Transferable Development Rights and 1031 Exchanges: Understanding How They Work Together
In real estate, value isn’t always tied solely to the land or the structures on it—it can also lie in the right to develop that property. Known as Development Rights, these rights determine how much, how high, or how densely a property can be built, as regulated by local or state zoning laws.
In certain jurisdictions, these rights can be transferred from one property to another through a system known as Transferable Development Rights (TDRs). This opens the door for creative planning and, in some cases, tax-deferral opportunities under a 1031 Exchange.
Let’s explore what TDRs are, how they function, and when they may qualify as either relinquished or replacement property in a 1031 Exchange.
What Are Transferable Development Rights (TDRs)?
Transferable Development Rights allow a property owner to transfer unused development potential from one parcel of land (the “sending” property) to another parcel (the “receiving” property).
For example, if zoning laws allow a building up to 10 stories but the owner only builds 5, they may be able to sell or transfer the remaining 5 stories of unused development rights to another property in an area designated to receive additional density.
TDR Programs typically serve two main purposes:
Preservation: Protect open space, agricultural land, or historic sites by compensating owners for unused development potential.
Smart Growth: Encourage higher-density development in urban or transit-oriented areas.
By separating the development right from the underlying land, municipalities give property owners a flexible tool to manage growth while preserving community balance.
TDRs as Property Interests
For tax purposes, the key question is whether Transferable Development Rights qualify as real property under IRS rules.
Historically, the IRS and courts have treated TDRs as interests in real property—provided they are recognized under state or local law as such. Because TDRs are typically inseparable from zoning and land-use regulations, they are generally considered real property rights, not personal property.
This classification is crucial because only real property qualifies for tax deferral under Section 1031.
Using TDRs in a 1031 Exchange
If TDRs are recognized as real property under applicable law, they can be exchanged under Section 1031, either as:
Relinquished Property: When selling or transferring development rights, the proceeds can be reinvested in other qualifying real estate or real property interests.
Replacement Property: When purchasing development rights to enhance or expand the development potential of another parcel.
Example:
An investor sells TDRs from a downtown property (recognized as real property under local law) and uses the proceeds in a 1031 Exchange to acquire a replacement property in another district. As long as both assets qualify as real property interests, the exchange can meet IRS requirements.
Important IRS and Legal Considerations
Because local law plays a central role in determining whether TDRs are real property, eligibility for 1031 treatment depends on jurisdiction-specific rules and proper documentation.
The IRS has issued private letter rulings confirming that certain development rights and easements can qualify as like-kind real property—but these rulings are limited to specific facts and cannot be broadly applied.
To ensure compliance:
Verify that the TDRs are treated as real property under state or local law.
Confirm that both the relinquished and replacement properties are held for investment or business use.
Work with a Qualified Intermediary (QI) experienced in complex exchanges involving partial or intangible property interests.
The Investor’s Takeaway
Transferable Development Rights (TDRs) represent a unique intersection of zoning policy and real estate investment. When properly structured and recognized as real property, they can be exchanged under Section 1031 — offering investors the potential to defer capital gains while repositioning their portfolios for future growth.
Disclaimer
This article is for informational purposes only and does not constitute legal or tax advice. Investors should consult with a Qualified Intermediary, CPA, or tax attorney to determine whether Transferable Development Rights qualify as real property under Section 1031 and applicable state or local law.
