Development

Tag: 1031 exchange

  • What are Valid 1031 Exchange Selling Expenses?

    When selling or purchasing an investment property in a IRS 1031 exchange purposes are:

    Real estate broker’s commissions, finder or referral fees
    Owner’s title insurance premiums
    Closing agent fees (title, escrow or attorney closing fees)
    Attorney or tax advisor fees related to the sale or the purchase of the property
    Recording and filing fees, documentary or transfer tax fees

    Closing expenses which result in a taxable event are:

    Pro-rated rents
    Security deposits
    Utility payments
    Property taxes and insurance
    Associations dues
    Repairs and maintenance costs
    Insurance premiums
    Loan acquisition fees: points, appraisals, mortgage insurance, lenders title insurance, inspections and other loan processing fees and costs

    To reduce the taxable consequences of these operating, financing and other closing fees, try to:

    Pay security deposits, pro-rated rents and any repair or maintenance costs outside of closing, or deposit these amounts in escrow with the closing agent.
    Treat accrued interest, prorated property tax payments or security deposits as non-recourse debt that the exchanger is relieved of on the sale of their old property, which could be offset against the debt assumed on the replacement property. Note: this would only work if mortgage debt is obtained on the replacement property purchase that exceeds the mortgage debt paid off on the sale of the relinquished property.
    Match any prepaid taxes or association dues credited to the investor against the unallowable closing expenses listed on the settlement statement.

    Check with your tax advisor prior to the closing to review the closing settlement statements to determine if there is an opportunity to

  • What are Valid 1031 Exchange Selling Expenses?

    When selling or purchasing an investment property in a IRS 1031 exchange purposes are:

    Real estate broker’s commissions, finder or referral fees
    Owner’s title insurance premiums
    Closing agent fees (title, escrow or attorney closing fees)
    Attorney or tax advisor fees related to the sale or the purchase of the property
    Recording and filing fees, documentary or transfer tax fees

    Closing expenses which result in a taxable event are:

    Pro-rated rents
    Security deposits
    Utility payments
    Property taxes and insurance
    Associations dues
    Repairs and maintenance costs
    Insurance premiums
    Loan acquisition fees: points, appraisals, mortgage insurance, lenders title insurance, inspections and other loan processing fees and costs

    To reduce the taxable consequences of these operating, financing and other closing fees, try to:

    Pay security deposits, pro-rated rents and any repair or maintenance costs outside of closing, or deposit these amounts in escrow with the closing agent.
    Treat accrued interest, prorated property tax payments or security deposits as non-recourse debt that the exchanger is relieved of on the sale of their old property, which could be offset against the debt assumed on the replacement property. Note: this would only work if mortgage debt is obtained on the replacement property purchase that exceeds the mortgage debt paid off on the sale of the relinquished property.
    Match any prepaid taxes or association dues credited to the investor against the unallowable closing expenses listed on the settlement statement.

    Check with your tax advisor prior to the closing to review the closing settlement statements to determine if there is an opportunity to

  • Can a Taxpayer Use Exchange Proceeds to Build on Property Owned by a Related Party?

    Utilizing a long term ground lease on real estate owned by a party related to the taxpayer can enable a taxpayer to invest proceeds into making improvements on that property. In a recent blog post we discussed build-to-suit and property improvement exchanges.  As that post made clear, a taxpayer cannot do improvements on property that is already owned by the taxpayer. Another post pertaining to exchange transactions between related parties underscored the admonition against a taxpayer acquiring replacement property from a related party.  Merging these two issues provides an opportunity for us to discuss the potential of a taxpayer using exchange proceeds to improve a property owned by a related party.
    This type of transaction is made possible by introducing a long term lease for the property into the ownership structure of the land.  For 1031 exchange purposes, a long term lease is defined as a lease with 30 years or more to run, including renewal options.  As an example, a ten year ground lease with two ten year options would be a sufficient interest in the land to constitute an ownership of the “leasehold estate” by the lessee which is legally recognizable as a separate and distinct ownership from that of the underlying land itself.  This long term interest is considered like-kind to a direct (“fee”) interest in land.  Consequently if improvements are built upon the land those improvements belong to the ground lessee and conversely, the land owner, the related party, has no ownership rights in those improvements.    
    Looking back to the rules disallowing a taxpayer to build on property it already owns, this issue can be resolved by having an Exchange Accommodation Titleholder (“EAT”) become the ground lessee and for the EAT to build the improvements per the plans and specifications required by the taxpayer (This was the gist of the first blog referenced above).  Further, if the interest in a long term ground lease, including improvements upon the property, is recognized as a separate and distinct real property interest, then the taxpayer’s receipt of these leasehold improvements should not be deemed to be received from the underlying related party land owner.
    This structure was the subject of a 2002 Private Letter Ruling. In that fact pattern the related party was not the land owner but rather a lessee itself of the property under a long term lease.  As stated above, a long term lease interest for 1031 exchange purposes is the same as a fee interest and, as such, the ground lease was subleased to an EAT for purposes of constructing upon the property.  This structure was approved.
    A short time later PLR 200329021 was issued.  In this case too, the related party had a lease in excess of thirty years.  The leasehold interest was assigned to an EAT for purposes of constructing taxpayer desired improvements.  This structure got a favorable ruling from the IRS.
    The most recent ruling on this structure was PLR 201408019. In this case a part of the property leased to the related party was subleased to an EAT with a lease term in excess of thirty years.  Similar to the findings in the prior Private Letter Rulings, the IRS ruled that the sublease and the improvements were like kind to the taxpayer’s fee interest in the relinquished property.
    There were a couple of common threads to these rulings which someone structuring such a transaction should keep in mind. 

    First, a fair market rental payment was paid by the EAT to the lessor/sublessor. Sometimes in practice the start of those payments is deferred for the first 180 days of the sublease in order to avoid having the EAT getting involved with the rent payment. 
    Second, the lease/sublease should have 30 or more years to run as of the time the EAT leases the property. 
    Lastly, the rulings all had language suggesting that neither the related party nor the taxpayer should dispose of its interest for at least two years, which is a requirement of one of the exceptions to the related party rules. 

    Regarding this last item, one could argue that had the related party been the land owner, the two year holding requirement would not be needed since the taxpayer would receive nothing from the related party throughout the transaction.  The fact that the EAT is leasing the property from the related party should not be relevant. The situation in the Private Letter Rulings involved the EAT taking an assignment of the ground lease from the related party and the ground lease was ultimately transferred to the taxpayer. Nevertheless, it is not usually necessary in these transactions for a party to dispose of either property within two years, so it is not a burdensome requirement in any event. Also, most advisors agree that the lease relationship can be terminated after a time in excess of two years when the exchange transaction is considered “old and cold.”
    So, quite often a taxpayer – whether an individual, partnership or limited liability company – has the desire to use exchange proceeds towards building upon land owned by a related person or entity.  The taxpayer can take advantage of the legal fiction that improvements to property under a long term ground lease do not constitute building upon the underlying land owned by a related party and therefore they can use exchange proceeds to fund the improvements. They are acquiring the improvements from the EAT and not the related party.
    Documents for a build-to-suit under a ground lease on property owned by a related party include:

    Qualified Exchange Accommodation Agreement
    Ground Lease
    Build-to-Suit Agreement between Taxpayer and EAT
    Agreement between Contractor and Owner
    Evidence of Liability Insurance, including Builder’s Risk coverage
    Environmental Indemnity

  • Can a Taxpayer Use Exchange Proceeds to Build on Property Owned by a Related Party?

    Utilizing a long term ground lease on real estate owned by a party related to the taxpayer can enable a taxpayer to invest proceeds into making improvements on that property. In a recent blog post we discussed build-to-suit and property improvement exchanges.  As that post made clear, a taxpayer cannot do improvements on property that is already owned by the taxpayer. Another post pertaining to exchange transactions between related parties underscored the admonition against a taxpayer acquiring replacement property from a related party.  Merging these two issues provides an opportunity for us to discuss the potential of a taxpayer using exchange proceeds to improve a property owned by a related party.
    This type of transaction is made possible by introducing a long term lease for the property into the ownership structure of the land.  For 1031 exchange purposes, a long term lease is defined as a lease with 30 years or more to run, including renewal options.  As an example, a ten year ground lease with two ten year options would be a sufficient interest in the land to constitute an ownership of the “leasehold estate” by the lessee which is legally recognizable as a separate and distinct ownership from that of the underlying land itself.  This long term interest is considered like-kind to a direct (“fee”) interest in land.  Consequently if improvements are built upon the land those improvements belong to the ground lessee and conversely, the land owner, the related party, has no ownership rights in those improvements.    
    Looking back to the rules disallowing a taxpayer to build on property it already owns, this issue can be resolved by having an Exchange Accommodation Titleholder (“EAT”) become the ground lessee and for the EAT to build the improvements per the plans and specifications required by the taxpayer (This was the gist of the first blog referenced above).  Further, if the interest in a long term ground lease, including improvements upon the property, is recognized as a separate and distinct real property interest, then the taxpayer’s receipt of these leasehold improvements should not be deemed to be received from the underlying related party land owner.
    This structure was the subject of a 2002 Private Letter Ruling. In that fact pattern the related party was not the land owner but rather a lessee itself of the property under a long term lease.  As stated above, a long term lease interest for 1031 exchange purposes is the same as a fee interest and, as such, the ground lease was subleased to an EAT for purposes of constructing upon the property.  This structure was approved.
    A short time later PLR 200329021 was issued.  In this case too, the related party had a lease in excess of thirty years.  The leasehold interest was assigned to an EAT for purposes of constructing taxpayer desired improvements.  This structure got a favorable ruling from the IRS.
    The most recent ruling on this structure was PLR 201408019. In this case a part of the property leased to the related party was subleased to an EAT with a lease term in excess of thirty years.  Similar to the findings in the prior Private Letter Rulings, the IRS ruled that the sublease and the improvements were like kind to the taxpayer’s fee interest in the relinquished property.
    There were a couple of common threads to these rulings which someone structuring such a transaction should keep in mind. 

    First, a fair market rental payment was paid by the EAT to the lessor/sublessor. Sometimes in practice the start of those payments is deferred for the first 180 days of the sublease in order to avoid having the EAT getting involved with the rent payment. 
    Second, the lease/sublease should have 30 or more years to run as of the time the EAT leases the property. 
    Lastly, the rulings all had language suggesting that neither the related party nor the taxpayer should dispose of its interest for at least two years, which is a requirement of one of the exceptions to the related party rules. 

    Regarding this last item, one could argue that had the related party been the land owner, the two year holding requirement would not be needed since the taxpayer would receive nothing from the related party throughout the transaction.  The fact that the EAT is leasing the property from the related party should not be relevant. The situation in the Private Letter Rulings involved the EAT taking an assignment of the ground lease from the related party and the ground lease was ultimately transferred to the taxpayer. Nevertheless, it is not usually necessary in these transactions for a party to dispose of either property within two years, so it is not a burdensome requirement in any event. Also, most advisors agree that the lease relationship can be terminated after a time in excess of two years when the exchange transaction is considered “old and cold.”
    So, quite often a taxpayer – whether an individual, partnership or limited liability company – has the desire to use exchange proceeds towards building upon land owned by a related person or entity.  The taxpayer can take advantage of the legal fiction that improvements to property under a long term ground lease do not constitute building upon the underlying land owned by a related party and therefore they can use exchange proceeds to fund the improvements. They are acquiring the improvements from the EAT and not the related party.
    Documents for a build-to-suit under a ground lease on property owned by a related party include:

    Qualified Exchange Accommodation Agreement
    Ground Lease
    Build-to-Suit Agreement between Taxpayer and EAT
    Agreement between Contractor and Owner
    Evidence of Liability Insurance, including Builder’s Risk coverage
    Environmental Indemnity

  • Can a Taxpayer Use Exchange Proceeds to Build on Property Owned by a Related Party?

    Utilizing a long term ground lease on real estate owned by a party related to the taxpayer can enable a taxpayer to invest proceeds into making improvements on that property. In a recent blog post we discussed build-to-suit and property improvement exchanges.  As that post made clear, a taxpayer cannot do improvements on property that is already owned by the taxpayer. Another post pertaining to exchange transactions between related parties underscored the admonition against a taxpayer acquiring replacement property from a related party.  Merging these two issues provides an opportunity for us to discuss the potential of a taxpayer using exchange proceeds to improve a property owned by a related party.
    This type of transaction is made possible by introducing a long term lease for the property into the ownership structure of the land.  For 1031 exchange purposes, a long term lease is defined as a lease with 30 years or more to run, including renewal options.  As an example, a ten year ground lease with two ten year options would be a sufficient interest in the land to constitute an ownership of the “leasehold estate” by the lessee which is legally recognizable as a separate and distinct ownership from that of the underlying land itself.  This long term interest is considered like-kind to a direct (“fee”) interest in land.  Consequently if improvements are built upon the land those improvements belong to the ground lessee and conversely, the land owner, the related party, has no ownership rights in those improvements.    
    Looking back to the rules disallowing a taxpayer to build on property it already owns, this issue can be resolved by having an Exchange Accommodation Titleholder (“EAT”) become the ground lessee and for the EAT to build the improvements per the plans and specifications required by the taxpayer (This was the gist of the first blog referenced above).  Further, if the interest in a long term ground lease, including improvements upon the property, is recognized as a separate and distinct real property interest, then the taxpayer’s receipt of these leasehold improvements should not be deemed to be received from the underlying related party land owner.
    This structure was the subject of a 2002 Private Letter Ruling. In that fact pattern the related party was not the land owner but rather a lessee itself of the property under a long term lease.  As stated above, a long term lease interest for 1031 exchange purposes is the same as a fee interest and, as such, the ground lease was subleased to an EAT for purposes of constructing upon the property.  This structure was approved.
    A short time later PLR 200329021 was issued.  In this case too, the related party had a lease in excess of thirty years.  The leasehold interest was assigned to an EAT for purposes of constructing taxpayer desired improvements.  This structure got a favorable ruling from the IRS.
    The most recent ruling on this structure was PLR 201408019. In this case a part of the property leased to the related party was subleased to an EAT with a lease term in excess of thirty years.  Similar to the findings in the prior Private Letter Rulings, the IRS ruled that the sublease and the improvements were like kind to the taxpayer’s fee interest in the relinquished property.
    There were a couple of common threads to these rulings which someone structuring such a transaction should keep in mind. 

    First, a fair market rental payment was paid by the EAT to the lessor/sublessor. Sometimes in practice the start of those payments is deferred for the first 180 days of the sublease in order to avoid having the EAT getting involved with the rent payment. 
    Second, the lease/sublease should have 30 or more years to run as of the time the EAT leases the property. 
    Lastly, the rulings all had language suggesting that neither the related party nor the taxpayer should dispose of its interest for at least two years, which is a requirement of one of the exceptions to the related party rules. 

    Regarding this last item, one could argue that had the related party been the land owner, the two year holding requirement would not be needed since the taxpayer would receive nothing from the related party throughout the transaction.  The fact that the EAT is leasing the property from the related party should not be relevant. The situation in the Private Letter Rulings involved the EAT taking an assignment of the ground lease from the related party and the ground lease was ultimately transferred to the taxpayer. Nevertheless, it is not usually necessary in these transactions for a party to dispose of either property within two years, so it is not a burdensome requirement in any event. Also, most advisors agree that the lease relationship can be terminated after a time in excess of two years when the exchange transaction is considered “old and cold.”
    So, quite often a taxpayer – whether an individual, partnership or limited liability company – has the desire to use exchange proceeds towards building upon land owned by a related person or entity.  The taxpayer can take advantage of the legal fiction that improvements to property under a long term ground lease do not constitute building upon the underlying land owned by a related party and therefore they can use exchange proceeds to fund the improvements. They are acquiring the improvements from the EAT and not the related party.
    Documents for a build-to-suit under a ground lease on property owned by a related party include:

    Qualified Exchange Accommodation Agreement
    Ground Lease
    Build-to-Suit Agreement between Taxpayer and EAT
    Agreement between Contractor and Owner
    Evidence of Liability Insurance, including Builder’s Risk coverage
    Environmental Indemnity

  • Installment Sales and 1031 Like-Kind Exchanges, Part 1

    Seller Financing in the Context of a 1031 Exchange
    It is not unusual for a taxpayer to finance the buyer in whole or in part.  Such transactions may or may not involve the seller’s intent to complete a 1031 exchange.  The structure of the seller’s financing can take the form of a note and mortgage/deed of trust from the buyer or under Articles of Agreement for Deed.  The specific form should not impact the seller’s options in structuring an exchange as part of the transaction. 
    Under an installment sale using a note and mortgage/deed of trust, the question frequently arises whether a taxpayer can structure an exchange when the balloon payment becomes due, rather than at the time the parties enter into the installment sale.  Similar questions are raised with Articles of Agreement for Deed – can the exchange be done at the time of the balloon payment when the buyer is receiving the deed? It cannot, since, for tax and legal purposes, the point of transfer of ownership occurs when the parties enter into the note and mortgage or an Articles of Agreement for Deed rather than when the balloon payment is made or when the deed is issued.
    Taxpayer Receiving Cash and a Note
    It’s very common for the taxpayer/seller to receive money down from the buyer and to carry a note for the additional sum due.  At times, this arrangement is entered into because the parties wish to close, but the buyer’s conventional financing is taking more time than expected.  In this instance, the note should be made payable to the qualified intermediary (the exchange company).  To the extent that the buyer can procure the financing from the institutional lender before the taxpayer closes on the replacement property, the note may simply be substituted for cash from the buyer’s loan. 
    It is more likely that the taxpayer’s 180 day exchange period will fall prior to the receipt of funds into the exchange account.  In this case, a solution is for the seller to “buy” his own note from his exchange account with fresh cash.  Essentially, the taxpayer advances personal funds into the replacement property while not receiving the equivalent amount of cash from the buyer at that time. These funds can be cash that the taxpayer already has available, or it can be from a loan that the taxpayer takes out to buy the note.  The benefit to the note buyout is that the future principal payments received by the taxpayer over time will be fully tax deferred. 
    In the example above, care should be taken as to when the note (or installment agreement) should be turned over to the taxpayer. There is a natural tendency to pass the cash and note simultaneously. After all, the client is putting into the exchange account the exact same value that he is taking out.  However, because the regulations prohibit the taxpayer from the “right to receive money or other property pursuant to the security or guaranty arrangement,” it is probably better to receive the cash into the account sometime prior to the purchase of the replacement property, while assigning the note to the seller after all the replacement property has been acquired.  Some qualified intermediaries will have a form that they will sign acknowledging the substitution of cash for the note with a promise to distribute the note upon the closing of the exchange account.
    Conclusion
    There are various scenarios in which an installment sale can impact tax deferral.  In some cases deferral can be attained by the taxpayer’s substitution of cash into an exchange account for an installment note or a sale under articles of agreement for deed. In our next post, we examine more complex instances involving installment sales and 1031 exchanges.

     

  • Installment Sales and 1031 Like-Kind Exchanges, Part 1

    Seller Financing in the Context of a 1031 Exchange
    It is not unusual for a taxpayer to finance the buyer in whole or in part.  Such transactions may or may not involve the seller’s intent to complete a 1031 exchange.  The structure of the seller’s financing can take the form of a note and mortgage/deed of trust from the buyer or under Articles of Agreement for Deed.  The specific form should not impact the seller’s options in structuring an exchange as part of the transaction. 
    Under an installment sale using a note and mortgage/deed of trust, the question frequently arises whether a taxpayer can structure an exchange when the balloon payment becomes due, rather than at the time the parties enter into the installment sale.  Similar questions are raised with Articles of Agreement for Deed – can the exchange be done at the time of the balloon payment when the buyer is receiving the deed? It cannot, since, for tax and legal purposes, the point of transfer of ownership occurs when the parties enter into the note and mortgage or an Articles of Agreement for Deed rather than when the balloon payment is made or when the deed is issued.
    Taxpayer Receiving Cash and a Note
    It’s very common for the taxpayer/seller to receive money down from the buyer and to carry a note for the additional sum due.  At times, this arrangement is entered into because the parties wish to close, but the buyer’s conventional financing is taking more time than expected.  In this instance, the note should be made payable to the qualified intermediary (the exchange company).  To the extent that the buyer can procure the financing from the institutional lender before the taxpayer closes on the replacement property, the note may simply be substituted for cash from the buyer’s loan. 
    It is more likely that the taxpayer’s 180 day exchange period will fall prior to the receipt of funds into the exchange account.  In this case, a solution is for the seller to “buy” his own note from his exchange account with fresh cash.  Essentially, the taxpayer advances personal funds into the replacement property while not receiving the equivalent amount of cash from the buyer at that time. These funds can be cash that the taxpayer already has available, or it can be from a loan that the taxpayer takes out to buy the note.  The benefit to the note buyout is that the future principal payments received by the taxpayer over time will be fully tax deferred. 
    In the example above, care should be taken as to when the note (or installment agreement) should be turned over to the taxpayer. There is a natural tendency to pass the cash and note simultaneously. After all, the client is putting into the exchange account the exact same value that he is taking out.  However, because the regulations prohibit the taxpayer from the “right to receive money or other property pursuant to the security or guaranty arrangement,” it is probably better to receive the cash into the account sometime prior to the purchase of the replacement property, while assigning the note to the seller after all the replacement property has been acquired.  Some qualified intermediaries will have a form that they will sign acknowledging the substitution of cash for the note with a promise to distribute the note upon the closing of the exchange account.
    Conclusion
    There are various scenarios in which an installment sale can impact tax deferral.  In some cases deferral can be attained by the taxpayer’s substitution of cash into an exchange account for an installment note or a sale under articles of agreement for deed. In our next post, we examine more complex instances involving installment sales and 1031 exchanges.

     

  • Installment Sales and 1031 Like-Kind Exchanges, Part 1

    Seller Financing in the Context of a 1031 Exchange
    It is not unusual for a taxpayer to finance the buyer in whole or in part.  Such transactions may or may not involve the seller’s intent to complete a 1031 exchange.  The structure of the seller’s financing can take the form of a note and mortgage/deed of trust from the buyer or under Articles of Agreement for Deed.  The specific form should not impact the seller’s options in structuring an exchange as part of the transaction. 
    Under an installment sale using a note and mortgage/deed of trust, the question frequently arises whether a taxpayer can structure an exchange when the balloon payment becomes due, rather than at the time the parties enter into the installment sale.  Similar questions are raised with Articles of Agreement for Deed – can the exchange be done at the time of the balloon payment when the buyer is receiving the deed? It cannot, since, for tax and legal purposes, the point of transfer of ownership occurs when the parties enter into the note and mortgage or an Articles of Agreement for Deed rather than when the balloon payment is made or when the deed is issued.
    Taxpayer Receiving Cash and a Note
    It’s very common for the taxpayer/seller to receive money down from the buyer and to carry a note for the additional sum due.  At times, this arrangement is entered into because the parties wish to close, but the buyer’s conventional financing is taking more time than expected.  In this instance, the note should be made payable to the qualified intermediary (the exchange company).  To the extent that the buyer can procure the financing from the institutional lender before the taxpayer closes on the replacement property, the note may simply be substituted for cash from the buyer’s loan. 
    It is more likely that the taxpayer’s 180 day exchange period will fall prior to the receipt of funds into the exchange account.  In this case, a solution is for the seller to “buy” his own note from his exchange account with fresh cash.  Essentially, the taxpayer advances personal funds into the replacement property while not receiving the equivalent amount of cash from the buyer at that time. These funds can be cash that the taxpayer already has available, or it can be from a loan that the taxpayer takes out to buy the note.  The benefit to the note buyout is that the future principal payments received by the taxpayer over time will be fully tax deferred. 
    In the example above, care should be taken as to when the note (or installment agreement) should be turned over to the taxpayer. There is a natural tendency to pass the cash and note simultaneously. After all, the client is putting into the exchange account the exact same value that he is taking out.  However, because the regulations prohibit the taxpayer from the “right to receive money or other property pursuant to the security or guaranty arrangement,” it is probably better to receive the cash into the account sometime prior to the purchase of the replacement property, while assigning the note to the seller after all the replacement property has been acquired.  Some qualified intermediaries will have a form that they will sign acknowledging the substitution of cash for the note with a promise to distribute the note upon the closing of the exchange account.
    Conclusion
    There are various scenarios in which an installment sale can impact tax deferral.  In some cases deferral can be attained by the taxpayer’s substitution of cash into an exchange account for an installment note or a sale under articles of agreement for deed. In our next post, we examine more complex instances involving installment sales and 1031 exchanges.

     

  • Can Property Improvement Costs Be Part of a 1031 Tax Deferred Exchange?

    What is a build-to suit or 1031 improvement exchange?
    Often a taxpayer will sell his old property (the relinquished property) for a greater value than the cost of purchasing the new property (the replacement property).  If nothing further is done, the excess value that is not reinvested is taxable and referred to as “boot” in the context of an Internal Revenue Code (IRC) 1031 exchange.  However, if the new property is land to be constructed upon (a build-to-suit exchange) or consists of land with a structure on it that needs further improvements (a property improvement exchange), it is possible for the improvement costs to be incurred prior to the exchange.  As is the case with many IRC §1031 procedures, there are safe harbor provisions which must be closely adhered to. 
    Many people assume that so long as the taxpayer uses exchange proceeds to acquire the new property and makes the improvements within the 180-day window for an exchange, the taxpayer can include the cost of the improvements into the value of the new property.  However, IRC §1031 regulations require a valid exchange to consist of like-kind properties being exchanged.  Hiring a contractor or other service provider and paying for labor and materials is not like-kind to the sale of real estate.  As expressed by the IRS the problem is as follows:

    “The transfer of relinquished property is not within the provisions of Section 1031(a) if the relinquished property is transferred in exchange for services. Thus any additional production occurring with respect to the replacement property after the property is received by the taxpayer will not be treated as the receipt of property of a like kind.” (Reg § 1.1031(k)-1(e)(4)).

    The exchange regulations became effective in 1991.  Approximately ten years later, in 2001, the IRS issued Revenue Procedure 2000-37 part of which dealt with this situation.  The IRS came up with the idea of a Qualified Exchange Accommodation Titleholder, an entity able to work around the issue of improvements not being like-kind to the taxpayer’s old property.  Revenue Procedure 2000-37 refers to this entity as an “Exchange Accommodation Titleholder,” now commonly called an EAT.
    There are many companies that act as qualified intermediaries for conventional forward exchanges, and a limited number of those companies are also set up to provide EAT services.  Selecting a knowledgeable qualified intermediary is critical to the success of the transaction (Read why in my recent discussion about the Case of Kreisers Inc. v. First Dakota Title Limited Partnership).
    How does the use of an EAT help in an exchange involving improvements?
    The EAT can acquire title to the new property on behalf of the taxpayer and to “park” it  until the improvements are in place (but in no event beyond 180 days).  Once the EAT transfers ownership of the property to the taxpayer, the taxpayer has acquired improved real estate, which then includes the value of the improvements that were made during the parking period.  For the mutual benefit of the taxpayer and the EAT, it is customary for the EAT to take title to the property using a special purpose entity, usually a limited liability company (LLC).  This insulates the client’s exchange transaction from other clients’ transactions as well as from the affairs of the exchange company acting as the EAT.

    What’s the difference between how forward and reverse build-to-suit or improvement exchanges are structured?
    A build-to-suit or improvement exchange can take two different forms.  The first occurs when the taxpayer has sold property and funded the exchange account prior to the acquisition date of the new property.  The exchange funds can pass to the EAT to cover the purchase price of the new property.  The balance of the funds are given to the EAT as necessary to cover the costs associated with making the improvements.  This is known as a forward build-to-suit or property improvement exchange.
    If the taxpayer wants to begin the improvements before the sale of the old property,  a reverse build-to-suit or property improvement exchange is necessary, since the sequence of buying (by the EAT) and selling is “reverse” from a normal exchange. In the case of a reverse transaction, since the exchange account it not yet funded, funding of the purchase price and improvements needs to be provided to the EAT from a bank or taxpayer loan or sometimes both.  These loans get paid back at the conclusion of the transaction when the exchange funds are used by the taxpayer to acquire the property from the EAT.
    Do all of the improvements need to be made during the 180-day parking period?
    It is not necessary for the improvements to be completed during the parking period, however the taxpayer only gets credit for the value of the land and improvements that are in place at the time the taxpayer takes direct ownership.  The taxpayer can make additional improvements after the exchange has taken place.
    What flexibility does Revenue Procedure 2000-37 allow in a build-to-suit or property improvement exchange?
    Revenue Procedure 2000-37 contains some very taxpayer friendly provisions including:

    The terms of any build-to-suit/property improvement contract between the taxpayer and EAT do not have to be at arm’s length.
    The taxpayer may loan funds directly to the EAT.
    The taxpayer is permitted to guaranty any bank loan made to the EAT.
    The taxpayer may indemnify the EAT for costs and expenses incurred.
    The taxpayer or a “disqualified person” (generally an agent of the taxpayer) may advance funds to the EAT.
    The property may be leased by the EAT to the taxpayer during the parking period.
    The taxpayer may act as the contractor (and receive a fee) or supervise the making of the improvements.

    In a reverse build-to-suit/property improvement exchange, at some time during the parking transaction (but no later than 180 days) the old property gets sold and the net proceeds go into the taxpayer’s  exchange account.  No later than 180 days from the inception of the parking transaction, the exchange funds are sent to the EAT as the nominal seller and the EAT uses these funds to repay the original bank and/or taxpayer loan. 
    The procedure is much the same for a forward build-to-suit/property improvement exchange where the exchange account has been funded prior to the parking transaction.  In this case, although the funds may have been paid out to the EAT, the taxpayer still needs to complete the conventional exchange by acquiring the improved property from the EAT.
    Whether it is a forward or reverse build-to-suit exchange, completing the transaction is the same.  The taxpayer’s rights under the contract to acquire the improved property from the EAT are assigned to the qualified intermediary, and the transfer to the improved property is accomplished by either assigning the membership interest in the EAT to the taxpayer or by the EAT issuing a deed to the taxpayer.
    Customary agreements that would be used to document this type of exchange include:

    Qualified Exchange Accommodation Agreement (required under Revenue Procedure 2000-37)
    Assignment by the taxpayer to the EAT of the purchase contract for the new property
    Loan documents between the EAT as borrower and the lender
    Master Lease if the property has a tenant or tenants
    Sale Contract for the sale of the property from the EAT back to the taxpayer
    Environmental Indemnity Agreement

     

  • Can Property Improvement Costs Be Part of a 1031 Tax Deferred Exchange?

    What is a build-to suit or 1031 improvement exchange?
    Often a taxpayer will sell his old property (the relinquished property) for a greater value than the cost of purchasing the new property (the replacement property).  If nothing further is done, the excess value that is not reinvested is taxable and referred to as “boot” in the context of an Internal Revenue Code (IRC) 1031 exchange.  However, if the new property is land to be constructed upon (a build-to-suit exchange) or consists of land with a structure on it that needs further improvements (a property improvement exchange), it is possible for the improvement costs to be incurred prior to the exchange.  As is the case with many IRC §1031 procedures, there are safe harbor provisions which must be closely adhered to. 
    Many people assume that so long as the taxpayer uses exchange proceeds to acquire the new property and makes the improvements within the 180-day window for an exchange, the taxpayer can include the cost of the improvements into the value of the new property.  However, IRC §1031 regulations require a valid exchange to consist of like-kind properties being exchanged.  Hiring a contractor or other service provider and paying for labor and materials is not like-kind to the sale of real estate.  As expressed by the IRS the problem is as follows:

    “The transfer of relinquished property is not within the provisions of Section 1031(a) if the relinquished property is transferred in exchange for services. Thus any additional production occurring with respect to the replacement property after the property is received by the taxpayer will not be treated as the receipt of property of a like kind.” (Reg § 1.1031(k)-1(e)(4)).

    The exchange regulations became effective in 1991.  Approximately ten years later, in 2001, the IRS issued Revenue Procedure 2000-37 part of which dealt with this situation.  The IRS came up with the idea of a Qualified Exchange Accommodation Titleholder, an entity able to work around the issue of improvements not being like-kind to the taxpayer’s old property.  Revenue Procedure 2000-37 refers to this entity as an “Exchange Accommodation Titleholder,” now commonly called an EAT.
    There are many companies that act as qualified intermediaries for conventional forward exchanges, and a limited number of those companies are also set up to provide EAT services.  Selecting a knowledgeable qualified intermediary is critical to the success of the transaction (Read why in my recent discussion about the Case of Kreisers Inc. v. First Dakota Title Limited Partnership).
    How does the use of an EAT help in an exchange involving improvements?
    The EAT can acquire title to the new property on behalf of the taxpayer and to “park” it  until the improvements are in place (but in no event beyond 180 days).  Once the EAT transfers ownership of the property to the taxpayer, the taxpayer has acquired improved real estate, which then includes the value of the improvements that were made during the parking period.  For the mutual benefit of the taxpayer and the EAT, it is customary for the EAT to take title to the property using a special purpose entity, usually a limited liability company (LLC).  This insulates the client’s exchange transaction from other clients’ transactions as well as from the affairs of the exchange company acting as the EAT.

    What’s the difference between how forward and reverse build-to-suit or improvement exchanges are structured?
    A build-to-suit or improvement exchange can take two different forms.  The first occurs when the taxpayer has sold property and funded the exchange account prior to the acquisition date of the new property.  The exchange funds can pass to the EAT to cover the purchase price of the new property.  The balance of the funds are given to the EAT as necessary to cover the costs associated with making the improvements.  This is known as a forward build-to-suit or property improvement exchange.
    If the taxpayer wants to begin the improvements before the sale of the old property,  a reverse build-to-suit or property improvement exchange is necessary, since the sequence of buying (by the EAT) and selling is “reverse” from a normal exchange. In the case of a reverse transaction, since the exchange account it not yet funded, funding of the purchase price and improvements needs to be provided to the EAT from a bank or taxpayer loan or sometimes both.  These loans get paid back at the conclusion of the transaction when the exchange funds are used by the taxpayer to acquire the property from the EAT.
    Do all of the improvements need to be made during the 180-day parking period?
    It is not necessary for the improvements to be completed during the parking period, however the taxpayer only gets credit for the value of the land and improvements that are in place at the time the taxpayer takes direct ownership.  The taxpayer can make additional improvements after the exchange has taken place.
    What flexibility does Revenue Procedure 2000-37 allow in a build-to-suit or property improvement exchange?
    Revenue Procedure 2000-37 contains some very taxpayer friendly provisions including:

    The terms of any build-to-suit/property improvement contract between the taxpayer and EAT do not have to be at arm’s length.
    The taxpayer may loan funds directly to the EAT.
    The taxpayer is permitted to guaranty any bank loan made to the EAT.
    The taxpayer may indemnify the EAT for costs and expenses incurred.
    The taxpayer or a “disqualified person” (generally an agent of the taxpayer) may advance funds to the EAT.
    The property may be leased by the EAT to the taxpayer during the parking period.
    The taxpayer may act as the contractor (and receive a fee) or supervise the making of the improvements.

    In a reverse build-to-suit/property improvement exchange, at some time during the parking transaction (but no later than 180 days) the old property gets sold and the net proceeds go into the taxpayer’s  exchange account.  No later than 180 days from the inception of the parking transaction, the exchange funds are sent to the EAT as the nominal seller and the EAT uses these funds to repay the original bank and/or taxpayer loan. 
    The procedure is much the same for a forward build-to-suit/property improvement exchange where the exchange account has been funded prior to the parking transaction.  In this case, although the funds may have been paid out to the EAT, the taxpayer still needs to complete the conventional exchange by acquiring the improved property from the EAT.
    Whether it is a forward or reverse build-to-suit exchange, completing the transaction is the same.  The taxpayer’s rights under the contract to acquire the improved property from the EAT are assigned to the qualified intermediary, and the transfer to the improved property is accomplished by either assigning the membership interest in the EAT to the taxpayer or by the EAT issuing a deed to the taxpayer.
    Customary agreements that would be used to document this type of exchange include:

    Qualified Exchange Accommodation Agreement (required under Revenue Procedure 2000-37)
    Assignment by the taxpayer to the EAT of the purchase contract for the new property
    Loan documents between the EAT as borrower and the lender
    Master Lease if the property has a tenant or tenants
    Sale Contract for the sale of the property from the EAT back to the taxpayer
    Environmental Indemnity Agreement