Build-To-Suit Exchanges: Using Exchange Funds For Improvements On Your Replacement Property

INTRODUCTION

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 one or more replacement properties with a total 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. 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.

 

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 (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 (QI). 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.

 

In a deferred build-to-suit exchange, the relinquished property is disposed of and the sale proceeds go to the qualified intermediary. The investor must identify what is to be acquired within 45 days, including a description of what will be built on the property. The EAT acquires the property using the exchange funds. The investor oversees the construction of the improvements and periodically sends invoices to the EAT, who pays them using exchange funds. The replacement property is transferred from the EAT to the investor on the sooner of when the construction is complete, when the 180 days expires or when enough value is added to the replacement property for full tax deferral.

 

In a reverse build-to-suit exchange, the replacement property is acquired by the EAT first, using funds from the investor or a lender. As with a deferred exchange, the investor supervises the construction and sends invoices to the EAT, but the EAT must borrow money from the lender or the investor to pay the invoices. At some point during the 180 day period, the relinquished property is sold and funds are transferred to the QI. If there is more construction needed, the exchange funds can be used for the construction until the 180 day period expires. As with the deferred build-to-suit, the replacement property is transferred from the EAT to the investor on the sooner of when the construction is complete, when the 180 days expires or when enough value is added to the replacement property for full tax-deferral.

 

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 an additional real estate transfer. Escrow fees, closing costs and transfer taxes may be charged twice (once when the EAT takes title and a second time when the EAT transfer 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 contract to purchase the replacement property that the contract is assignable in connection with a 1031 exchange.

 

It is also important to contact the EAT and any lender early in the process, particularly if the investor intends to borrow money to acquire the replacement property or for construction. Since the EAT will be on title, it will be signing the loan documents and the lender must be willing to cooperate in the build-to-suit exchange. The EAT must have no personal liability for any loan obligations. If the loan is to be fully or partially recourse, the investor can sign a guaranty.

 

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 investor.

 

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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