Just like you cannot use 1031 exchange proceeds to pay off debt on property you already own, you cannot 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. What you ultimately want is to take the 1031 exchange proceeds, purchase new land and have it built to your specifications, i.e., you obtain the desired physical structure and buy a replacement property of equal or greater value. So how can you do 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, Tammy Taxpayer sells her property worth $100 thousand dollars, and wants to purchase a replacement property worth $100 thousand dollars or greater. 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, Tammy 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, Tammy will be purchasing property of equal value ($100 thousand dollars). 

 

Finding a replacement property seller who is willing to increase the sales price, and make improvements before closing, may be difficult.  Another option in Tammy’s case is to have the qualified intermediary (QI) buy the replacement property for $10 thousand dollars, take title in a LLC wholly owned by the QI and use the remaining exchange monies to construct improvements to the property. In other words, the QI holds the property during the construction process, and funds the improvements with the exchange monies. When the improvements to the replacement property are finished, Tammy can complete the exchange by receiving the property from the QI. 

 

Keep the following points to in mind about the 1031 Build to Suit 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. Second, the improvements to the replacement property must constitute “real estate” for purposes of a like-kind exchange, 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 the pitfalls and get all of  the tremendous tax benefits of a 1031 Build to Suit exchange.