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Build To Suit and a 1031 Exchange
A build to suit exchange, also known as an “improvement” or “construction” exchange is a way in which the IRS allows an investor to use the proceeds from their relinquished property to build a property that fits their specific needs (build to suit), or to upgrade the improvements of an existing property prior to taking title. The proceeds from the sale of the relinquished property are held by a qualified intermediary who then uses those pre-tax dollars to purchase the property to be upgraded or the land upon which the replacement property is to be built. Any remaining funds will be used to build the new or to improve the existing structure. The investor may add funds or debt financing if necessary.
It should be understood that although the format of obtaining the replacement property may be different, the basic rules of a 1031 exchange tax deferral must be met. That is to say that both the relinquished and replacement properties must be of “like kind” and the value of the replacement property must be of “equal or greater value” as the relinquished property at the time the exchanger takes possession of the replacement property.
The investor must submit detailed plans, including but not limited to any construction documents when identifying the property within the usual 45 day identification period. In order to qualify for the tax deferral, the completed structure must match the identified structure very closely and be completed within the standard 180 day period allowed by the IRS to close on a replacement property. Even with the best laid plans and particularly in a build to suit real estate project, the actual building of the replacement property can and most likely will take longer than expected. If the project is not completed within the time frame allowed an investor may defer the amount of capital gains tax obligation on a prorated basis. In other words if only 75% of the project is complete at the end of the 180 day period, then the investor will only be able to defer 75% of it capital gains tax obligation, this is known as a “partial exchange”.
The rule can be very effectively applied when the build to suit project will be much greater in value than the relinquished property. The rule permits an investor to plan for at least a portion of the property to be completed by the end of the specified time frame, meaning, that even though the entire project may not be completed within the required time frame, the “pro rata” share of the project that is complete at the end of the 180 days can satisfy the “of equal or greater value” requirement of a tax deferred exchange.
There have been some rulings by the IRS that allow an investor to use the “build to suit” exchange on a piece of land it already owns. This is an aggressive approach and must be looked at carefully by tax and legal advisors. Make sure to weigh both the possible benefits of this type of exchange and the impact the 1031 exchange being disallowed by the IRS.
As with all investments it is crucial that investors consult with their tax and legal advisors prior to committing to making any commitments.
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