1031 Exchange Strategy for Ground Leases and Long-Term Land Plays

The fee under the building needs no special test; the leasehold needs 30 years left on the day you close

Buying the land beneath someone else's building is an ordinary purchase of real property and clears §1031 on the same terms as a parcel of farmland. Buying the other side of the same deal, the tenant's leasehold, clears only if enough term remains.

Reg. §1.1031(a)-1(c) puts it plainly, describing a taxpayer who "exchanges a leasehold of a fee with 30 years or more to run for real estate." The 2020 real property regulations back that up: Reg. §1.1031(a)-3 lists "a leasehold" among the interests in real property that qualify, alongside fee ownership, co-ownership, options and easements.

Two practical consequences follow. A 25-year leasehold cannot absorb your exchange proceeds, and a long leasehold you buy today quietly loses its exchangeability for the next buyer as the remaining term drifts under 30 years. §1031(h) adds the other boundary: land abroad is never like-kind to land here.

Land throws off no depreciation, so a ground-lease landlord pays tax on every dollar of rent

The fee under a ground lease produces no depreciation deduction at all. Reg. §1.167(a)-2 denies the allowance for "land apart from the improvements or physical development added to it," and in a true ground lease the improvements belong to the tenant for the whole term.

Hypothetical, round numbers: $2,000,000 of exchange proceeds buys a fee subject to a 99-year lease at a 5% ground rent, which is $100,000 a year, all of it taxable. The same $2,000,000 placed in a trust holding an apartment property where 80% of the price is depreciable improvements produces about $58,000 a year of depreciation ($1,600,000 spread over 27.5 years), which offsets most of that year's distribution.

Neither number is a forecast; they exist to show the shape of the difference. That gap over a twenty-year hold is why buyers who want quiet income usually compare a ground lease against a traditional DST rather than against a bond.

At expiration the building reverts to you tax-free under §109, and with zero basis under §1019

The reversion is not a taxable event. §109 excludes from the lessor's gross income the value "attributable to buildings erected or other improvements made by the lessee" on termination of the lease.

It is also not a depreciation opportunity. §1019 says neither the basis nor the adjusted basis of the property is increased on account of income excluded under §109, so the building arrives with nothing to write off and a later sale is taxed on the full price.

On a 99-year lease that is a grandchild's issue. On a 35-year leasehold bought in the secondary market it is the pricing input, because the reversion is most of what makes the land worth more than the discounted stream of rent.

Fixed bumps, CPI or a reset to appraised land value — and the §467 accrual rule behind all three

The escalation clause is the economic engine of a ground lease, and the three common designs behave very differently in inflation. Read the clause before the cap rate.

§467 governs the tax timing of increasing rent and reaches agreements where the payments exceed $250,000, which covers essentially every ground lease. A lease running longer than 75% of the 19-year statutory recovery period for nonresidential real property is a "long-term agreement" under §467(b)(4), and constant rental accrual is imposed only where the increasing rent has tax avoidance as a principal purpose.

Have your CPA or attorney read the rent schedule against §467 before you sign, because level accrual would tax you on rent that has not yet arrived.

• Fixed percentage bumps: predictable underwriting, and a known loser to a decade of unexpected inflation.
• CPI-linked adjustments: inflation protection, usually bounded by a floor and a cap that decide how much protection you actually bought.
• Periodic reset to a percentage of appraised land value: the largest upside and the only clause that can reprice your income by a multiple, in either direction, depending on who appraises and how often.

Four terms separate a ground lease that behaves like a bond from one that behaves like a bet

None of these show up in a marketing yield. All four show up in the lease document, which is the asset you are actually buying when you take the landlord's position.

• Tenant credit and who signs: a lease guaranteed by an operating company is a different instrument from one signed by a single-purpose entity whose only asset is the building.
• Subordination: an unsubordinated fee sits ahead of the tenant's leasehold mortgage, so a default lets you take the land back with the improvements on it; a subordinated fee stands behind that lender and can be wiped out in a foreclosure.
• Reset mechanics: the appraisal standard, the floor, the arbitration path and the interval decide whether a reset is a windfall or a fight.
• Remaining term: every year shortens the leasehold side toward the 30-year line and narrows your eventual buyer pool to people who do not need like-kind treatment.

The same $2,000,000 in a ground-lease fee, a net-leased building and a DST: what each one gives up

Ground lease fee: no operating duties, no roof, no re-tenanting, no depreciation, and a reversion decades out. Net-leased building: a depreciable improvement that shelters part of the rent, plus residual risk on a specific building in a specific market when the lease ends. DST interest: depreciation and multiple properties, bought with sponsor fees and no liquidity until the trust sells.

Ground leases win on durability and on the sheer absence of work. They lose on early-year after-tax yield, because depreciation is the quiet part of a real estate return and land has none of it. For a taxable investor comparing a 5% ground rent to a 5% distribution from a DST holding depreciable buildings or a triple-net asset, the after-tax numbers are not close to equal.

Confirm every one of these rules with your own CPA or attorney against your basis, your state and the actual lease before you identify anything.