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