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 find replacement property with a fair market value that equals or exceeds what is being sold, and must use all the cash from the existing property and invest it in the new property. Build-to-suit exchanges can give investors more flexibility in structuring their transactions to meet these requirements.

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, if an investor sells relinquished property with a fair market value of $1 million, debt of $200,000 and equity of $800,000, he must acquire a property equal to at least $1 million and must invest at least $800,000 into that property. In a build-to-suit exchange, however, the investor could acquire property worth only $300,000, borrow an additional $200,000 and spend the remaining $500,000 of exchange proceeds plus the $200,000 in loan funds on improvements to the property. This would use up the remaining cash and increase the fair market value of the replacement property to $1 million, resulting in a fully tax-deferred exchange. 

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. It 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 by the EAT 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, which results in higher exchange fees and costs of closing.

For those intending to do a build-to-suit exchange, planning ahead is essential. 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 in 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, 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.

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 will have much more flexibility in finding appropriate properties and at the same time completely defer all capital gains tax.

TAX FILING REQUIREMENTS

At this time of year we are all thinking about filing our taxes. If you have started an exchange late in the year in 2007, it is important to remember that you may need to get an extension on the filing of your return to get the full 180 day period to buy your replacement property. Why is this necessary? The 1031 regulations say that once the relinquished property closes, the taxpayer has to buy replacement property during the "exchange period." The rules define the exchange period as being the sooner of 180 days after the closing of the relinquished property or when the tax return is due for the year in which the relinquished property has sold. If the sale of the relinquished property closes on December 1st, and the taxpayer's tax return is due on April 15th, he will have less than 180 days to buy replacement property. This is easily remedied by getting an extension to the filing of the tax return.