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S1031EXCHANGE.COM

CONSTRUCTION EXCHANGE

A Construction Exchange is also called a Build-to-Suit Exchange and an Improvement Exchange.

A Construction Exchange is the same as the Delayed Exchange explained in 1031 Exchange Rules, but a Construction Exchange uses an Exchange Accommodation Titleholder (EAT) like a Reverse Exchange.

In a Construction Exchange, the Replacement Property either has not been built, or will be remodeled before purchase.

So the EAT must acquire it and hold it until you are ready to take title.

That would be after you have done two things: sold your Relinquished Property, and caused the construction or remodeling to take place on the property that the EAT is holding.

The Example we will use here will be just for a construction, but the rules are the same for both a construction and a remodel.

You have already learned the process involved in a Delayed Exchange and a Reverse Exchange, so we won’t repeat them.

But you might want to look at Capital Gains Tax and the Home page for a refresher.

If you are not familiar with all of the terms that we use here, check out our Dictionary.

And you can avoid serious mistakes and you will benefit from a clear understanding of Intent and Dealer Property.

EXAMPLE

For our Construction Exchange Example, assume that Alan Adams wants to sell his Duplex because it is in a part of town where the growth has leveled out.

And instead of buying a Fourplex as the Replacement Property, he wants to build a Fourplex in a part of town near a new office complex and a trade school, where he has found an ideal lot, and where there are no other Fourplexes in the area.

The problem for Adams, a problem that he would not have in a regular Delayed Exchange, is that the Fourplex has not been built.

It does not exist.  And Adams will have to build it, or have it built.

If he just sells his Duplex, and buys the lot, with the plan to build on it, his Section 1031 Exchange is over.

At that point, whatever amount of his net sales proceeds from the sale of the Relinquished Property is not spent on the purchase of the lot will be distributed to him, and will be taxable.

The only way he can do a Construction Exchange is to not take title to the lot, but still build the Fourplex on the lot.

This is where the EAT comes in.

The EAT takes title to the lot, holds it until the Fourplex can be built, and then sells it to Adams.

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Construction Exchange aka Improvement Exchange in a Section 1031
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Construction Exchange aka Improvement Exchange in a Section 1031
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Meantime, Adams can sell his Relinquished Property and have the net sales proceeds sent to his QI to be held until he is ready to close on his newly-built Fourplex.

Like all Exchanges, the Construction Exchange is divided into two stages.

And the critical stage is the second, where he will either have completed the construction by the end of the 180-day deadline or not.

SUMMARY: The Replacement Property does not yet exist, except for the lot. The EAT purchases the lot and signs a Lease And Development Contract with Adams who arranges for the financing and acts as General Contractor for the construction, which must be done within 180 days.  If he makes the deadline, he buys the completed Fourplex from the EAT.  If he doesn’t make the deadline, he still closes and adjusts the numbers in order to save his Section 1031 Construction Exchange.

READING TIME: Approximately 10 minutes.

CONSTRUCTION EXCHANGE RELINQUISHED PROPERTY

Adams will first arrange for the sale of of his Duplex.

He will provide in the sales contract that the closing will take place within 30 days, with an option for him to extend the time for another 30-day period, giving him the flexibility he needs.

As in our other Examples, we use the following facts:

:: Alan Adams bought a Duplex ten years ago for $200,000 cash.

:: He assigned a value of $20,000 to the land, $180,000 to the building.

:: He began claiming depreciation on the $180,000 building.

:: He spent $30,000 on two garages, began claiming depreciation.

:: He borrowed $30,000 from the bank, put a lien on the property.

:: The balance on the note is now $18,000.

:: He spent $20,000 on furniture, began claiming depreciation.

:: He has claimed $65,400 straight-line depreciation on the Duplex.

:: He has claimed $7,644 straight-line depreciation on the garages.

:: His total straight-line depreciation claimed is $73,044.

:: He has claimed $15,200 accelerated depreciation on the furniture.

:: His total overall depreciation claimed is $88,244.

:: His Basis in the property is $161,756 (200,000 plus 30,000 plus 20,000 minus 88,244).

:: Bob Baker has offered him $400,000 cash for the Duplex.

:: His total costs of the sale will be $10,000 closing costs.

:: His net sales proceeds will be $372,000 (400,000 minus 10,000 minus 18,000).

:: His Capital Gains will be $228,244 (400,000 Sales Price minus 161,756 Depreciated Basis minus 10,000 closing costs).

:: $15,200 of the $228,244 will be Accelerated Depreciation Recapture, taxed at 39.6%, resulting in $6,019 tax.

:: $73,044 of the $228,244 will be Straight-line Depreciation Recapture, taxed at 25%, resulting in $18,261 tax.

:: $140,000 of the $228,244 will be regular Capital Gains (400,000 minus 10,000 minus 200,000 minus 30,000 minus 20,000) and will be taxed at 20%, resulting in $28,000 tax.

:: His total tax liability will be $52,280 (6,019 plus 18,261 plus 28,000).

Adams will need to know all of these numbers as he proceeds to build his Replacement Property.

He will also need to know them when he fills out his Form 8824.

CONSTRUCTION EXCHANGE REPLACEMENT PROPERTY

Adams will negotiate the contract to buy the vacant lot for $70,000 and make sure that the contract can be assigned.

He will deliver the contract to the Title Company, along with an Earnest Money Deposit check, payable to the Title Company.

He will instruct the Title Company to hold the check because it will be replaced by the entity to which the contract will be assigned.

Note, however, that some title companies operate under state regulations that require them to deposit earnest money checks into their escrow account within three working days of receipt.

If you run into this situation, just put language in the sales contract that the earnest money check must be delivered within thirty days, and that way, the check can be provided by the EAT after the contract is assigned to that entity, as described later.

The Construction Exchange will need a contractor.

Adams will become the General Contractor.

He will take his building plans and construction schedule to various sub-contractors and get bids on the work to be done.

Adams will also take his building plans to various building supply companies and have them compile a list of materials and give him a bid on supplying the necessary items.

The QI will form the LLC that will act as the EAT.

Adams will identify to his QI the Replacement Property to be built.

Since the property in a Construction Exchange does not exist, it is critical that it be described accurately.

In identifying the property, he will use the street address of the lot, the lot and block number of the lot, and the legal description of the lot if a survey has been done.

For the construction, he will describe the Fourplex by total square footage, the total square footage of each unit, and a description of each unit as to number of bedrooms and bathrooms, and might even attach a copy of his building plans.

He can make changes to this identification document for up to 180 days after the Exchange Date, which is the date the EAT closed on the purchase of the Construction Exchange lot.

Adams will assign to the EAT his contract for the purchase of the land.

Adams will arrange a loan from his bank to the EAT for $700,000 to be used to purchase the land for $70,000 plus closing costs, and to build the Fourplex for actual costs up to $630,000.

The loan will be guaranteed by Adams, and assumable by Adams, but secured by the lot and the construction.

Loan payments will begin after 180 days.

Adams will provide the bank with a copy of his building plans and tax appraisal on the land, the bids on the building materials, and a To-Be-Built Appraisal prepared by a Certified Appraiser.

Adams and the bank will agree on a Draw Schedule for the loan funds.

The EAT will purchase the land.

The date on which this occurs becomes the Exchange Date.

Within 45 days, Adams must identify to his QI three possible properties that will become the Relinquished Property.

Within 180 days, Adams must take title to the Replacement Property from the EAT.

If Adams did not provide an Earnest Money Check to the Title Company, the EAT will do so.  If he did provide a check, the EAT will replace the Earnest Money Check at the Title Company with a new check, using funds from the loan, and instruct the Title Company to return the first check to Adams, or do a refund check.

The EAT will sign a Lease And Development Contract with Adams for Adams to lease the land and complete the construction with funds provided by the bank.

The bank will sign the contract pro forma, indicating awareness and agreement.

Adams will hire a Construction Manager to supervise the subcontractors, scheduling and inspecting their work, and replacing any of them when necessary.

Adams will close on the sale of his Duplex and the net sales proceeds will be sent to his QI who will hold them until Adams closes on the purchase of the Replacement Property.

It will not be necessary for Adams to identify the Relinquished Property to his QI because the sale has taken place within the 45-day identification period.

Adams will proceed with the Construction Exchange by preparing the land for construction, subbing in the utilities, and pouring the foundation.

Adams will then proceed through the construction process in an orderly manner.

Any sub-contractor who is not available when he is scheduled to begin work, or does not proceed efficiently with his work, is replaced by another sub-contractor.

Adams will either complete the construction before the expiration of the 180-day period, or he will not.

Either way, Adams will still have a valid 1031 Exchange, but with different numbers.

We will look at it both ways.

CONSTRUCTION EXCHANGE IS COMPLETE

Adams completes the construction within the 180-day period from the time that the EAT purchased the land.

We will assume that the entire $700,000 of the bank loan funds were used.

The QI will arrange for the sale of the Replacement Property by the EAT to Adams.

The QI will transfer to the Title Company the $372,000 net sales proceeds from the sale of the Relinquished Property, which the Title Company will use to pay down the $700,000 bank loan.

Adams will sign an Assumption of the bank loan with a balance of $328,000.

The Construction Exchange is complete.

Adams now owns a $700,000 new Fourplex.

His tax deferred capital gains in the Replacement Property is $228,244.

The actual capital gains portion of this is $140,000.

The straight-line depreciation portion subject to 25% recapture tax is $73,044.

The accelerated depreciation portion subject to 39.6% recapture tax is $15,200.

His carryover basis in the property is $161,756 (200,000 plus 50,000 minus 88,244).

The amount of new money or new debt put into the property is $328,000.

He paid $70,000 for the land, leaving $630,000 paid for the building.

Of the total $700,000 price, $228,244 represents the capital gains from the sale of the Relinquished Property and $161,756 represents the basis of the Relinquished Property transferred into the Replacement Property.

Therefore, his basis in the Replacement property is $300,000 (700,000 minus 228,244 minus 161,756).

Add this to the basis of $161,756 transferred in and he has a new basis in the Replacement Property of $461,756.

Now subtract the $70,000 allocated for the cost of the land, and Adams has a depreciable basis in the Replacement Property of $391,756.

Now we will look at what happens if he doesn’t complete the construction on time.

CONSTRUCTION EXCHANGE IS NOT COMPLETE

Although everyone expended their best efforts, Adams was not able to complete the construction by the end of the 180-day period.

He recognized after 160 days that this was going to happen.

So, he scheduled closing on the purchase of the Replacement Property from the EAT in its unfinished condition.

His first task was to total up all of the money that had been spent on the project at that point.

It came to $180,000 spent on materials and $140,000 on labor, including $10,000 paid thus far to the Construction Manager.

The total was $320,000.

But $20,000 of the materials were appliances that had been delivered but were not ready to be installed because the flooring and the interior painting had not been done.

So the total that he can count is only $300,000.

He can’t count everything that has been delivered to the site, only what has become part of the construction.

Another $70,000 had been spent for the land, so the total that has gone into the property at this point was $370,000.

But the net sales proceeds from the sale of the Relinquished Property was $372,000.

That means that if Adams closes on the Construction Exchange Replacement Property at this point, the Exchange will not qualify for total tax deferral because the value of $370,000 is not equal to, or greater than, the net sales proceeds of $372,000.

So, all of the net sales proceeds will not have been put into the Replacement Property, as required by the rules of Section 1031.

Adams has 20 days before closing, so he hooks up all of the appliances so that he can add that $20,000 to the total, and he brings in the painters to do enough of the painting to add another $10,000 to the total.

He closes before the 180-day deadline and the total value of the Replacement Property at that point is $400,000.

So he has satisfied the requirement that the value of the Replacement Property be equal to, or greater than, the Relinquished Property, and that all of the net sales proceeds be put into the Replacement Property.

He has also satisfied an unwritten rule of the IRS for “substantial completion” of the construction in order to close on the property.

The Treasury Regulations provide no percentage, ratio, or fraction to be used as a guideline, but it is a good idea to be past the halfway point and beyond the dry-in stage, with all permits in place and the utilities connected or ready to hook up.

When Adams closes on the Fourplex, the QI transfers the $372,000 net sales proceeds being held from the sale of the Relinquished Property to the Title Company.

This is used to pay down the bank loan from $700,000 to $328,000.

Adams still has $300,000 of the loan that has not been drawn on, since only $400,000 has been used.

The Construction Exchange is now complete.

Adams completes the Fourplex during the next two months and only uses $250,000 of the available loan funds.

He now has a new Fourplex that cost $650,000.

He has tax deferred capital gains in the Replacement Property of $228,244.

The actual capital gains portion of this is $140,000.

The straight-line depreciation portion subject to 25% recapture tax is $73,044.

The accelerated depreciation portion subject to 39.6% recapture tax is $15,200.

His carryover basis in the property is $161,756 (200,000 plus 50,000 minus 88,244).

The amount of new money or new debt put into the property is $278,000.

He paid $70,000 for the land, leaving $580,000 for the building.

Subtracting the $228,244 of capital gains transferred into the new property, we have $351,756 in depreciable basis in the new property.

CONCLUSION

We have now covered all three of the like Section 1031 Like Kind Exchanges that you might consider doing, and we can compare the three.

A regular Delayed Exchange can be done by a busy Real Estate Investor who is mostly a passive investor.  If you find a competent QI, and you have studied everything here so that you can monitor the activities of the QI’s employees, you should be fine.

A Reverse Exchange will require quite a bit more time and attention.  But, again, if you found a good QI and you monitor his activities, you can do it with good organization and attention to detail.

But if you are considering doing a Construction Exchange, your should probably be ready to spend pretty much every day with the process, and have at least one experienced building professional helping you.  Turning it over to other people and expecting them to show up and do the job, is a train wreck waiting to happen.

But whichever one you do, keep in mind that the IRS is holding you responsible, not your QI, not your real estate salesperson, not anyone else.

You need to understand the process and control everything.

If you would like to see what a lifetime plan for wealth accumulation looks like, extending the above scenario for another thirty years, go to Swap ‘Til You Drop: 1031 Forever.

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