Construction 1031 Exchange

Construction 1031 Exchange2019-08-28T10:31:03-06:00

Construction 1031 Exchange
-aka “Build-to-Suit” or “Improvement”-

 

For most investors, it is challenging (and expensive) to build a new structure or make improvements within a 1031 exchange.

You know what else?

1031 companies find it challenging too. In fact, most avoid construction exchanges altogether.

So we created this guide to help navigate 1031 construction rules.

Table Of Contents:
Why Is It Difficult to Improve or Build Within a 1031?
Construction 1031 Exchanges Step-by-Step
Common Questions
How Do I Set Up an EAT?
The 180-Day Rule for a Construction Exchange
The “Reverse” Construction Exchange
What Happens When a Construction Exchange Fails?

A quick word:
Construction exchanges are not always the best solution. Our company is very good at thinking through cheaper, better options for our clients. Tell us about your circumstances. There’s a good chance we can help.

 

Why is it difficult to improve or build within a 1031?

A “construction 1031 exchange” (also called “build-to-suit” or “improvements exchange”) is not technically a different kind of exchange. In fact, the IRS specifically prohibits using 1031 proceeds to directly pay for repairs, maintenance, or new construction.

Over time, however, clever investors figured out how to make improvements to replacement properties without directly violating the rules. Eventually, the IRS recognized these strategies and now offers guidance on how to execute them safely.

Here is the short version:

If you want to build or improve your replacement property then it must be purchased and held, temporarily, by a holding company known as an Exchange Accommodation Titleholder (EAT). The EAT’s job is to capture the property for you and allow time for improvements before you officially take title.

The EAT stays on title during the building period. When that is over, you can perform a standard exchange into the newly improved property. But this is easier said than done.

(A construction exchange strategy is similar to an “exchange later” reverse exchange, if you’ve ever dealt with those.)

Construction 1031 exchanges: Step-by-step

We distilled the construction exchange process into these six steps.

That said, our decades of experience tell us that every single construction exchange will feel and look unique. Every deal has its own particular flavor and challenges.

  1. Contact our office
    Tell us about the replacement property you want to construct/improve as part of a 1031 exchange.
  2. Get an assignable contract
    You and the replacement property seller agree on a purchase agreement for the replacement property. Make sure that the PSA is assignable.
  3. Assign the purchase agreement to a third-party LLC
    This LLC is known as an Exchange Accommodation Titleholder, or “EAT.” We will help set up the EAT. You arrange financing so the EAT may buy the property.
  4. Closing occurs
    Title for the replacement property transfers to the EAT.
  5. The EAT names you “construction manager”
    You oversee the improvements (work with contractors, inspect work, collect invoices, etc). Funds for construction are drawn, at your direction, from the exchange account. The EAT makes the payments.
  6. EAT transfers title to you
    Once the construction is complete or the 180-day exchange period is over, whichever is first, the EAT transfers title of the property to you. The exchange is finished.

Important tips and reminders

    • You might hear a construction exchange called  an “improvement exchange” or a “build-to-suit exchange”.
    • In Rev, Proc. 2000-36, the IRS set forth the procedures to safely accomplish construction 1031 exchanges.
    • You must trade equal or up in equity and net sales price to have a completely tax-deferred exchange.
    • The construction on the replacement property must comply with the building provisions outlined in the purchase contract.
    • You can use the contractor of your choice — so long as the contractor is are not a “disqualified” person under the regulations.
    • Improvements must be part of the standing structure. If a contractor delivers building materials to the replacement property, this alone does not qualify as improved real property until it is part of the standing structure.

Common questions about construction exchanges

Dear 1031x.com,
I have two questions:
1) How do we account for improvements to the property? What is included/excluded? What records do we need.
2) If we decide to live in the property for two years, we understand that you only need to be there one half each year. Is this correct?

Our answer,
Improvements fall into one of two categories:

  1. Repairs
  2. Capital improvements.

Repairs are minor and are deductible expenses of operating investment property in the year they are incurred. Capital improvements are more major and are not deducted in the year incurred; instead their cost is added to your tax basis. Therefore, capital improvements increase your annual depreciation allowance, and decrease your gain, if and when you sell. Sometimes the distinction between a repair and a capital improvement is difficult to make.

In answer to your second question: In order to qualify for tax exemption under IRC section 121, you must live in and own the property for two years. You can only have one principal residence at a time. Usually, your principal residence is the place where you spend the majority of your overnights. So, yes, if your spend at least 50% of your night at your principal residence and otherwise treat it as your principal residence you will qualify under 121.

Dear 1031x.com,
We are selling our house in California that has been used as a rental for the last 6 years.
Our net gain after improvements less depreciation is $315,000.
We now live in a mid-western state, and we want to do 1031 exchange purchasing several replacement properties close to where we live.
Can we do a construction exchange?
And use part of the money to repair these houses? Or, do we need to take cash out to do the repairs? If we take cash out do we pay cap gains to the (government)?

Our answer,
In a construction 1031 exchange, we set up a holding company. This holding company takes title to replacement property and issues checks for improvements at your instruction. After all exchange proceeds are used, the title is transferred to the client, completing the exchange.

For most clients with relatively small deals (less $1,000,000), construction exchanges can be too expensive or complicated. A client with low- or no-debt property might instead look to borrow  money (loan proceeds are tax-free) and a 1031 exchange at the same time. Such a client might be able to liberate the cash needed to do repairs without undue hassle or expense.

How do I set up an EAT? How does it buy the replacement property?

Confused about the Exchange Accommodation Titleholder (EAT)?

You’re not alone.

Indeed, you are unlikely to hear or read those words in any other context. The EAT only exists to help you (and us) navigate a construction exchange without breaking IRS’ rules.  Thankfully, an EAT is much simpler than it sounds.

EATs are LLCs. They have no assets, no real management structure, and only one legitimate function: to purchase and hold your replacement property until you’re ready to take title.

We break it down here.

  1. We set up the EAT
    Our office will work with your state government to create a brand new LLC. You can’t be a member of this LLC (but you can pick the name). This LLC is your EAT.
  2. You and the EAT enter into a real estate holding contract
    The IRS calls this a “Qualified Exchange Accommodation Arrangement” (QEAA). The QEAA outlines the obligations of the EAT to you (and vice versa) during the holding period.
  3. You arrange financing for the EAT
    Our LLC will purchase the replacement property by borrowing 100 percent of the needed funds. We can borrow the funds from any source that you authorize. (It’s easiest and cheapest to borrow money directly from you.) The lender is protected by a note and deed of trust on the replacement property. Finding a lender for a construction exchange can be difficult. Please contact us is you need help finding a lender.
  4. The EAT buys the replacement property
    Remember, your PSA must be assignable to an LLC.
  5. EAT leases property to you
    Our LLC will also lease the replacement property to you during the construction period, or for 180 days, whichever ends first. During this time, you actively manage the improvements to the replacement property and direct payments to contractors trough the EAT.
  6. You finish your 1031x
    At the time of the sale of the relinquished property, 1031x.com, Inc. acts as Qualified Intermediary and escrows your sale proceeds. When ready, our EAT will contract to sell the replacement property to you. Your relinquished proceeds will be a down payment on that closing.

The 180-day rule for a construction exchange

To stay within the safest possible guidelines, you have 180 days to start and complete a construction 1031 exchange.

The holding company we set up will lease the replacement property to you once the construction ends, or for 180 days, whichever occurs first. So it is very important to get started on the improvements right away.

You can instead extend the 180-day exchange period with a “reverse” construction exchange, but this should be done cautiously.

Please speak with a 1031x.com exchange coordinator before attempting this.

With this option, you delay the transfer of the relinquished property to allow more time for construction. You must still close within 180 days from the sale of the relinquished property.

Real-life example

Take a look at this question from a past client

May I sell a relinquished property for about $13M and use the funds to buy replacement property (including land) for $3.5M?
Then use the remaining $9.5M to build improvements thereon as part of a valid 1031 exchange?
I am also willing to deposit or prepay the general contractor the full $9.5M within 180 days after the sale of the relinquished property.

This client raised several issues.

We told the client not to expect tax-deferred treatment for the transaction as he proposed. See our reasoning below and, at the end, our suggestion to the client for creating a tax-compliant exchange.

  1. Not like-kind.
    Improvements made to replacement property after the taxpayer takes title are not considered “like kind” property. The client would pay taxes as “boot” received as if they were unused exchange proceeds. [Treas. Reg. 1-.1031(k)-1(e)] To qualify for inclusion in the exchange, any improvements to the property must occur before taking title. [Bloomington Coca Cola Bottling Co. v. Commissioner, 189 F2d 14.]
  2. No holding company (EAT).
    Rev. Proc. 2000-37 provides a “safe harbor” for structuring construction exchanges. The client must use a holding company to buy and hold the replacement property during construction. The client may not own the holding company; that said, the client could act as construction manager to exercise effective control over the project.
  3. 180-day rule.
    The standard rules of all 1031 exchanges apply to this kind of exchange. Therefore, the taxpayer must acquire title to the replacement property from the holding company within 180 days after transfer of the relinquished property. In this case while the LAND would be titled to the taxpayer within 180 days, the to be built improvements would not be completed within 180 days and to the extent they were not completed within 180 days, the uncompleted portion of the project would be treated as unused exchange proceeds even if those excess funds were advanced to the General Contractor.

This strategy clearly wouldn’t work. So what did we suggest?

  • Rather than sell the relinquished property and use the funds to buy and build, the client should use the relinquished property as additional collateral for a construction loan on the replacement property.
  • The replacement property would be held in a holding company, not owned by the taxpayer, during construction. (Paragraph 2 above)
  • When the replacement property is within 180 days of completion, sell the relinquished property. Apply the $13 million in proceeds to the construction loan.
  • Upon completion of the replacement property — and within 180 days of the sale of the relinquished property — the replacement property would be transferred to the taxpayer by the holding company.

Note: This was not a perfect solution. Maybe the client had a buyer ready for the relinquished property lined up. The client faced additional financing costs. It does not cleanly stay within 180 days of the purchase of the replacement property. Even so, this is an example of the kind of creative solution that construction deals sometimes demand.

The “reverse” improvement exchange

Remember, a reverse exchange means that the replacement property closes before the relinquished property. It’s possible to execute a reverse with or without a construction component, but the difficulty goes up with construction.

Reverse exchanges present two main challenges (one practical, one legal).

First, financing can be difficult. The EAT needs someone to loan it enough money to buy the property and then pay for improvements. When you close on the replacement property first, you can’t use your 1031 sale proceeds for a possible loan. So the money has to come from somewhere else.

Second, most reverse construction 1031 exchanges struggle to close within 180 days after the EAT takes title to the replacement property. The longer your exchange extends past that deadline, the less the IRS will like your deal.

What happens if my construction exchange fails?

This is not something that occurs often with our clients, however it is important to know what happens when a construction exchange doesn’t work out.

Our real estate holding agreement states that we will transfer property held by our EAT to you at the end of 180 days (this may be different in a reverse construction exchange). There is no tax penalty for failing a construction exchange; you simply end up owning replacement property with its new improvements.

 

How can we help you?
Click
here to contact a 1031 exchange specialist
or call (303) 504-0144 for immediate help

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You may also need

1031 exchange strategies 

1031 tax calculator 

Frequently asked questions