What Real Estate Investors Need To Know About Custom-built Properties And 1031 Tax Exchanges

2008-02-13 Word Count: 601 Category: Taxes

A key fact in regard to 1031 exchanges is that you may not use the proceeds of the original sale to make improvements on land you own. This is a frequent stumbling block of inexperienced investors. To qualify for tax deferment, your replacement property must be of like kind with the relinquished property. For this reason, the property you acquire as a result of the 1031 exchange has to constitute real estate with a value greater than or equal to that of the property sold. A renovation that is not completed represents a contract for service, comprising personal property but not real property. Due to the fact that a property purchased as a replacement in a 1031 exchange has to be equivalent in type and value with the relinquished property upon closing, it is, at times, difficult to find one that complies with these legal requirements but also meets his or her personal specifications.

So, is there a way to what you really want out of a exchange? There are two main methods by which you can acquire a build to suit property that measures up to your wants and needs and fulfills the accounting requirements necessary for a like-kind exchange under section 1031

Your first option is to perform a poor man's build to suit in which you, as the purchaser, request that the seller make particular renovations on a property to increase its value prior to closing on the sale. To illustrate: if you were to sell a property with a value of $100,000, and were considering purchasing a replacement property worth at ten thousand dollars, the seller could construct ninety thousand dollars' of improvements to raise the property value. These completed improvements would constitute real estate. You would then be able to the property for one hundred thousand dollars, fulfilling the requirement of equivalent value. Most sellers, however, will not be eager to perform these improvements so that you may successfullyconduct a 1031 exchange.

In the other, more likely scenario an intermediary who is holding your money buys the replacement property and take title to it in a limited liability company owned by the intermediary. The intermediary would then use the remainder of the proceeds to make the desired improvements on the property. Upon completion, the intermediary returns the property to you, which then allows you to complete the exchange .

Returning to the previously mentioned ten thousand dollar replacement property: the intermediary who was holding your money would purchase the aforementioned piece of real estate at the asking price and would construct the required renovations using the remainder of the funds, transferring the property to you when the value of the property suffices to establish likeness with the relinquished property.

Though a build-to-suit exchange can help you acquire the property that you really want, it is key to consider the span of time required for the improvements that you would like to construct on your property. You have only 180 days in which to complete a 1031 exchange, so you need to be realistic regarding what can actually be brought to completion in this time span. Keep in mind that an improvement is only considered to be real estate when it is done, so work in the process of construction doesn't add to the property's value. Though you may or may not not be able to modify your property as extensively as you might want, 180 days is plenty of time to accomplish significant remodeling, and to bring your replacement property that much closer to the property of your dreams.

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