Part of the 1031 XChange Index - Originally Published 10/1/2007 at STEC
In a real property exchange, can proceeds from the relinquished property sale be used to acquire replacement property and improvements thereon? Yes. This type of exchange often falls under the moniker of construction exchange, improvement exchange or more commonly known as a build to suit (BTS) exchange.
While highly complex, the BTS exchange provides the taxpayer exchanger an opportunity to invest his or her exchange funds into replacement property and improvements thereon. This exchange structure can be attained through a forward or reverse exchange, allowing taxpayers the benefit of this tax deferral strategy while providing more flexibility to either renovate an existing improved property or construct new improvements on raw land. The delayed build-to-suit exchange begins when the taxpayer exchanger sells his/her relinquished property and acquires the identified replacement property, only after it has been improved, with the proceeds from the sale of the relinquished property.
Under the safe harbors noted in Revenue Procedure 2000-37, the entity created to hold title to the replacement property, during the exchange period, is referred to as the Exchange Accommodation Titleholder (EAT). The replacement property is parked with the EAT during the exchange period and while improvements are made. The EAT will typically be a special purpose entity like an LLC. The Qualified Exchange Accommodation Agreement (QEAA), the contractual agreement between exchange parties, will be created between the taxpayer exchanger, the EAT and the Qualified Intermediary.
The QEAA will allow the EAT to use exchange proceeds to acquire the replacement property and make any identified improvements made thereon. Typically, the contractor will arrange for the construction contract to spell out the construction details to take place during the exchange period. The EAT is party to the construction contract as the entity with qualified indicia of ownership of the property being improved. The QEAA also provides for the taxpayer exchanger to act as project manager to oversee all aspects of the construction during the exchange period. The taxpayer will approve and confirm improvements have been made to the real property and submit approved invoices for payment to the EAT. In the event the taxpayer exchanger secures a construction loan from a lender, the taxpayer or his/her counsel should clearly communicate the details of the exchange to the lender. The lender must be aware of the EAT holding title to the collateral property.
During the exchange, there may be many fees and disbursements that need to be monitored carefully by the EAT and QI. Most build-to-suit exchanges are burdened with architect's fees, permit fees, demolition expenses, debris removal, etc., all before any improvements are actually constructed. Without payment of those fees, the project would not get underway. It is crucial to remember, however, that even if it is permissible to disburse proceeds (either sale or loan proceeds) for these expenses, the expenditures themselves pre-construction do not improve the fair market value of the property. Taxpayers would be well cautioned to remember that even if they use all of their exchange proceeds during the 180-day construction period, the IRS may not view the exchange as one in which proceeds can be fully deferred if the fair market value of the replacement property does not exceed the fair market value of the relinquished property. An exchange that is fee-heavy on non-construction items may not yield the value expected, and needed, by the taxpayer.
Upon the earlier of the 180-day exchange period or construction project completion, the EAT conveys the deed to the replacement property, with improvements, to the taxpayer exchanger to complete the exchange. Any construction to be included in the exchange must be affixed to the real property prior to the replacement property being conveyed from the EAT to the taxpayer exchanger. It is important to note that any improvements made to the replacement property after the deed to the replacement property is transferred to the taxpayer will not be considered like kind to property sold in the exchange. Similarly, sale proceeds remaining after the replacement property is conveyed to the taxpayer will be treated as taxable boot.
The BTS exchange can also be facilitated when the taxpayer exchanger must acquire the replacement property to be improved prior to selling his/her relinquished property. This is a reverse BTS exchange. In a reverse BTS, the taxpayer's relinquished property does not close until later in the exchange period. In this structure, there are no exchange funds to draw from, so typically a lender will provide the funds to the EAT to acquire and improve the replacement property.
While the EAT takes title to the replacement property, the taxpayer exchanger must still appropriately identify the replacement property, including any improvements, he or she will take title to at the conclusion of the exchange. This identification must be submitted in writing, no later than midnight of the 45th day from the first closing, to a party not associated with the exchange, most commonly to the Qualified Intermediary. If the BTS exchange is conducted as a reverse build-to-suit, the relinquished property identification rules apply.
It is always wise to seek tax counsel before applying for any type of tax relief, particularly a BTS exchange. So many variables can affect this structure (weather, construction delays, permits, subcontractors, compliance issues, etc). The tax code provides only 180 days from closing on the relinquished property to acquire the replacement property. While there is great risk in whether that can be accomplished, not all improvements must be completed within the 180 day period. The challenge is to ensure the taxpayer takes title to property substantially similar to what is formally identified.
One of the best ways to accomplish the taxpayer's goal in this process is to ensure all parties involved have a clear understanding of the taxpayer's intent. The taxpayer, taxpayer's legal counsel, taxpayer's tax counsel, general contractor and QI should all have a clear understanding of the roles, responsibilities and timeframes involved in this process. Communication and education on the front end will help prove less complication and frustration on the back end.