Using Exchange Funds for Improvements on Your Replacement Property
A 1031 exchange is a great tool for investors who want to avoid paying tax on the gain from the sale of real estate; however, in order to completely defer the tax, an investor must 1) find one or more “like-kind” replacement properties with a total fair market value that equals or exceeds what is being sold, 2) invest all the cash from the existing property (“relinquished property”) in the new property; and 3) acquire debt on the replacement property equal to or greater than the debt on the relinquished property, unless cash is added to offset the debt.
Many experienced real estate investors who are familiar with 1031 exchanges don’t realize that a build-to-suit exchange can give them more flexibility in structuring their transactions to meet these requirements and more ability to take advantage of opportunities in today’s market.
The build-to-suit exchange allows an owner to use the proceeds from the sale of the relinquished property not only to acquire replacement property, but also to make improvements to the property. For example, in a typical forward exchange, if an investor sells relinquished property with a fair market value of $800,000, debt of $200,000 and equity of $600,000, he must acquire a property equal to at least $800,000 and must invest at least $600,000 into that property. In a build-to-suit exchange, however, the investor could acquire property worth only $200,000 and have $600,000 in improvements made to the property by using the remaining $400,000 in exchange proceeds and by borrowing $200,000. This would use up the remaining cash and increase the fair market value of the replacement property to $800,000, resulting in a fully tax deferred exchange. A build-to-suit exchange can be a great tool in this market for investors looking to buy and improve distressed assets; however, investors should consult with their legal/tax advisors to ensure that they properly structure their transaction.
Structuring a Build-to-Suit Exchange
A build-to-suit exchange is accomplished by having a holding entity (called an “exchange accommodation titleholder” or “EAT”) temporarily hold title to the replacement property while the improvements are being made. The EAT is typically a limited liability company owned by a qualified intermediary. The EAT is necessary because any work done to the property after the investor takes title to it is not considered like kind property and therefore will not increase the value of the property for exchange purposes.
A build-to-suit exchange can be structured either as a deferred exchange where the existing property is sold before the new property is acquired, or a reverse build-to-suit, where the new property is acquired first. In either case, the entire transaction must be completed within 180 days.
Benefits and Drawbacks of Doing a Build-to-Suit Exchange
The benefits of doing a build-to-suit exchange include the ability to buy property that is lower in value compared to the relinquished property and the ability to use exchange funds rather than loan proceeds to fund construction.
The principal drawback of doing a build-to-suit exchange is that the work must be done within the 180 day period in order to have any effect on the exchange. For most large construction projects, this is difficult; however, smaller projects or improvements to existing structures can often be accomplished within the required time frame. In addition, build-to-suit exchanges are more costly than regular deferred exchanges, because the EAT will take title to the replacement property. Escrow fees, closing costs and transfer taxes may be charged twice (once when the EAT takes title and a second time when the EAT transfers the property to the taxpayer). In addition, the exchange fees will be higher and the loan may be more expensive.
Planning for a Build-to-Suit Exchange
For those intending to do a build-to-suit exchange, planning ahead is essential. First, include a provision in the replacement property purchase contract that the contract is assignable in connection with a 1031 exchange.
It is also important to contact First American Exchange and any lender early in the process. Since the EAT will be on title, it will be signing the loan documents if the investor intends to borrow money to acquire the replacement property or for construction. The lender must be willing to cooperate in the build-to-suit exchange and your exchange officer will help ensure a smooth transaction.
Getting an accurate estimate of the amount of time it will take to complete the construction project is important, as it will affect whether enough value can be added during the 180 day period to make the exchange worthwhile. Although the construction does not have to be complete at the expiration of the 180 day period, it is important to use up as much of the exchange proceeds as possible. The only improvements that will affect the value of the replacement property for exchange purposes are the improvements that are done as of the date that the EAT transfers the replacement property to the exchangor.
Finally, investors should consult with their tax advisors before doing any exchange, particularly a build-to-suit exchange. By properly structuring a build-to-suit exchange, and by using a reliable qualified intermediary like First American Exchange Company, the investor may have much more flexibility in finding appropriate properties and at the same time completely defer all capital gains tax.
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