from entering contracts which bind succeeding councils. O.C.G.A. Section 36-30-3 (1993). A municipal corporation “means any city or town in [Georgia].” O.C.G.A. Section 36-42- 3(5) (1993). Some exceptions exist. Municipalities are allowed to enter long term contracts involving “street overpasses and underpasses of railroad property.” Id.
Georgia case law also provides some exceptions. A municipality can bind succeeding administrations if the municipality acts in a proprietary function instead of a governmental function. Southern Airways Co. v. DeKalb County, 118 S.E.2d 234 (1960). A proprietary function involves the government acting in a business capacity without the benefit of governmental immunity such as operating an airport. Southern Airways Co., 118 S.E.2d at 239. A governmental function would include property acquisition dedicated to public use. Jonesboro Area Athletic Ass’n v. Dickson, 181 S.E.2d 852, 855 (1971). Governmental functions include the maintenance of a park by a municipality. Stubbs v. City of Macon, 50 S.E.2d 866 (1948).
Under the ***, as amended, adopted in ***, the City has a right to grant franchises in parks and other property for a term of up to 50 years. Specifically, *** states as follows:
***Be it further enacted, that the Mayor and the Council of the Town of *** shall have the right and power to grant franchises, easements and rights of way, over, in, under and on the public streets, lanes, alleys, sidewalks, parks, and other property of said Town, on such terms and conditions as they may affix; provided, that no franchise shall be granted for a term of more than 50 years; but nothing in this Act shall interfere with the Town of *** incorporated under this Act in carrying out all contracts and agreements heretofore made by the Town of *** under the present Charter and granting franchises for telephone, electric light, gas, or for other purposes of public utility. All of said contracts and agreements heretofore made by the Town of *** under the present Charter are hereby and herein confirmed. ***
Based on our analysis of the facts and the law in this case, the taxpayer meets the requirement for a like-kind exchange under I.R.C. Section 1031. The taxpayer exchanged property through a qualified intermediary and held both properties for productive use in its trade or business. Georgia law holds that a possessory interest in land with a right of possession is a lease and creates a real property interest. Treasury Regulations consider a 30-year lease, including renewal options, as the equivalent of real property which qualifies for a like-kind exchange with a fee simple real property interest.
The original Concession and Development Agreement (the Agreement) dated ***, provided for an overall term of *** years with a right of first refusal to extend the Agreement beyond the initial term. The Agreement also contained clause (2)(b) which provides that the parties contemplate the renewal of the Agreement in *** of each year which begins a new term of office for the Mayor and city Council of the City of *** (the City). The Agreement further states that the parties understand that the City does not have a legal right to bind itself for the obligations set out in the Agreement beyond the current term of the Mayor and City Council. The Agreement goes on to say that in the event the State of Georgia changes its law to allow the City to bind itself beyond a single term of mayor and city council that the parties will amend this Agreement and delete the above language.
The Agreement also contains a clause that provides for payment to the taxpayer for its investment in developing the property as a *** in the event the City terminates the Agreement without “reasonable cause.” The Agreement does not define “reasonable cause.” The City agrees to reimburse the taxpayer for the costs of the capital improvements less an allowance for depreciation. Concession and Development Agreement 2.(c). The parties signed a First Amendment to Concession and Development Agreement on ***, providing for a term extending through the year *** and for increased payments from the taxpayer to the City. The Amendment also deleted the paragraph setting out the penalty for the nonrenewal of the Agreement by a subsequently-elected mayor and city council. The Amendment also included the provision for the renewal of the contract in *** of each year a new mayor and city council are elected.
In order to clarify the terms and conditions of the Agreement, the taxpayer filed a declaratory judgment action with the ***. The taxpayer’s declaratory judgment action sought three things:
1. A finding that the *** allowed the City to grant franchises regarding activities in the City’s public parks for terms up to 50 years.
2. That the Agreement and its Amendment were in fact the grant of a franchise to operate a *** on a public park.
3. To declare that the paragraph regarding the renewal of the Agreement with each new term of mayor and city council is superceded by the laws of the State of Georgia and deleted from the agreements. See ***.
The Superior Court of *** County held in its order dated ***, that the City did have the ability to enter into a franchise Agreement for a period of time up to 50 years. The Court then held that the Agreement and its Amendment did contract to establish property rights in the taxpayer and therefore the Agreement and its Amendment were in fact a franchise Agreement. Finally, the Court held that while the parties could have entered into a franchise Agreement for up to 50 years based on the law in effect at the time of the execution of the Agreement and the Amendment, the parties did not in fact enter into a franchise Agreement for up to 50 years. The *** section allowing the City to enter into franchise agreements to operate parks was enacted in ***. The parties had entered into an Agreement renewable with each new term of office for the mayor and council. The Court then went on to state that the findings made in its order did not preclude the City and the taxpayer from entering into a franchise Agreement in the future for a period of up to 50 years.
The Code allows a taxpayer to treat a 30-year leasehold as like-kind property when exchanged for a fee simple real estate. Treas. Reg. 1.1031(a)-1(c). In Central Electric Company v. Commissioner, 15 T.C. 581 (1950), aff’d 192 F.2d 155 (8th Cir. 1951), cert. denied, 342 U.S. 954 (1952), the Court held that optional renewal periods could be added to the initial term to meet the requirement of a leasehold for 30 years or more so as to qualify the property for a like-kind exchange with fee simple real property. Id at 595. The Service in Rev. Rul. 78-72, 1978-1 C.B. 258, allowed the addition of the optional renewal periods to determine if the leasehold interest was for 30 years or more.
Georgia law considers the franchise agreement a lease for land and therefore a real property interest. The agreement by its terms extends for a period greater than 30 years. The exchange of the taxpayer’s leasehold interest for greater than 30 years for a fee simple interest qualifies as a like-kind exchange under I.R.C. Section 1031. The parties to the franchise agreement intended it to extend for more than 30 years as evidenced by the parties agreement to delete the 4 year renewal clause in the event Georgia law changed. Despite the renewal requirement, the agreement by its terms is still a leasehold for more than 30 years under the Internal Revenue Code. The Service has taken the position that options to terminate by the lessor do not affect the nature or character of the lease as like kind to a fee simple interest.
At this time, we are closing our file. If you have any further questions, please call me at 404-331-1176.
This document may not be used or cited as precedent.