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Improving Your Exchange: The Use of Build-to-Suit Exchanges Under Section 1031

Allen J. Popowitz and Jason A. Rubin

AN ALTERNATE OF THIS PUBLICATION CAN ALSO BE FOUND HERE

Anyone paying attention to trends in the world of real estate transactions has surely noticed the growing frequency with which Internal Revenue Code Section 1031 exchanges have been occurring over the past decade.

A 1031 exchange allows a taxpayer to relinquish a property or properties they already own and reinvest the proceeds in another property or properties of equal or greater value without recognizing any gain on the transaction. The realized gain is deferred until the taxpayer disposes of the property in a later taxable transaction. When structured properly, 1031 exchanges can be used by real estate investors to defer gain on their property until a later tax year, or theoretically until the property is eventually passed on to their descendants.

It sounds like an easy concept; you sell property and then purchase another property and defer the taxable gain. Except, finding quality replacement property has become very difficult. All too often, taxpayers have found themselves with a buyer that is ready, willing and able to pay a premium for their property, however, the replacement properties currently available in the marketplace do not come close to the quality that the taxpayer is seeking to own and manage. It is this lack of acceptable, quality replacement properties that has led some real estate investors to utilize a rarely used form of a 1031 exchange referred to as an improvement (or build-to-suit) exchange.

An improvement exchange allows a taxpayer to improve a replacement property to their specifications before taking title. The type of improvements made to the replacement property can range from enhancements to an existing building, to the complete construction of a new building or facility from the ground up on vacant, unimproved land. Such an arrangement provides the taxpayer with a significantly wider range of potential investment opportunities; and, therefore, more flexibility when searching for a property to complete their exchange. However, as with all 1031 tax deferred exchanges, the improvement exchange does not come without its share of risks and limitations. The following sections set forth some of the steps required to complete either a forward improvement exchange or a reverse improvement exchange.

In a forward improvement exchange, the taxpayer first relinquishes a property or properties they own, and then acquires one or more replacement properties. To facilitate this exchange, the taxpayer will need to retain the services of a Qualified Intermediary. The QI will in turn form an Exchange Accommodation Titleholder for the purposes of taking title to the relinquished property.

According to the IRS, the QI must be a party other than the taxpayer, who is not a “disqualified person” (basically a related party). The EAT is an entity, typically a single purpose LLC, set up by the QI to hold title to the property during the exchange, to prevent the taxpayer from achieving any form of ownership of the replacement property. The EAT will be treated as the beneficial owner of the property for all federal and state income tax purposes. If it is determined that the taxpayer manifested any indicia of ownership of the replacement property, the 1031 exchange will fail. Once the QI has set up the EAT, and all of the agreements are in place, the taxpayer is ready to structure their 1031 exchange. The taxpayer will first negotiate a Purchase and Sale agreement with a buyer containing a clause where the buyer will agree to cooperate in the 1031 exchange, and then assign its rights under the contract to the QI. At closing, the taxpayer will transfer title to the buyer, who will in turn transfer the purchase proceeds to the QI.

This begins the exchange, and the timing provisions kick in. Beginning with the closing date on the sale of the relinquished property, the taxpayer has 45 days to identify a replacement property as well as the improvements to be made to the property. The taxpayer may identify: (i) up to three properties; (ii) any number of properties as long as the aggregate fair market value (FMV) of the properties does not exceed 200 percent of the aggregate FMV of the exchanged properties; or (iii) any number of replacement properties if the FMV of the properties received is at least 95 percent of the aggregate FMV of all the potential replacement properties identified. The identification of the improvements should also contain as much detail as possible; typically construction plans or blueprints would be appropriate.

In addition to the identification timing requirements, as with a straightforward 1031 tax-deferred exchange, the taxpayer has 180 days to take title to the replacement property and complete the exchange. Once an appropriate replacement property has been identified, the taxpayer negotiates a Purchase and Sale agreement containing a cooperation clause with the seller, and then assigns its rights under the contract to the QI. The QI pays the seller with the proceeds from the sale of the relinquished property and directs the seller to deed the property to the EAT. While the replacement property is parked with the EAT, the improvements are made. Once the improvements are complete, the EAT transfers title to the taxpayer to complete the exchange.

However, given the short period of time (180 days) to complete the improvements, in many cases a portion of the improvements are not completed by the time that title to the replacement property is required to be deeded to the taxpayer. This failure to complete all of the improvements will not affect the overall validity of the exchange. However, any improvements not completed by the date the title is transferred will not be included in the value of the replacement property for exchange purposes. By way of example, if 40 percent of the building on the replacement property is completed at the time of the transfer of title to the taxpayer, then this 40 percent shall be included as like kind replacement property and the 60 percent not completed shall not be included.

In a reverse improvement exchange, the taxpayer purchases a replacement property first, and then parks it with the EAT while the taxpayer works to sell the property to be relinquished. This type of exchange would make sense when there is pressure to close on the replacement property due to competition, or the closing on the sale of the relinquished property is delayed beyond the closing for the purchase of the replacement property.

The taxpayer begins by negotiating and signing a Purchase and Sale agreement containing a cooperation clause with the seller, and then assigns its rights under the agreement to the EAT. The taxpayer would then provide the EAT with the funds necessary for the purchase of the replacement property from the seller. Typically, in this type of exchange, the loan to the EAT would most likely come from the taxpayer directly, or in the form of seller financing, since outside institutional lending may be difficult to secure because the EAT will be holding title to the parked replacement property and, therefore, will be the borrower in connection with any such loans. In some cases, the taxpayer may have a relationship with a lender, who will allow the taxpayer to arrange for financing on behalf of the EAT by guaranteeing the loan. Once the EAT has the funds, it would transfer the funds to the seller who would transfer title to the EAT.

The taxpayer now has 45 days to identify the property to be relinquished as well as the improvements to be made to the replacement property. Additionally the taxpayer has 180 days to complete the improvements on the replacement property and cause the title to the replacement property to be transferred from the EAT. As with the forward improvement exchange, any improvements not completed by the date title to the replacement property is transferred to the taxpayer will not be included in the exchange.

The complexities and tax implications involved with the facilitation of a 1031 exchange are obvious and require thorough planning from both a tax and real estate perspective. There are numerous intricacies in terms of how to draft the exchange agreements, and the structuring of the parties which could have a serious impact on the ultimate validity of the exchange. However, if structured properly, the advantages from both an investment and tax perspective far outweigh the risks associated with improvement exchanges and make them a unique and in many cases, wise investment alternative.