Understanding Ground Lease Interests and Their Role in §1031 Exchanges

In the world of real estate invest­ment, lever­ag­ing the ben­e­fits of a §1031 exchange can pro­vide investors with a pow­er­ful tool to defer tax­es and rein­vest in prop­er­ties. One unique oppor­tu­ni­ty with­in this strat­e­gy involves the use of ground lease inter­ests.

March 14, 2025

By Al DiNi­co­la, AIF®
Direc­tor Real Prop­er­ty Con­sult­ing Ser­vices
1031 Tax Deferred Exchange Spe­cial­ist & DST Advisor/Specialist
NAMCOA® — Naples Asset Man­age­ment Com­pa­ny®, LLC
Secu­ri­ties offered through MSC-BD, LLC, Mem­ber of FINRA/SIPC

While ground leas­es are typ­i­cal­ly con­sid­ered long-term rental agree­ments, they can also play a sig­nif­i­cant role in tax-deferred exchanges under spe­cif­ic con­di­tions. But how exact­ly do ground leas­es fit into the frame­work of a §1031 exchange, and what are the ben­e­fits, chal­lenges, and con­sid­er­a­tions investors should be aware of when using this strat­e­gy?

What is a Ground Lease?

A ground lease is a long-term lease arrange­ment where the ten­ant holds exclu­sive rights to the land for a spec­i­fied peri­od, typ­i­cal­ly 30 years or more. In these leas­es, the ten­ant is respon­si­ble for devel­op­ing and main­tain­ing the prop­er­ty, but the own­er­ship of the land remains with the land­lord. Ground leas­es are often used in com­mer­cial real estate, allow­ing ten­ants to build and oper­ate prop­er­ties with­out the upfront costs asso­ci­at­ed with own­ing the land.

Can a Ground Lease Be Used in a §1031 Exchange?

Yes, a ground lease can qual­i­fy for a §1031 exchange under the right con­di­tions. The Inter­nal Rev­enue Ser­vice (IRS) treats long-term lease­hold inter­ests (those last­ing at least 30 years) as sim­i­lar to fee sim­ple own­er­ship, which makes them eli­gi­ble for §1031 exchange tax defer­ral. For investors look­ing to defer cap­i­tal gains tax­es on the sale of a relin­quished prop­er­ty, the lease­hold inter­est in a ground lease presents an effec­tive and flex­i­ble option.

How Does a Ground Lease §1031 Exchange Work?

In a typ­i­cal §1031 exchange, an investor sells a prop­er­ty and rein­vests the pro­ceeds into anoth­er like-kind prop­er­ty, thus defer­ring cap­i­tal gains tax­es. A ground lease §1031 exchange fol­lows a sim­i­lar process but involves acquir­ing a long-term lease­hold inter­est in a prop­er­ty along with the right to devel­op or improve the land.

In this case, an investor sells a prop­er­ty and uses the pro­ceeds to acquire a lease­hold inter­est in a ground lease. The investor can then devel­op or improve the land accord­ing to their spec­i­fi­ca­tions, allow­ing for sig­nif­i­cant cus­tomiza­tion of the prop­er­ty. This type of exchange is par­tic­u­lar­ly advan­ta­geous for investors seek­ing strate­gic loca­tions for devel­op­ment or those who wish to avoid the high costs of pur­chas­ing land out­right.

Ben­e­fits of a Ground Lease §1031 Exchange

A ground lease §1031 exchange offers sev­er­al com­pelling advan­tages for real estate investors:

Tax Defer­ral: As with tra­di­tion­al §1031 exchanges, the most sig­nif­i­cant ben­e­fit is the abil­i­ty to defer cap­i­tal gains tax­es on the sale of the relin­quished prop­er­ty. This allows investors to pre­serve more cap­i­tal for rein­vest­ment and grow their port­fo­lios with­out the imme­di­ate tax bur­den.

Cost Effi­cien­cy: Ground leas­es can often be more afford­able than pur­chas­ing land, allow­ing investors to focus their cap­i­tal on prop­er­ty devel­op­ment rather than land acqui­si­tion. This strat­e­gy allows for greater finan­cial flex­i­bil­i­ty and effi­cien­cy.

Flex­i­bil­i­ty in Devel­op­ment: A ground lease pro­vides the flex­i­bil­i­ty to devel­op or enhance the prop­er­ty. Investors can cre­ate cus­tomized improve­ments, which are par­tic­u­lar­ly use­ful for those seek­ing to tai­lor prop­er­ties to spe­cif­ic mar­ket needs or oper­a­tional goals.

Prime Loca­tion Oppor­tu­ni­ties: Ground leas­es often involve secur­ing prime real estate loca­tions that may be unavail­able for direct pur­chase. Investors can gain access to valu­able prop­er­ties in key areas with­out the sub­stan­tial upfront costs asso­ci­at­ed with land acqui­si­tion.

Risk Mit­i­ga­tion: Since ground leas­es are long-term con­tracts, they offer sta­bil­i­ty for investors who ben­e­fit from fixed lease terms and reli­able landown­ers. This can reduce the uncer­tain­ty and risk asso­ci­at­ed with short­er-term invest­ments.

Prac­ti­cal Con­sid­er­a­tions and Chal­lenges

While ground lease §1031 exchanges present sig­nif­i­cant oppor­tu­ni­ties, they also come with spe­cif­ic con­sid­er­a­tions that investors must nav­i­gate.

Eli­gi­bil­i­ty and Lease Term Require­ments: The IRS requires the lease term to be at least 30 years for the exchange to qual­i­fy. If the lease term is short­er than this, it will not be con­sid­ered “like-kind” and will not qual­i­fy for tax defer­ral.

Improve­ment Require­ments: In some cas­es, investors may choose to improve or devel­op the prop­er­ty as part of the exchange. The IRS requires that the improve­ments meet or exceed the val­ue of the relin­quished prop­er­ty to qual­i­fy for tax defer­ral ben­e­fits. These improve­ments must also be com­plet­ed with­in 180 days of the sale of the relin­quished prop­er­ty, adding a lay­er of com­plex­i­ty to the process.

Delaware Statu­to­ry Trust (DST) offer­ings. There have been and poten­tial­ly, may con­tin­ue to be a select num­ber of offer­ings of struc­tures built on a ground lease.  These ground leas­es are very long in the num­ber of years. One of the poten­tial ben­e­fits, maybe the depre­ci­a­tion sched­ules on the asset may be on the build­ing only. In addi­tion, there may also be accel­er­at­ed depre­ci­a­tion sched­ules and cost seg­re­ga­tion pro­vid­ing addi­tion­al pass-through ben­e­fits to the investors.

Involve­ment of a Qual­i­fied Inter­me­di­ary (QI): As with any §1031 exchange, the use of a Qual­i­fied Inter­me­di­ary (QI) is required to facil­i­tate the trans­ac­tion. The QI helps ensure that the tax­pay­er does not have direct con­trol over the pro­ceeds of the relin­quished prop­er­ty sale, which is cru­cial for main­tain­ing the tax-deferred sta­tus of the exchange.

Legal and Doc­u­men­ta­tion Require­ments: The IRS requires detailed doc­u­men­ta­tion of the intend­ed improve­ments and their legal descrip­tion, as well as strict time­lines. It is essen­tial to have clear plan­ning and the nec­es­sary legal and finan­cial resources to ensure the exchange is exe­cut­ed cor­rect­ly.

State-Spe­cif­ic Reg­u­la­tions: State laws may vary on what con­sti­tutes real prop­er­ty, so it’s cru­cial to be aware of the spe­cif­ic reg­u­la­tions in the state where the prop­er­ty is locat­ed. Work­ing with an expe­ri­enced legal team can help mit­i­gate poten­tial risks asso­ci­at­ed with state-spe­cif­ic rules.

Key Steps in a Ground Lease §1031 Exchange

Sale of the Relin­quished Prop­er­ty: The process starts with the sale of the relin­quished prop­er­ty. The pro­ceeds are then trans­ferred to a Qual­i­fied Inter­me­di­ary.

Iden­ti­fi­ca­tion of the Replace­ment Prop­er­ty: With­in 45 days of the sale, the investor must iden­ti­fy the replace­ment prop­er­ty (in this case, a lease­hold inter­est in a ground lease) and any intend­ed improve­ments.

Involve­ment of the Accom­mo­da­tion Title­hold­er (AT): Dur­ing the con­struc­tion peri­od, a spe­cial pur­pose enti­ty (SPE) or Accom­mo­da­tion Title­hold­er holds the lease­hold inter­est while the investor man­ages the devel­op­ment process.

Com­ple­tion of Improve­ments: The investor must ensure that the improve­ments are com­plet­ed with­in the IRS’s 180-day win­dow. If any issues arise dur­ing con­struc­tion, con­tin­gency plans should be in place to avoid jeop­ar­diz­ing the exchange.

Trans­fer of Lease­hold Inter­est: Upon com­ple­tion, the lease­hold inter­est, along with the improve­ments, is trans­ferred to the investor, final­iz­ing the exchange.

NAMCOA® is a SEC reg­is­tered invest­ment advi­so­ry firm that pro­vides com­pre­hen­sive port­fo­lio man­age­ment, finan­cial plan­ning, and fidu­cia­ry deci­sion-mak­ing ser­vices on behalf of retire­ment plan spon­sors. Our Dif­fer­ence is sum­ma­rized by our fidu­cia­ry approach which enables us to bet­ter meet port­fo­lio and retire­ment plan objec­tives, result­ing in stronger risk adjust­ed returns for investors and peace of mind for Clients. We also focus on alter­na­tive real estate invest­ment. Many real estate investors are seek­ing tax deferred solu­tions uti­liz­ing §1031 exchanges or Oppor­tu­ni­ty Zones.

DSTs are not for all investors.  The acqui­si­tion of a DST is for accred­it­ed investors only.  Con­tact your invest­ment advis­er for addi­tion­al details on how a DST may be a solu­tion to your §1031 Exchange and suit­ed for your invest­ment future. For more infor­ma­tion on how to prop­er­ly set up an IRC §1031 Tax Deferred Exchange or if you are an accred­it­ed investor and would like addi­tion­al infor­ma­tion on a DST con­tact Al DiNi­co­la at 239–691-8098 or email adinicola@namcoa.com.

This is not an offer to pur­chase or solic­i­ta­tion to pur­chase any secu­ri­ty, as such be made only through an offer­ing mem­o­ran­dum or prospec­tus.  Invest­ing in secu­ri­ties, real estate, or any invest­ment, whether pub­lic or pri­vate, involves risk, includ­ing but not lim­it­ed to the poten­tial of los­ing some or all of your invest­ment dol­lars when you invest in secu­ri­ties. You should review any planned finan­cial trans­ac­tions that may have tax or legal impli­ca­tions with your per­son­al tax or legal advi­sor.   NAMCOA, LLC is a Reg­is­tered Invest­ment Advi­sor, reg­u­lat­ed by SEC (Secu­ri­ties and Exchange Com­mis­sion). Our cor­po­rate office is locat­ed at 999 Van­der­bilt Beach Road, Suite 200, Naples Flori­da 34108. Secu­ri­ties Offered through MSC-BD, LLC, Mem­ber of FINRA/SIPC. 5 Cen­ter­pointe Dri­ve, Ste. 400 Lake Oswego, OR, 97035. MSC-BD, LLC and NAMCOA are inde­pen­dent­ly owned and are not affil­i­at­ed.

Thank you.