Many real estate investor are aware of the money saving power of a 1031 exchange, and how it allows one to transfer their captial gains taxes from the sale of a property, into another like-kind property. However, it is not possible to use 1031 exchange proceeds to pay off debt on property you already own, nor can you 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.
The 1031 exchange proceeds would ideally be used to make the build to suit to your specifications on the new land, i.e., you get the built structure you want and purchase a replacement-property that is worth the same amount (or greater value). So how is it possible for you to do this?
There is an option that is referred to the “Poor Man’s” build to suit, in which the buyer asks the seller to make improvements to the replacement property before the close. For example, an investor (after selling her investment property) – wants to buy another property to replace it – for an equal or greater value.Although the vacant land she wants to buy is worth only ten-thousand dollars, which doesn’t fully qualify for a “like-kind” exchange, thus making an exchange impossible.
In this case, the property investor would request that the seller raise the price of the property 0,000 – but before closing – construct ,000 worth of improvements to the investment property. In the end, she will be purchasing property of equal value (100 thousand dollars).
It might be difficult to find a seller who is willing to increase the price of the property – in order to make improvements to it before selling it to you. Alternately, in our investors case, she can have her QI purchase the investment property on her behalf for k (using an LLC that the Qualified Intermediary owns outright) then construct the improvements to the property using the remaining funds from the exchange.
So likewise, your QI can fund the improvements during their construction, holding the property for you and paying for everything with the proceeds from the exchange. The investor can complete the exchange by receiving the replacement property from the Qualified Intermediary when the improvements are completed.
Consider the following things when you attempt to use a build to suite exchange. First of all, the one hundred and eighty day requirement allowed to complete a 1031 exchange, will not provide you with enough time for a “fancy” build to suit. But, this should be enough time to rehab and update an already standing building.
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. Simply dropping off some building materials on location is not acceptable; to constitute “real estate” your supplies must literally be attached to the building as a permanent part of the structure or affixed into the land that it is on.
Keep the foregoing in mind and you can avoid any pitfalls and get all of the tremendous tax benefits of a 1031 exchange that is build to suit.