1031 CONSTRUCTION EXCHANGE
A 1031 Construction Exchange is also called a Build-to-Suit Exchange and an Improvement Exchange.
A 1031 Construction Exchange is the same as the Delayed Exchange explained in 1031 Exchange Rules, but a 1031 Construction Exchange uses an Exchange Accommodation Titleholder (EAT) like a Reverse Exchange.
In a 1031 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.
If you are not familiar with all of the terms that we use here, check out our Dictionary.
For our 1031 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 1031 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.
It's Like A Seminar In A Book
IF YOU USE A DELAWARE STATUTORY TRUST, TRIPLE NET LEASE, OR A T-I-C, YOU MUST HAVE THIS EDITION.
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 1031 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.
READING TIME: Approximately 10 minutes.
1031 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.
1031 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 1031 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
I hope you are enjoying this free content.
The remainder of this content, plus additional content, is available in my book “How To Do A Section 1031 Like Kind Exchange: Simultaneous, Delayed, Reverse, Construction” available at Amazon.com/dp/B01MY433L6.
And if you are dealing with a Triple Net Lease, Delaware Statutory Trust, or a Tenancy-In-Common property, you need the OMNIBUS EDITION at Amazon.com/dp/B07BJLZNZN.
Or you can see all ten of my books on Real Estate Investing at Amazon.com/author/michaellantrip.