Many real estate investor are aware of the money saving power of a 1031 exchange, and how it allows one to transfer their captial gains taxes from the sale of a property, into another like-kind property. However, it is not possible to use 1031 exchange proceeds to pay off debt on property you already own, nor can you build improvements on land you already own in a 1031 exchange. Making improvements on land already owned is not a qualifying like-kind 1031 exchange, and can be a trap for the unacquainted taxpayer.
The 1031 exchange proceeds would ideally be used to make the build to suit to your specifications on the new land, i.e., you get the built structure you want and purchase a replacement-property that is worth the same amount (or greater value). So how does one accomplish 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, an investor (after selling her investment property) - wants to buy another property to replace it - for an equal or greater value. But the raw land she desires is only worth $10 thousand dollars, which will obviously not completely qualify for a like-kind exchange and thus, no deferred tax gain.
In this scenario, the investor would ask the replacement property seller to increase the sales price to 100 thousand dollars, and before closing, the seller will have to construct 90 thousand dollars worth of improvements to the property. In the end, she will be purchasing property of equal value (100 thousand dollars).
Finding a seller (of the property) that is willing to charge more, then make improvements to it before closing - may not be all that easy to find. One other approach to this is to have the QI (or qualified intermediary) purchase the replacement property for $10,000 - then take the title into an LLC that is owned exclusively for the purpose of a 1031 exchange, and use the remaining money from the exchange to make improvements to the replacement property.
So likewise, your QI can fund the improvements during their construction, holding the property for you and paying for everything with the proceeds from the exchange. When the improvements to the replacement property are finished, the investor can complete the exchange by receiving the property from the QI.
Consider the following things when you attempt to use a build to suite exchange. First, the 180-day requirement in order to complete a 1031 exchange does not allow sufficient time for an elaborate Build to Suit. However, it should be enough time to rehabilitate or remodel an existing structure.
Secondarily, to be considered an actual “like kind” exchange, any of the improvements to the replacement property must constitute “real-estate”, i.e., real estate for real estate. Merely dumping materials on the property will not suffice; the materials must be constructed or affixed into the land and be made a permanent part of the structure to constitute real estate.
Keep the foregoing in mind and you can avoid any pitfalls and get all of the tremendous tax benefits of a 1031 exchange that is build to suit.
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