Part of the requirement for completing a 1031 Exchange is that once an investor sells their property, they are required to find a “replacement property” within 45 days. While this may seem simple enough, it can actually turn out to be very challenging for investors to find just the right property in a relatively short period of time. When these challenges arise, it may make sense to build or renovate one.
In this article, we are going to discuss how to complete a 1031 Exchange into a new property that involves construction. We’ll start by describing 1031 Exchanges in general and then discuss the specifics of completing one where construction is involved. By the end, readers will have a better idea of what goes into a 1031 Construction exchange and will be able to use this information to determine if this type of transaction is a good fit for their needs.
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What is a 1031 Exchange?
Before discussing a construction 1031 exchange, it first makes sense to define what a 1031 exchange is more broadly.
A 1031 exchange is a type of commercial real estate transaction that allows taxpayers to defer capital gains taxes on the profitable sale of an investment property (the “relinquished property”) as long as they reinvest the sales proceeds into a new property (the “replacement property”) that is “like kind” to the property that was sold. In addition to this requirement, there are a few rules that investors must follow:
- Investors must identify their planned replacement property within 45 days of the sale date of the relinquished property and close on the purchase of it within 180 days.
- The equity and the debt in the replacement property must be equal to or greater than the equity and debt in the relinquished property.
- Both the relinquished property and the replacement property must be titled similarly – usually a limited liability company (LLC).
- The replacement property must be a like kind property to the one that was sold – meaning they must be of the same nature or character. In general, most commercial properties are like kind to other commercial properties.
When the 1031 exchange is completed within the bounds of internal revenue service (IRS) rules, investors are able to defer capital gains taxes on the profit indefinitely.
Types of 1031 Exchanges
Every transaction is unique so there are four types of 1031 Exchanges that accommodate the vast majority of them:
- Delayed Exchange: A delayed exchange is the one described above. In it, an investor sells the relinquished property first and then has 45 days to identify a replacement property and 180 days to close on the purchase of it. Most 1031 exchanges fall into this category.
- Reverse Exchange: As the name suggests, a reverse exchange happens backwards. In it, the replacement property is purchased first and then investors have 45 days to identify the relinquished property and 180 days to sell it.
- Simultaneous Exchange: In a simultaneous exchange, the relinquished property is sold and the replacement property is purchased at the same time. This type of exchange is most common when the taxpayer knows exactly what replacement property they want to purchase ahead of time.
- Construction Exchange: Sometimes called an “improvement exchange”, this type of tax deferred exchange allows investors to use a portion of the relinquished property sales proceeds to complete improvements on their replacement property prior to occupying it.
This construction exchange is the focus of the remainder of this article.
Can 1031 Exchange Funds Be Used For New Construction?
Yes, 1031 exchange funds can be used for new construction, but certain rules must be followed to achieve full tax deferral. They include:
- Once the relinquished property is sold, investors must receive the completed, improved replacement property within 180 days. So, this may put a limit on the number of improvements that can be completed in such a short time period.
- Before investors take title to the replacement property, the improvements must be substantially complete
- The new construction project, once complete, must have a market value that is equal to or greater than the value of the relinquished property.
- Title cannot be transferred back to the investor until construction is complete
- All of the equity from the relinquished property must be used for either construction costs or as a down payment during the 180-day exchange period.
In short, there are a lot of rules and they can be complex. For this reason, it is always a best practice to work with a qualified intermediary to complete the exchange. They are an expert in the rules and can help avoid any mistakes that may cause the transaction to become taxable.
How Does a Construction 1031 Exchange Work?
To demonstrate how a construction exchange works, an example is helpful.
Suppose that a small manufacturing company has outgrown their current space and they need to find a bigger one. So, the owner of the company sells their existing location – the relinquished property – for $1,000,000 and uses the funds to purchase a newer, larger space. But, before they can occupy the new space – the replacement property – they must complete some improvements to customize it for their needs. They can use the exchange proceeds to do this.
In the mechanics of the transaction, the relinquished property is sold and the replacement property is purchased, but under IRS rules, the taxpayer cannot take title to it. It must be held by an exchange accommodation titleholder – EAT for short – whose name will be on the purchase agreement.
At the time of sale, exchange proceeds are transferred into an escrow account and construction costs are paid by the EAT out of this account.
Once construction/renovations are complete (by the 180th day), title to the property is transferred to the taxpayer and the remainder of the 1031 exchange proceeds as normal.
It should be noted that the requirements for a construction exchange transaction are fairly stringent and any violation of them could cause the transaction to become taxable. Again, this highlights the need to work with a qualified intermediary who can help ensure that there are no issues throughout the process.
Forward/Reverse Construction 1031 Exchanges
A 1031 construction exchange can happen in forward or reverse.
A forward exchange is the one described above. In it, the relinquished property is sold, proceeds are used for construction/renovations, and the replacement property is acquired.
In a reverse exchange, the replacement property is acquired first and improvements are completed to it while the relinquished property is being sold.
In both cases, the 45 day/180 day time limits still apply.
Construction Exchanges & Real Estate Syndications
A construction exchange is not necessary in all cases. It may only be a good fit in certain circumstances like the one described above with an owner-occupied property. But, in other scenarios, it may not be the right option.
In some cases, individual investors may find that placing their sales proceeds in a commercial real estate syndication, using a Tenants in Common ownership structure, may be a compelling option. With this strategy, investors use their sale funds to purchase a fractional piece of a larger property that is managed by a professional firm.
The key benefit to this approach is that it takes away much of the stress of finding a replacement property in such a short period of time and, since it is managed by a third party, it can be a truly passive investment. For many investors, this may be a good fit.
Summary of Doing a 1031 Exchange Into New Construction
A 1031 exchange is a type of commercial real estate transaction that allows investors to defer capital gains taxes on the profitable sale of an investment property as long as they reinvest the sale proceeds into a new, like kind property.
There are four types of 1031 exchanges to account for most transaction needs, including a construction or improvement exchange.
In a construction/improvement exchange, investors can use some or all of the sales proceeds to make improvements or renovations to the replacement property.
The benefit of this type of transaction is that it allows investors or property owners to customize a space for their needs.
A construction exchange may not be the best fit in all cases. Sometimes, especially for individual investors who are looking for a new investment opportunity, it may be worthwhile to consider placing sale proceeds into a syndication, which will provide passive income and will take the stress away of having to find a replacement property in such a short period of time.
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