Ground Lease Tax Treatment for Lessors and Lessees

A ground lease is a long-term agreement where a tenant leases land and constructs a building on it. This arrangement allows a developer to build on a desirable plot without incurring the cost of purchasing the land. The separation of land ownership from building ownership creates distinct tax considerations for both the landowner (the lessor) and the developer (the lessee).

Tax Treatment for the Landowner (Lessor)

For the landowner, all payments received for the use of the land are treated as ordinary rental income and are subject to ordinary income tax rates. From this income, the landowner can deduct necessary expenses related to owning the land, such as mortgage interest and real estate taxes.

A more complex tax situation arises at the conclusion of the ground lease when buildings constructed by the tenant revert to the landowner. Under Internal Revenue Code (IRC) Section 109, the fair market value of these improvements is excluded from the lessor’s gross income. This tax-free receipt has a condition: the improvements cannot be a substitute for rent. If the building’s construction was intended as a form of rent payment, its value is taxable as rental income to the lessor.

The tax benefit of excluding the building’s value from income is paired with a rule under IRC Section 1019. This section dictates that since the lessor did not recognize income on the building, they cannot add its value to their tax basis in the property. The lessor’s basis in the newly acquired improvements is zero, meaning their total property basis consists only of their original basis in the land. The consequence of this zero basis becomes apparent if the lessor later sells the property.

For example, if a landowner with a $500,000 land basis receives a building worth $4 million, their total basis remains $500,000. Selling the land and building for $5 million results in a $4.5 million taxable capital gain.

Tax Treatment for the Tenant (Lessee)

The rent a tenant pays to the landowner for the land is considered a business expense under IRC Section 162. These payments are fully deductible, reducing the tenant’s taxable income each year.

Initial costs to secure the ground lease, such as legal fees or brokerage commissions, cannot be deducted immediately. These lease acquisition costs must be capitalized and amortized over the term of the lease, allowing the tenant to deduct a portion of these costs annually.

Since the tenant owns the building during the lease term, they are entitled to claim depreciation deductions on the structure. These deductions allow the tenant to recover the cost of the building over time, lowering taxable income. The depreciation period is not the term of the ground lease but the statutory recovery period for the asset. For nonresidential real property, the Modified Accelerated Cost Recovery System (MACRS) specifies a recovery period of 39 years, even if the ground lease is for a longer term.

Tax Implications of Selling or Transferring Interests

The tax consequences for the lessor and lessee extend to the sale of their respective interests before the lease term ends. These transactions are treated as the sale of distinct property assets, and the tax treatment is based on the specific interest being sold.

Sale by the Lessee

When a tenant sells their rights under a ground lease, they sell a “leasehold interest,” which includes ownership of the building and the right to use the land. This interest is classified as Section 1231 property. If this asset is held for more than one year, a gain from its sale is treated as a long-term capital gain, while a loss is an ordinary loss. However, any gain from previous depreciation deductions may be taxed at higher ordinary income rates due to recapture rules.

Sale by the Lessor

When the landowner sells their interest, they sell the “leased fee estate,” which is their ownership of the land subject to the lease. This is treated as the sale of a capital asset. The gain or loss is calculated by subtracting the landowner’s adjusted basis in the land from the sale price, resulting in a long-term capital gain or loss if held for more than one year.

Both the lessee’s leasehold interest and the lessor’s leased fee estate may qualify for a tax-deferred exchange under IRC Section 1031. This allows an investor to sell their interest and reinvest the proceeds into a “like-kind” property, deferring capital gains. For a leasehold interest to be considered like-kind to an ownership interest, the lease must have 30 or more years remaining, including optional renewal periods.