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 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.
Below is a checklist of common items needed to prepare for the EAT’s acquisition closing, which may be supplemented:
Closing date
The taxpayer’s exact name
Settlement agent’s name and contact information
Title commitment or preliminary title report
Copy of the purchase agreement
Formation of LLC in state of exchangor’s choice, with the accommodator’s LLC as the sole member and manager
Property and liability insurance, naming the EAT as the insured or additional insured
Phase 1 environmental site assessment dated within one year and showing “No further action required”
Lender’s contact information (if applicable)
If you are interested in learning more about how a build-to-suit exchange may benefit your tax situation, feel free to contact us with any questions.