Your Ground Lease to a Tenant Is Expiring: Sell Before or After, and How to 1031

The reversion is valuable, but it arrives with no basis

When a ground lease ends, the tenant's building usually becomes yours under the lease. Section 109 says your gross income does not include income "derived by a lessor of real property on the termination of a lease, representing the value of such property attributable to buildings erected or other improvements made by the lessee." So the reversion is not taxed when it happens.

The cost of that exclusion is in section 1019: neither the basis nor the adjusted basis of the property is increased on account of income excluded under section 109. Your basis stays what you paid for the land, and the building sits on top of it with no basis at all.

Read the exclusion closely. Section 109 covers income "other than rent," so improvements the tenant made in place of rent, as the lease's consideration to you, are not covered by it. Have your CPA read the lease's improvement and surrender clauses before the reversion date.

Two consequences follow. You cannot depreciate the reverted building, so its rents are taxed with nothing to shelter them, and a later taxable sale recognizes its entire value as gain. The ground lease strategy guide covers the same rule from the side of a landlord holding a long lease.

Selling the leased fee before expiry trades the reversion for a known price

Before the lease ends you own a fee interest subject to a lease. That is real property, it qualifies as relinquished property in a 1031 exchange regardless of how many years remain, and the buyer is paying for two things: the remaining ground rent and the right to the building when the lease ends.

As expiry approaches, the reversion is most of the value, and buyers price in the building's condition, the cost of re-leasing it, and the chance the tenant leaves it in poor shape. A tenant who wants to stay is often the most motivated buyer, because owning the land merges with its building; selling a rental to your tenant covers that sale.

The tenant's own position is different. A leasehold is like-kind to a fee only with 30 years or more to run under Reg. section 1.1031(a)-1(c), so a tenant with a short remaining term cannot exchange it; exchanging a leasehold interest explains why.

Waiting means owning a building you cannot depreciate, and possibly an empty one

If you let the lease run out, you become a building owner overnight. The tenant may leave, and a vacant building with no depreciation and full operating costs is the most expensive version of the property to hold.

You can still exchange after reversion. The land and building are held for investment, and the deferred gain, which now includes the building's full value, carries into the replacement under section 1031(d). The Form 8824 instructions allocate the carried-over basis across the like-kind assets received, so part of your old land basis can land on a depreciable replacement building.

What you must not do is take a cash payment to let the tenant out early and expect to exchange it. Publication 527 says that if a tenant pays you to cancel a lease, "the amount you receive is rent," included in income in the year received.

Worked example: land bought for $200,000 with a lease ending in three years

These are hypothetical round numbers. An owner bought land for $200,000 decades ago and ground-leased it. The lease ends in three years, when a building the market values at $1,500,000 will revert. An investor offers $1,600,000 for the leased fee today.

Selling now and exchanging defers a $1,400,000 gain, before selling costs, into replacement property, and the owner no longer carries the re-leasing risk. The replacement takes the $200,000 carried-over basis plus any new money and debt, allocated among its assets.

Waiting three years gives the owner land and building, perhaps worth $2,300,000 if it can be leased, but with no depreciation in the meantime and the chance of vacancy. A taxable sale at that point would recognize $2,100,000 of gain; an exchange would defer it. Run your own numbers with your CPA and an appraiser.

• Sell now: $1,600,000 − $200,000 basis = $1,400,000 gain, deferrable.
• Wait: building reverts with $0 basis; no depreciation on it while you hold.
• Taxable sale after reversion at $2,300,000: $2,100,000 gain, before costs.

Pick the path by the risk you want to carry, then line up the replacement

Owners who want certainty sell the leased fee and exchange into property with depreciable basis and less concentrated risk. Owners willing to manage a building, or with a tenant ready to sign a new lease, wait and exchange later. Either way, the identification period runs from the transfer under Reg. section 1.1031(k)-1(b)(2).

If you plan to wait, decide before the reversion whether to offer the existing tenant a new lease. A signed lease turns a possibly vacant building into a leased one that buyers can value, and your exchange clock does not start until you actually sell.

A Delaware statutory trust interest is one replacement that moves the leasing risk to the trust's sponsor; traditional DST exchange solutions describes the structure, and comparing a DST with a net-leased property sets out the trade-offs.