§1031 Exchanges Allows Construction or Improvement Properties

§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 180^th 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

1. Replace­ment prop­er­ty can­not be a prop­er­ty you already own
2. In a construction/ improve­ment exchange you can­not acquire the prop­er­ty your­self
3. The QI needs to set up a spe­cial pur­pose enti­ty, usu­al­ly an LLC that is an Exchange Accom­mo­da­tion Title­hold­er (aka EAT).
4. QI hold prop­er­ty until improve­ments are com­plet­ed.
5. QI funds draw sched­ule to com­plete cap­i­tal improve­ments.
6. When prop­er­ty com­plet­ed QI trans­fers title to investor
7. 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.

This is not an offer to pur­chase or solic­i­ta­tion to pur­chase any secu­ri­ty, as such be made only through an offer­ing mem­o­ran­dum or prospec­tus.  Invest­ing in secu­ri­ties, real estate, or any invest­ment, whether pub­lic or pri­vate, involves risk, includ­ing but not lim­it­ed to the poten­tial of los­ing some or all of your invest­ment dol­lars when you invest in secu­ri­ties. You should review any planned finan­cial trans­ac­tions that may have tax or legal impli­ca­tions with your per­son­al tax or legal advi­sor.   NAMCOA, LLC is a Reg­is­tered Invest­ment Advi­sor, reg­u­lat­ed by SEC (Secu­ri­ties and Exchange Com­mis­sion). Our cor­po­rate office is locat­ed at 999 Van­der­bilt Beach Road, Suite 200, Naples Flori­da 34108. Secu­ri­ties Offered through MSC-BD, LLC, Mem­ber of FINRA/SIPC. 8215 SW Tualatin- Sher­wood Rd, Suite 200, Tualatin, OR 97062.  MSC-BD, LLC and NAMCOA are inde­pen­dent­ly owned and are not affil­i­at­ed.

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