Improvement and Build-to-Suit Exchanges Offer Investors New Opportunities in 2004
Articles from The Massachusetts Focus
Newsletter of Stewart Title Guaranty Company, Massachusetts Offices
Winter 2004, Volume 3, Number 1
Improvement and Build-to-Suit Exchanges Offer Investors New Opportunities in 2004
by Robert HB Buckner of Asset Preservation Inc, a subsidiary of Stewart Title Company
As IRC §1031 tax deferred exchanges continue to become more popular, taxpayers are discovering creative strategies that provide full tax deferral and offer the ability to acquire a wider range of replacement properties. A variation of a "parking arrangement," called the improvement exchange, can be an excellent alternative in many situations. The improvement exchange, also called a construction or build-to-suit exchange, allows a taxpayer (also referred to as an Exchanger), through the use of a Qualified Intermediary (QI) and Exchange Accommodation Titleholder (EAT), to make improvements on a replacement investment property using exchange equity.
Benefits of the Improvement Exchange
Improvement exchanges offer a taxpayer a wide array of benefits which often result in a better investment than properties readily available on the open market. The ability to renovate, add capital improvements, or build from the ground up, while using tax deferred dollars, creates tremendous investment opportunities.
A taxpayer must meet three basic requirements in order to defer all of their capital gain in the improvement exchange format:
- Reinvest the entire net exchange equity on completed improvements or down payment by the 180th day.
- Receive substantially the same property identified by the 45th day.
- The replacement property must be of equal or greater value at time of transfer to the taxpayer.
The final value of the replacement property is the combination of the original purchase price plus the capital improvements made to the property. The improvements needed to meet the requirements for full deferral must be in place prior to the taxpayer taking title to the replacement property. Note: The taxpayer does not have to have a Certificate of Occupancy nor a completed building transferred to qualify for tax deferral. For example, if a taxpayer is selling a $1 million relinquished property that is free and clear and they plan to have a $3 million replacement property constructed, they only need to have at least $1 million of combined value in the partially completed building and land to qualify for full tax deferral.
In a typical improvement exchange, the taxpayer uses a Qualified Intermediary to sell its relinquished property. An affiliate of the Qualified Intermediary (QI), an Exchange Accommodation Titleholder (EAT), uses the proceeds from this sale to purchase a new replacement property from a third-party seller, improve the property, and transfer improved property to the taxpayer within 180 days after the day the relinquished property was transferred.
The use of the EAT and QI, in this manner, allows the taxpayer to control the property and improvements built thereon. Because the EAT is treated as owning the property for federal income tax purposes, however, the taxpayer is able to reinvest the proceeds from the sale of the relinquished property into the land and improvements, tax deferred. This creates greater tax deferral than the taxpayer would obtain if only the land had been replacement property.
As with any tax deferred exchange, the taxpayer must acquire a property or properties identified in accordance with the rules of identification specified in the 1991 Treasury Regulation within 45 calendar days from the close of the relinquished property sale (the "Identification Period"). In an improvement exchange, the rules are more specific. The Treasury Regulations state: "if the identified replacement property consists of improved real property where the improvements are to be constructed, the description of the replacement property satisfies the requirements of paragraph (c)(3) of this section (relating to description of replacement property) if a legal description is provided for the underlying land and as much detail is provided regarding construction of the improvements as is practicable at the time the identification is made." As a result of this requirement, many taxpayers provide the Qualified Intermediary with the parcel they are purchasing and a copy of the construction blueprints. A taxpayer is entitled to make ongoing construction changes, such as moving the location of a wall a foot or two as long as what they ultimately acquire is substantially the same as what was identified. The Treasury Regulations note the following: "…(relating to receipt of the identified replacement property), in determining whether the replacement property received by the taxpayer is substantially the same property as identified where the identified replacement property is property to be produced, variations due to usual or typical production changes are not taken into account. However, if substantial changes are made in the property to be produced, the replacement property received will not be considered to be substantially the same property as identified." Certainly a taxpayer would not want to identify the construction of a small retail center build end up acquiring an apartment complex as their replacement property.
Another potential pitfall is that the taxpayer must actually receive improved real property before the 180th calendar from the sale of the relinquished property. Only those real property improvements that have been made within the exchange period are considered qualifying property in a typical improvement exchange.
The Treasury Regulations state: "…if the identified replacement property is real property to be produced and the production of the property is not completed on or before the date the taxpayer receives the property, the property received will be considered to be substantially the same property as identified only if, had production been completed on or before the date the taxpayer receives the replacement property, the property received would have been considered to be substantially the same property as identified. Even so, the property received is considered to be substantially the same property as identified only to the extent the property received constitutes real property under local law. The transfer of relinquished property is not within the provisions of section 1031(a) if the relinquished property is transferred in exchange for services (including production 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." For example, if the taxpayer has $40,000 remaining in the EAT's exchange account on day 179 that is released to the builder for improvements to be made after the 180th day, this $40,000 amount would be considered "cash boot" to the taxpayer. However, all the other funds already reinvested into real property improvements prior to the date of transfer back to the taxpayer, qualify for deferral.
A taxpayer is selling a $1,000,000 (free & clear) automobile dealership in Framingham and wants to build a new and larger automotive dealership in Marlborough. The new dealership - both land and improvements - will be worth $2,000,000 at completion and will consist of $930,000 equity and $1,030,000 financing with a local lender. The $930,000 net equity must be reinvested in "like-kind" real property within the 180-day exchange period. The taxpayer will complete the remainder of the improvements after the exchange is completed and they are back on title to the land and a partially completed building.
Making Improvements on Property Already Owned by an Affiliate or Party Related to the Taxpayer Sometimes taxpayer wants to make improvements to a property already owned because they are familiar with their own property and feel it is easier to improve a property they already own. It is well established that a taxpayer cannot include improvements to property already owned as replacement property. (See Bloomington Coca Cola.) However, recently the IRS released Private Letter Rulings 200251008 and 200329021, which set forth structures where an EAT made improvements to a property owned by an affiliate or related party and then the taxpayer received the improved property as qualifying replacement property. Although these rulings are not identical, they do share a similar approach:
- Taxpayer enters into a Qualified Exchange Accommodation Agreement (QEAA) with the EAT and enters into an exchange agreement with a QI;
- Taxpayers's affiliate or related party leases the replacement property to EAT at fair market rent, for a term of not less than 30 years, as part of the QEAA as defined in Revenue Procedure 2000-37;
- Taxpayer (or a third-party bank where the Exchanger gives its personal guaranty) lends EAT the funds needed to construct improvements on the leased property;
- Taxpayer assigns its rights to the sale contract of the relinquished property to the QI;
- Taxpayer transfers title to the relinquished property to the buyer;
- Taxpayer assigns its rights in the QEAA to the QI;
- QI uses proceeds from the sale of the relinquished property to pay EAT;
- EAT uses the proceeds received from the QI to pay for improvements and/or to pay the construction loan in full; and
- QI directs EAT to transfer the improved replacement property directly to the taxpayer.
The improvement exchange allows the taxpayer to either take advantage of an excellent purchase opportunity on a building needing renovations or construct a new building from the ground up that either meets the exact requirements of an owner-user or will satisfy very specific investment objectives. Essentially, taxpayers are no longer limited to existing inventory, but can take full advantage of more diverse replacement property purchase opportunities.
Note: Asset Preservation, Inc. urges every taxpayer to consult with their own legal and/or tax advisors regarding their specific situation. A Private Letter Ruling (PLR) applies to the facts and circumstances of a taxpayer's specific situation. Most Private Letter Rulings have language as follows: "This ruling is directed only to the taxpayer who requested it. Section 6110(k) (3) of the Code provides that it may not be cited as precedent."
For additional information contact Mr. Buckner at Asset Preservation, Inc., a Subsidiary of Stewart Title Company 617-571-8217 or firstname.lastname@example.org.