§1031 Tax Deferred Exchanges typically are used for existing investment properties. However, there is an opportunity to do a §1031 exchange into a partially built property or property to be built.
By Al DiNicola, AIF®, CEPA™
September 14, 2023
Adinicola@namcoa.com
DST 1031 Specialist
NAMCOA® – Naples Asset Management Company®, LLC
Securities offered through MSC-BD
The investor exchanger may want to invest in a new property rather than an existing property. This is permitted but there are benefits as well as pitfalls when entering into an exchange that involves construction or improvements on a property. One example, maybe an investor who has owned an older investment property that has needed consistent capital improvements and maintenance may wish to exchange into a newer construction property.
Permission Granted
IRC §1031 tax deferred exchange enables an investor to utilize proceeds from the relinquished property to acquire and make improvements in the replacement property. Technically you will take title to the replacement property after the improvements are completed. You will need the services of a Qualified Intermediary (QI) or an Exchange Accommodator. The QI will need to hold title to the property acquired and that will receive the construction improvement until the §1031 financial requirements are fulfilled.
What could go Wrong?
The 180-day closing requirement is potentially one of the biggest stumbling blocks to a construction exchange. The value of the replacement property and the improvements must meet the market value of the relinquished property by the 180-day deadline. If you are acquiring a property that is substantially completed and the construction schedule is projected well within the 180-days, you may breathe easier. Construction schedules (depending on seasonal delays as well as materials may be elongated and create a degree of concern. Many regular exchanges are challenged to identify the potential replacement properties, arrange for inspections, apply for financing and get approval, and a host of other items during the 45-days so that the replacement properties can be placed on the list submitted to the QI. Then the task for arranging the closing before the balance of 135 days goes by. The 45 days plus the 135 days equal the total of 180 days.
Construction & Improvement Exchanges Described §1031 exchanges require that all proceeds be held by the QI. If you have sold your investment property for $1,500,000 (all cash) the QI will retain those proceeds until you start your acquisition. You will identify the replacement property (within the required 45-day period) and provide instructions on disbursement of part of those funds to close on the property in the current condition.
Replacement Strategy
If there are two smaller properties that may be acquired for a total $800,000 (one property at $350,000 and one at $450,000) there would need to be a contract and a closing on each of the properties in the current condition. Replacement property (or properties) can be acquired and parked with a qualified intermediary (QI), as defined in Regs. Section 1.1031(k)-I (g)(4), or more likely, an affiliate of a QI. This is known as a Parking Arrangement. The QI will arrange to hold the title to the property while the construction improvements are completed. The home does not need to be completed at the end of the 10 days, but the improvements completed need to have a market equal to or greater than the relinquished property.
Any Danger in the Structure?
There is usually the need for a special purpose LLC that the QI will hold. This special arrangement is referenced as an Exchanging Accommodating Titleholder (EAT). The investor may be faced with entering into indemnifications against liabilities and losses, so that the parking entity would not get stuck with the property, or that the parking entity could refuse to transfer the property to the taxpayer. That would be another liability to cover.
The Clock is Ticking.
There is a total period of 180 days from when you closed on the relinquished property for the construction project to qualify for the exchange. Remember if you took the entire 45 days to identify a replacement property and then additional time to close on the property your construction period may be reduced drastically. You will have a request for funding from the QI on the improvements being made to the property. All the funds being spent need to go towards real property and not personal property. In the best case the improvements should be completed, inspected if applicable, and may need to be appraised by the 180th day for the exchange to be valid.
Maximizing the exchange
In the example above the investor is somewhat aggressive and attempting to replace the relinquished property with two properties. Being conservative, the two replacement properties may be in the same geographic location being completed by the same builder. Being very aggressive, the replacement properties may be a rental property in Ohio and a rental property in Florida. Juggling one construction project is enough stress and adding a second would be very stressful but attainable, maybe. Just food for thought.
Sequential Thought Process for successful Construction/ Improvement 1031
- Replacement property cannot be a property you already own
- In a construction/ improvement exchange you cannot acquire the property yourself
- The QI needs to set up a special purpose entity, usually an LLC that is an Exchange Accommodation Titleholder (aka EAT).
- QI hold property until improvements are completed.
- QI funds draw schedule to complete capital improvements.
- When property completed QI transfers title to investor
- As always check with your CPA for additional details.
Final thoughts
Investors need to have a well thought out plan. The need to replace a loan being paid off and arranging for financing creates additional complications.
Delaware Statutory Trust (DSTs) have been used as a back up property many times. Utilizing with a construction/improvement exchange may be a little outside the box. However, if the investor has additional funds to complete the construction or improvements on the property then the DST could be used to satisfy the exchange. The DST may also be used to satisfy the IRC requirements to replace the debt being paid off on the relinquished property. There are several strategies that may assist an investor. We have several ideas on difficult 1031 exchanges as well as construction improvement exchanges.
DSTs are not for all investors. The acquisition of a DST is for accredited investors only. Contact your investment adviser for additional details on how a DST may be a solution to your 1031 Exchange and suited for your investment future. For more information on how to properly set up an IRC 1031Tax Deferred Exchange or if you are an accredited investor and would like additional information on a DST contact Al DiNicola at 239-691-8098 or email adinicola@namcoa.com.
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