Great Chitter Chatter - Stories from Loud Voices

Many real estate investor are aware of the money saving power of a 1031 exchange, and how it allows one to transfer their captial gains taxes from the sale of a property, into another like-kind property. But it isn’t possible to use the money from your exchange to pay the debt on an investment property that you already own - and likewise, you can’t build improvements on land that you own with a 1031 exchange.Commissioning updates on land that you already hold title to doesn’t qualify as “like-kind”, and can be problematic for uneducated investors.

The 1031 exchange proceeds would ideally be used to make the build to suit to your specifications on the new land, i.e., you secure the desired property and buy another investment property that is equal to or greater than in value.  So how can you do this?

There is an option called “the poor man’s build to suit exchange” wherein the buyer requests that the seller make the desired improvements to the structure prior to the completion of the sale. For example, a taxpayer sells her property worth 0 thousand dollars, and wants to purchase a replacement property worth 0 thousand dollars or greater.  But the raw land she desires is only worth thousand dollars, which will obviously not completely qualify for a like-kind exchange and thus, no deferred tax gain.

In this scenario, the investor would ask the replacement property seller to increase the sales price to 100 thousand dollars, and before closing, the seller will have to construct 90 thousand dollars worth of improvements to the property. In the end, she will be purchasing property of equal value (100 thousand dollars).

It might be difficult to find a seller who is willing to increase the price of the property - in order to make improvements to it before selling it to you.  One other approach to this is to have the QI (or qualified intermediary) purchase the replacement property for ,000 - then take the title into an LLC that is owned exclusively for the purpose of a 1031 exchange, and use the remaining money from the exchange to make improvements to the replacement property.

Put another way, your qualified intermediary will hold the property during it’s improvement process, funding them with the money from the exchange. The investor can complete the exchange by receiving the replacement property from the Qualified Intermediary when the improvements are completed.

These are important things to consider when you are conducting a build to suite exchange. First, the 180-day requirement in order to complete a 1031 exchange does not allow sufficient time for an elaborate Build to Suit.  And existing structure can hopefully be updated and rehabbed within this time.

Second, the improvements to the replacement property must constitute “real estate” for purposes of a like-kind exchange, i.e., real estate for real estate. Merely dumping materials on the property will not suffice; the materials must be constructed or affixed into the land and be made a permanent part of the structure to constitute real estate.

Keep the foregoing in mind and you can avoid any pitfalls and get all of the tremendous tax benefits of a 1031 exchange that is build to suit.