Adding Improvements To Your IRC §1031 Exchange: The Delayed Build-To-Suit Exchange

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August 16, 2013
Author: , Esq.

Rome wasn’t built in a day, and your construction in a delayed build-to-suit IRC §1031 exchange does not have to be completed in a day either. In fact, the good news is that the improvements are not required to be completed when your exchange must end after 180 days either. The bad news, however, is that the value of your replacement property will be determined by the value of the real estate – both the land value plus the value of the improvements made – at the time the property is transferred from an entity known as an Exchange Accommodation Titleholder (“EAT”) to the Exchanger. This article will outline some of the basic concepts for the delayed build-to-suit exchange and help you avoid common pitfalls that many exchangers encounter.

It is essential to plan ahead to achieve a delayed build-to-suit exchange that fully-defers the tax hit that comes with a regular sale of real estate. One reason to plan ahead was mentioned in the preceding paragraph: you will only be credited with the value of the real estate improvements (plus the original land value) that are completed by the end of the exchange period. You have a maximum of 180 days to get the bulldozers in gear and get as much done as possible. In the ideal exchange when the timing of construction will be difficult, the Exchanger closes on the relinquished property and the EAT takes title to the replacement property at about the same time such that all or most of the 180 days may be used for construction.

The construction may be renovation of an existing improved property, or the construction may be new improvements on raw land. The same rules from a standard delayed exchange also apply to a build-to-suit exchange – including the requirement to identify the property to be acquired within 45 days from the date of the sale of the relinquished property. Unlike in the standard delayed exchange, the identification process in a build-to-suit exchange is not complete with a mere address or legal description. The identification rules are satisfied by the Exchanger “if a legal description is provided for the underlying land and as much detail is provided regarding the construction of the improvements as is practicable at the time the identification is made.” Treasury Regulations §1.1031(k)-1(e)(2).

In a typical build-to-suit exchange, the EAT will form a disregarded special purpose entity (the “Holding Entity”) to take title to the replacement property. The Exchanger, EAT and the Holding Entity enter into a “Qualified Exchange Accommodation Agreement” (“QEAA”) to express the contractual relationship among the parties. The Exchanger assigns the rights in the purchase contract to the Holding Entity. Either the Exchanger or its representative is retained by the Holding Entity to manage the construction project. Construction draws may be paid from the funds in the exchange account. Either at the earlier of the end of the 180 day exchange period or the end of the construction, the Holding Entity will transfer the property to the Exchanger and the exchange is completed.

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Don’t play games with the valuation of the property: the tax rules specifically prohibit increasing the exchange value by including prepaid, but not completed, construction services or materials. Only the value of real estate – as defined by state law – that is in place at the time the exchange is completed by the taxpayer taking title can be included in the balancing of the exchange. Additionally, any improvements made to the property after the transfer to the Exchanger will add to the tax basis of the property but do not count in determining if the tax exposure has been deferred under the exchange. The improvements must occur prior to the time the Exchanger takes title. Bloomington Coca Cola Bottling Co. v. Commissioner, 189 F.2d 14 (CA7 1951)

Both Bloomington and DeCleene v. Commissioner, 115 T.C. No. 34 (2000), provide the authority that Exchangers may not complete a build-to-suit exchange where the construction takes place on land owned by the Exchanger. Revenue Procedure 2004-51 states that the “safe harbor” protection dictated in Revenue Procedure 2000-37 “does not apply to replacement property held in a QEAA if the property is owned by the taxpayer within the 180-day period ending on the date of transfer of qualified indicia of ownership of the property to an exchange accommodation titleholder” (Rev. Proc. 2004-51, Section 4).

If the Exchanger plans to obtain a construction loan, it is essential that the lender be involved in the exchange planning process. The loan will be made to the Holding Entity, and the Holding Entity will sign the promissory note and mortgage. Obviously, the Holding Entity will insist on a non-recourse loan. The lender will typically require the Exchanger to also sign the note or a separate guarantee document. When the exchange ends, the Exchanger assumes the loan.

The Holding Entity faces many risks by subjecting itself to the chain of title during the exchange. Therefore, the Exchanger should expect to provide hazard and commercial general liability insurance, an updated Phase I Environmental Assessment Report, and an indemnity to cover the Holding entity. Additionally, because of the need to place the Holding Entity in title to the property, the Exchanger should be aware of the possibility in some jurisdictions for transfer taxes and assessments that must be paid both when the replacement property seller deeds the property to the Holding Entity as well as when the Holding Entity deeds the property to the Exchanger.

A quick review:

  • PLAN AHEAD: Have your exchange organized so that as much construction time as possible is available. Don’t wait until the last minute to make arrangements with your Qualified Intermediary and your lender.
  • IDENTIFY the improvements to be made to the replacement property as well as the address or legal description.
  • CONSTRUCTION DRAWS from the exchange account are permitted.
  • EXPECT ADDITIONAL COSTS from the lender, your advisors (attorneys and accountants), and the Qualified Intermediary.

With these ideas in mind, build-to-suit exchanges can be a creative and valuable tool to defer taxes. Plan ahead and enjoy this great benefit of the tax code.

Greg D. Smith, Esq. is an Assistant Vice President for Investment Property Exchange Services, Inc., the country’s largest Qualified Intermediary and full-service Exchange Accommodation Titleholder. Greg can be reached at (866) 443-1031 to answer questions about this article or any exchange topic.

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