Construction 1031 Exchanges

How To Do a Construction 1031 Exchange

A brief overview of the process of a construction 1031 exchange

  1. 1. Exchanger informs us of his intention to construct a building as his replacement property.

  2. 2. Exchanger and seller agree on a purchase agreement for the purchase of the lot for the building.

  3. 3. Exchanger assigns the purchase agreement to a EAT, such as 1031x.com to hold the title to this property.

  4. 4. Closing occurs and title for the lot is transferred to the EAT.

  5. 5. The exchanger directs the construction of the building (or works with a contractor). Funds for construction are drawn from the exchange account at the direction of the exchanger and are paid by the EAT.

  6. 6. Once either the construction is complete or the 180-day exchange period is over, the title is transferred from the EAT to the exchanger and the exchange is finished.


It is so important for our clients to understand all types of 1031 exchanges so they can make an informed decision on their real estate. In a construction exchange, the exchanger has found, and wants to buy, the replacement property before improvements required to meet or exceed the value of the relinquished property have been constructed. Another term you might hear construction exchanges being called is “improvement exchange”. In 2000 in Rev, Proc. 2000-36 the IRS set forth the procedures to safely accomplish what may be termed a construction 1031 exchanges. The exchanger must trade across or up in equity and debt to have a completely tax deferred transaction. If the exchanger’s property goes down in value when acquiring the replacement property, they will have a tax liability. Once the exchanger makes the improvements to the replacement property, the exchanger can then defer the tax liability. The construction on the replacement property is completed in agreement with the building provisions outlined in the purchase contract. The exchanger can use the contractor of their choice as long as they are not a “disqualified” person under the regulations.

The holding company leases the replacement property to the exchanger during the construction period, or for 180 days, whichever occurs first. The only way a 180-day exchange period could be extended is by delaying the transfer of the relinquished property. This would give some time for construction to begin on the replacement property. In a construction exchange, after the 180-day exchange period, if the property that is getting improvements is not part of the standing structure, it may not be considered real property by law. So, it is very important to get started on the improvements right away when doing a construction exchange. For example, if a contractor has a lot of building materials delivered to the replacement property, this will not qualify as improved real property until it is part of the standing structure. Only then will it be considered real property.

"The exchanger must trade across or up in equity and debt to have a completely tax deferred transaction."

Common questions from clients 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?

Dear B,
Improvements fall into one of two catagories: 1) repairs, or 2) capital improvments. Repairs are minor and are dedcutible 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 imrpovement is difficult to make. In answer to your second question, in order to qualify for tax exemptioon 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. I hope this helps

Steps of a Construction Exchange

In a construction 1031 exchange, the exchanger cannot improve upon a property that he/she already owns. Therefore, either the replacement property must be held, temporarily, by a holding company known as an Exchange Accommodation Titleholder (EAT). Construction exchanges are similar to reverse exchanges, where the exchanger cannot hold title to both the relinquished property and the replacement property at the same time and must use an EAT

When the replacement property is to be held by the EAT the procedure which we follow is:

  1. At the time of the sale of the relinquished property, 1031x.com, Inc. will act as Qualified Intermediary for the exchanger and escrow the funds from the sale of the relinquished property. Net proceeds from the sale of the relinquished property will be used to buy replacement property and for improvements to this property.

  2. Our Limited Liability Company buys the replacement property. The LLC will act in the capacity of an “Exchange Accommodation Titleholder” (EAT) as that term is defined by the IRS. The EAT and the exchanger will enter into a real estate holding contract termed by the IRS a “Qualified Exchange Accommodation Arrangement” (QEAA). The QEAA will outline the obligations of the EAT and the exchanger during the real estate holding period.

  3. Our LLC will purchase the replacement property by borrowing 100 percent of the needed funds. We can borrow the funds from any source authorized by the exchanger. The easiest source of borrowed funds in the exchanger themselves. However, we can borrow from any source. 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. Our LLC will also lease the replacement property to the exchanger during the construction period, or for 180 days, whichever occurs first. Lease payments from the exchanger to Our LLC will correspond in amount to mortgage payments made by Our LLC.

  5. Our, LLC will also agree to re-sell the replacement property to the Exchanger closing to occur no later than 180 days after Our, LLC acquires the replacement property. The 180-day time limit for completing a construction 1031 exchange is set by the IRS.

  6. The exchanger actively manages the improvements to the replacement property. At the time, the improvements meet or exceed the value of the exchanger’s relinquished property, 1031x.com, Inc. will act as Qualified Intermediary for the exchanger and escrow the funds from the sale of the relinquished property. Net proceeds from the sale of the relinquished property will be used to buy replacement property, from Our LLC. THE NET EFFECT OF THIS WILL BE SIMPLY TO SHIFT ALL EQUITY FROM THE RELINQUISHED PROPERTY TO THE REPLACEMENT PROPERTY. In the end, this looks very much like a forward exchange with us having captured and held the replacement property.

Defer your taxes with a 1031 exchange

We can answer your questions about construction exchanges.
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About the 180 Day Rule in Construction Exchanges

ISSUE

You pose the following hypothetical to me: May a taxpayer sell a relinquished property for about $13M and use the funds to buy replacement property including land for $3.5M and use the remaining $9.5M to build improvements thereon as part of a valid 1031 exchange? The client is also willing to deposit or prepay the general contractor the full $9.5M within 180 days after the sale of the relinquished property.

ANALYSIS

  1. Improvements made to replacement property after the taxpayer takes title are “goods and services” and are not considered “like kind” property and will be taxed as “boot” received like 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 the taxpayer takes title. Bloomington Coca Cola Bottling Co. v. Commissioner, 189 F2d 14.

  2. Rev. Proc. 2000-37 provides a “safe harbor” for structuring build to suit exchanges by using a holding company to buy and hold the replacement property during construction. While the taxpayer may not own the holding company the taxpayer may act as construction manage on the project exercising effective control over the project.

  3. However, 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.

CONCLUSION

The taxpayer may not expect tax deferred treatment if the transaction is structured as outlined above.

SUGGETIONS

The taxpayer, instead of selling the relinquished property and using the funds to buy and build, could 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 the relinquished property could be sold and the proceeds applied 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. I know this is not a perfect solution because there is a buyer for the relinquished property now, and additional financing costs are involved.

Use our tool to calculate your 45th / 180th day for free and add it to your personal calendar!

Common questions from clients about construction exchanges

Dear 1031,
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 are now living 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 FED?

Dear A,
A construction 1031 exchange is deal where the accommodator takes title to replacement property and issues checks for improvements at the instruction of the client. After all exchange proceeds are used, the title is transferred to the client, completing the exchange.

Many clients think that they need to do a construction exchange to accomplish their goals of tax deferral. For most clients with relatively small deals (less $1,000,000), construction exchanges are very expensive and complicated. If a client who has property that is not heavily burdened by debt, a better solution for them would be to, do a date of closing loan to get money out of their deal tax-free and a 1031 exchange at the same time. We charge 1% or $500 whichever is larger, for this service. This allows the client to liberate the cash needed to do repairs and upgrades on the replacement property and satisfy the constraints of their exchange. Please, contact us if you need more information and guidance regarding your transaction.

Example of a reverse improvement exchange

Below is a example summary of a reverse 1031 improvement exchange in Minnesota.

  1. 1. In a reverse 1031x the taxpayer wants to buy their replacement property before they sell their relinquished property.

  2. 2. But the IRS says that the taxpayer may not own both properties at the same time. So you cannot just do what you want to do in a straight forward way.

  3. 3. The procedures, approved by the IRS, (Rev, Proc. 2000-37) are for an independent, unrelated entity be set up to hold either the relinquished property or the replacement property in order to satisfy the requirement that you not hold title to both properties at the same time. In your case we will set up a single purpose LLC formed in the State of Minnesota. The operating agreement for this new LLC can conform to the lending requirements of the REO Bank.

  4. 4. In the more common reverse 1031x, our holding company buys the replacement property (captures it for you) and holds it for you until you sell the relinquished property.

  5. 5. During our holding period, you can act as a construction manager and authorize improvements to the property. However, invoices need to be submitted to our company for payment.

  6. 6. The relinquished property is in Minnesota. Its value is about $200K. There is no mortgage on this property.

  7. 7. The replacement property is in Minnesota. Its value is about $300k. You have arranged for a down payment on the replacement property of about $100K with the balance financed by the REO lender. You also plan to make an additional $100K in improvements to the property during our holding period.

  8. 8. You lend our holding company $100K which we use to buy the replacement property. You have a note and deed of trust on the replacement property that shows that you loaned us the money and it will need to be repaid to you when the relinquished property sells. During the improvement phase you lend our holding company the funds necessary to make the additional $100K in improvements.

  9. 9. The REO Bank lends our holding company the additional $200K for the purchase. This loan is personally guaranteed by you.

  10. 10. You list and sell the relinquished property.

  11. 11. When the relinquished property sells the $200K flows through a 1031x account and becomes the repayment of the loan that you made to us to buy and improve the replacement property.

  12. 12. The net effect of the transaction is to transfer your equity in the relinquished property into the replacement property. Our fee for handling this transaction will be $2,500 plus $50.00 per disbursement from the construction/improvement account.

What happens when a 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 fails. Our real estate holding agreement states that we will transfer whatever property we are holding to you at the end of 180 days. You end up owning replacement property with its new improvements. If the total value of the property does not meet or exceed the value of the relinquished property, you will need to pay taxes on the difference up to the amount of your total capital gains.

Defer your taxes with a 1031 exchange

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