You may have heard of the money saving capability of a 1031 tax exchange – and how it allows you to defer all of the capital gains taxes on the sale of your investment property, buy moving them into another investment property that is similar in kind. But it isn’t possible to use the money from your exchange to pay the debt on an investment property that you already own – and likewise, you can’t build improvements on land that you own with a 1031 exchange.Commissioning updates on land that you already hold title to doesn’t qualify as “like-kind”, and can be problematic for uneducated investors.
Ideally, you would take the money that was collected during the exchange and build to suit on the new land yourself, i.e., you obtain the desired physical structure and buy a replacement property of equal or greater value. So how is it possible for you to do this?
One option, called, “the Poor Man’s Build to Suit”, is to ask the seller to make improvements to the property before closing. For example, a taxpayer sells her property worth 0 thousand dollars, and wants to purchase a replacement property worth 0 thousand dollars or greater.Although the vacant land she wants to buy is worth only ten-thousand dollars, which doesn’t fully qualify for a “like-kind” exchange, thus making an exchange impossible.
In this example, the buyer asks the seller of the replacement property – to raise the sales price up to one-hundred thousand dollars, then before the close, building in ninety-thousand dollars worth of improvements to the said property. In the end, she will be purchasing property of equal value (100 thousand dollars).
Finding a replacement property seller who is willing to increase the sales price, and make improvements before closing, may be difficult. Alternately, in our investors case, she can have her QI purchase the investment property on her behalf for k (using an LLC that the Qualified Intermediary owns outright) then construct the improvements to the property using the remaining funds from the exchange.
Put another way, your qualified intermediary will hold the property during it’s improvement process, funding them with the money from the exchange. The investor can complete the exchange by receiving the replacement property from the Qualified Intermediary when the improvements are completed.
Consider the following things when you attempt to use a build to suite exchange. First of all, the one hundred and eighty day requirement allowed to complete a 1031 exchange, will not provide you with enough time for a “fancy” build to suit. However, it should be enough time to rehabilitate or remodel an existing structure.
Second, the improvements to the replacement property must constitute “real estate” for purposes of a like-kind exchange, i.e., real estate for real estate. Just dumping the building supplies on the location of your property won’t be enough, to constitute “real estate” those materials must be made a permanent part of the structure or affixed into the land.
Keeping your savings in mind, be careful to stay away from any potential problems, to get the money saving tax benefits of a build to suit exchange.
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