When a taxpayer acquires the Replacement Property for and amount less than sale price of the Relinquished property, the trade-down amount generally is considered ‘boot’, which will be subject to capital gains tax to the extent there is gain on the Relinquished property sale.  Amounts invested for capital improvements in the Replacement property after it is acquired by the Exchanger are not included in the acquisition cost for the purpose of calculating Boot.

If the taxpayer plans to make significant improvements, repairs, or modifications to the Replacement property after it is acquired; then a Construction Exchange (also referred to as ‘Improvement’ or ‘Build-to-Suit’ Exchanges) is a sound strategy to lessen or perhaps eliminate a partial capital gains liability relating to the sale. 

The following are two examples of the applicability of a Construction Exchange:

     (i) A taxpayer sells improved real property and decides to acquire raw land, which will then be improved with the construction of a rental property, or

    (ii) A taxpayer sells improved real property and decides to acquire a neglected property which will require significant improvements before it can be rented to a business.

IRS regulations explicitly permit exchanges in which the Replacement property does not exist at the time the Relinquished property is transferred.

 

 

The Construction Exchange Process

 

Construction Exchanges can be structured either as a Forward Exchange, whereby the taxpayer first sells the Relinquished Property, then acquires the Replacement property which is then constructed or renovated; or as a Reverse Exchange, whereby the taxpayer first acquires and improves the Replacement Property, then sells the Relinquished property when the Replacement property is ready to be placed in service. 

 

The objective in a Construction Exchange is to add value to the Replacement property before it is acquired by the taxpayer to complete his or her Section 1031 Exchange. 

 

       Forward Construction Exchange:

1. The taxpayer first sells the Relinquished property to begin the exchange.  Net sale proceeds are held by Beacon Exchange Company as Qualified Intermediary ('QI'). 

 

2. A Special Purpose Entity ('SPE'), such as a nominee trust, is created that acquires the Replacement property on behalf of the taxpayer with the proceeds from the sale of the Relinquished property. 

 

3. The taxpayer must send the Identification Statement to the QI no later than 45-days following the sale of the Relinquished property.

 

4. Improvements to the Replacement property are constructed and paid for with funds held by the QI, if any, from the sale of the Relinquished property. 

 

5. The Replacement property is transferred to the taxpayer by the earlier of:

        (i) The completion of the improvements;

 

      (ii)  When the value of the Replacement value, with the improvements, equals the value of the Relinquished property; or

 

       (iii) To preserve the 1031 Exchange, 180-days after the sale of the Relinquished property.

 

       Reverse Construction Exchange:

1. The Replacement property is acquired by a Special Purpose Entity ('SPE') that will act as Accommodation Titleholder ('AT').  This begins the 180-day Exchange Period.  The taxpayer must finance this acquisition of the Replacement  property.

 

2. Construction begins on the improvements to the Replacement property.

 

3. Prior to the end of the Exchange Period, the taxpayer arranges for the sale of the Relinquished property. 

 

4. The Replacement property is transferred to the taxpayer upon the sale of the Relinquished property, provided that: 

         (i)  Construction of the improvements has been completed, or

 

      (ii)  The value of the Replacement value, with the improvements, equals or exceeds the value of the Relinquished property; or

 

       (iii) To preserve the 1031 Exchange, not later than 180-days after the AT has acquired the Replacement property.

 

Please note that only those improvements that are actually in place at the time the replacement property is transferred to the taxpayer in completion of the exchange qualify as like-kind property received in the exchange.  Pre-payment of improvements to occur after the closing do not qualify.  

 

 

Summary

 

Beacon Exchange Company is well-versed in the mechanics of exchanges involving construction improvements.  We invite you to contact us so that we can work with you and your tax advisor to structure the exchange structure that will achieve the highest possible deferral under Section 1031.