Untitled Document

3 Methods For A Construction
Exchange

By Mary Lou Schwab CPA

How can a 1031 exchange be accomplished when a real estate investor is required to buy their lot first and then build a structure prior to selling their old investment property? With proper planning, there are three different methods that would enable the investor to structure a 1031 exchange. All have various degrees of risk, complexity and costs.

The first improvement exchange method is a Reverse Construction Exchange. A qualified intermediary will set up a limited liability company (LLC), which purchases the property and then builds the improvements. Once the improvements are completed, the LLC would sell the improved property, at cost, to the exchanger as their replacement 1031 property. The exchanger may lend the needed funds directly to the LLC or both parties could find a lending source for the entire lot purchase and improvements. Proceeds from the sale of the old investment property may also be utilized if the improvements can be completed within 6 months from the sale of the Exchangers old investment property. If outside lending is necessary, a regular mortgage portfolio lender cannot be used so a commercial bank loan is obtained. Generally commercial banks have higher interest rates, shorter loan terms and demand more guarantees from the exchanger.

The second method consists of a leasehold improvement exchange. If the exchanger purchases the vacant land before any improvements are made or already owns vacant land this method could work. The qualified intermediary with its LLC enters into a 30+ year leasehold interest with the exchanger for the vacant land. The improvements are then constructed on the vacant land. Once the improvements are completed, the LLC would sell their interest in the 30+ year land lease as replacement 1031 property to the exchanger. Again the exchanger or a commercial bank would provide the funds to the LLC for the improvements to be constructed.
The third technique is a creative “build and exchange with a friend” method. This could work if the exchanger has an acquaintance who is not a related party, but plans on building in the same subdivision for new construction. There are builders that require vacant lots to be purchased first with mortgage financing in place prior to any construction. This requirement makes 1031 exchanges almost impossible. If there are two parties who desire to exchange their old investment property into this type of new construction property, they could each build a house to the others specification and have an option contract. Both parties would sell the completed homes at the option price coordinating their old investment property sale with a simple deferred exchange. This method requires coordination of the improvements to be constructed and the timing of the sale of the old exchanged property. The possible benefits of utilizing this exchange method would be lower exchange fees, interest fees and the ability to utilize the entire sale proceeds from the old exchanged property.

Check with your direct tax advisor if you are considering a construction improvement exchange to see if any of the above methods could work for you. Real estate investors will need to review their old investment property equity balance, the expected timing to sell the old investment property and the tax implications on a direct sale of the old property. You just might be able to take advantage of the tax saving benefits of Section 1031!

©2004 Bankers Escrow Corp. Mary Lou Schwab CPA is Vice President of Bankers Escrow Corporation and oversees the 1031 Exchange Division. She has over 22 years experience in real estate taxation. For questions on 1031 exchanges call 303-986-4848 or 800-571-6595. Bankers Escrow Corporation provides qualified intermediary services for all types of exchanges including simple deferred, reverse, construction, leasehold interest and business property exchanges.