Like so many other Americans, I enjoy watching a bit of television every now and then. Recently, I watched a show about couples searching for their dream home. In the program, the couples would look at several different properties and then jointly decide which one best fit their needs and wants.
Being in real estate investment, I naturally tied this to what I do for a living, and I got to thinking about how a person who is involved in a section 1031 exchange could acquire a new property that met their specific needs. As it turns out, taxpayers can engage in “build-to-suit” 1031 exchanges, which allow for the replacement property of the transaction to be either improved upon or newly constructed. You can use build-to-suit 1031 exchanges to “customize” your replacement property and receive something that fits your needs entirely.
Suppose you find a location you think would be perfect for a particular business or rental property, but the location is currently vacant. You could conduct a build-to-suit exchange by contacting the owner of the land and having the physical building desired by you constructed on that land. This would be an entirely legitimate build-to-suit 1031 exchange: The rules allow for a property to be constructed specifically for the purpose of being used as part of a 1031 exchange.
Like reverse section 1031 exchanges, build-to-suit exchanges can be considered a variation on the standard 1031 transaction. And, as is the case with reverse exchanges, there are several important subtleties about build-to-suit exchanges that you and other investors should be aware of. It’s also strongly advised that you partner with a qualified real estate investment management firm that can help guide you through the process and maximize your whole experience.
Let’s discuss some of the unique requirements of a build-to-suit exchange.
Firm Identification of the Future Replacement Property Is Required
One of the main things to know when you’re involved in a build-to-suit exchange is that you must provide a written notice (to your qualified intermediary initially, and then to the IRS on form 8824) that clearly identifies the property that will be either improved upon or newly constructed. This is also done in traditional exchanges, but the process differs in build-to-suit exchanges in one important respect.
When you provide your written identification in build-to-suit transactions, you have to make sure that your description accurately encompasses whatever will be included in the construction process. If your replacement property differs substantially from the property described in your written identification, you run the risk of losing section 1031 treatment.
Construction Must Be Completed Within the Standard 180-Day Time Window
Though it may seem harsh to you and other investors, build-to-suit exchanges are governed by the same 180-day time limit that applies to standard 1031 exchanges. This is true even despite the fact that build-to-suit exchanges clearly involve challenges that aren’t present in standard transactions.
What this means is that all improvements, alterations, and developments made to the replacement property must be completed prior to the completion of the exchange. In other words, you cannot take possession of the new property and then continue to make improvements beyond the 180-day time window. If you do continue to make improvements, these improvements will be considered personal property and will not fall within section 1031, meaning the improvements can’t be claimed as part of the 1031 transaction.
While this rule might seem tough, remember that the law could easily rationalize the exclusion of build-to-suit exchanges. Lawmakers could argue that exchanging a fully constructed property for a property not yet fully constructed is not a genuine “like-kind” transfer of property, and so the fact that a build-to-suit exchange is permitted at all is in some sense a clear victory for you.
Build-to-Suit Exchanges Cannot Occur on Land Owned by the Taxpayer
The other key point to remember is that you cannot conduct a build-to-suit exchange on land that you already own. Because the core of section 1031 is about the exchange of interest in like-kind real estate, if you intend to exchange your property for property constructed on your own land, such a transaction cannot be said to involve a true “transfer” of interest.
For your build-to-suit exchange to qualify for non-recognition of capital gains under section 1031, your replacement property needs to be constructed on land that is not owned by you. The land must be owned by someone else for a true transfer of interest to take place.
There is one way that you might be able to conduct a build-to-suit exchange involving your own land. You could convey the land temporarily to the contractor or other qualified entity and then have the land deeded back to you when the construction of the replacement property is finished. However, this arrangement is not without considerable risk, as the IRS could very easily impugn such an exchange as a “step transaction,” and you might end up failing to qualify for section 1031.
A step transaction is an exchange that involves numerous steps but is categorized as a single, continuous transaction by the IRS. It is possible that the IRS could argue that such an exchange was actually a single sale that simply involved multiple steps. This would trigger tax consequences, and so deeding your land temporarily for this purpose is a risky thing.
This is just an overview of some of the subtleties related to build-to-suit 1031 exchanges. Whether a given build-to-suit exchange will go through without a hitch is always dependent on the particular facts of the case. CWS Capital Partners has years of experience partnering with investors on 1031 exchanges and in developing new investment properties—luxury apartment complexes are our specialty. We can answer questions about your particular situation and help ensure your transaction goes smoothly.
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The information provided here is for your general informational purposes only. It should not be considered a recommendation or personalized advisory advice. CWS has made this third party information available from authors it believes are knowledgeable and reliable resources. However, its accuracy or completeness cannot be guaranteed and sentiment may change due to legal or economic conditions.
All investments involve risk including the possible loss of principal. You should familiarize yourself with all risks associated with any investment product before investing.
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