CAN I USE A SECTION 1031 EXCHANGE TO BUILD OR IMPROVE A PROPERTY?

May, 2009

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Occasionally a client will ask that question, and we can usually answer, "YES!" It does depend upon exactly what the client's plans and intentions are, but in general, the replacement property in a Section 1031 exchange can be newly constructed during the exchange or substantially improved during the exchange. Here are the details:

Let's assume that an exchanger has sold his relinquished property and plans to construct a new duplex on a lot that he intends to purchase through his 1031 exchange. A key thing to remember is that once the exchanger takes title to the replacement property, any funds remaining in the exchange account will be transferred to the exchanger and will be taxable! Therefore, the improvements must be structured within the exchange in some way. The process to do this duplex construction small.jpgs by using an Exchange Accommodation Titleholder ("EAT") to hold title to the land until the exchange is complete. There is some similarity, then, to a Reverse Exchange in that the exchanger cannot hold title to both the relinquished property and the replacement property at the same time and must use an EAT.

In practice, how does this work? Consider this typical sequence of events:

  • Exchanger and buyer agree on a purchase agreement for the sale of exchanger's relinquished property.
  • Exchanger enters into an exchange agreement with Iowa Equity Exchange.
  • Exchanger assigns the purchase agreement to Iowa Equity Exchange.
  • Closing occurs on the relinquished property.
  • Exchanger informs us of his intention to construct a duplex as his replacement property.
  • Exchanger and seller agree on a purchase agreement for the purchase of the lot for the duplex.
  • Exchanger assigns the purchase agreement to the EAT, which is a single-purpose LLC formed by Iowa Equity Exchange for the express purpose of holding title to this property.
  • Closing occurs and title for the lot is transferred to the EAT.
  • The exchanger directs the construction of the duplex (or works with a contractor to do so). Funds for construction are drawn from the exchange account at the direction of the exchanger and are paid by the EAT.
  • Upon completion of the construction or completion of the exchange period (see below), title can be transferred from the EAT to the exchanger and the exchange is finished.

The process is identical if the exchanger wishes to purchase a property and add substantial improvements within his exchange.

The primary hurdle to the construction/improvement exchange is that of timing, which can be a concern in this type of exchange. Both the 45-day Identification Period and the 180-day Exchange Period still apply. The property to be purchased must be unambiguously identified during the 45-day ID period. This means that construction must either be completed during the 180-day exchange period, meaning the identification will be that of a fully-completed building OR the exchanger must be able to see into the future and accurately describe how far along the construction process will be by the end of the 180-day period. By using the 3-Property Rule for identification, it is possible to identify the property in three different stages of completion to somewhat circumvent this obstacle.

Construction/improvement exchanges carry a significantly higher fee than standard exchanges. This is due to the need to create and administer an LLC, plus the additional time requirements of handling payments to contractors during the construction phase. Contact us for details on fees.

Just as every other Section 1031 exchange has its unique qualities, so does every construction/improvement exchange. Construction and improvement exchanges are an extremely valuable tool that can allow the exchanger to end up with just the property that he or she desires. If you have general or specific questions about the process, please feel welcome to get in touch.