Build-To-Suit: Use the 1031 Exchange to Build The Perfect Investment Property

You’ve probably heard of the Internal Revenue Code (IRC), a multi-volume compilation of domestic tax law that codifies how the US government imposes taxes. Also known as Title 26 of the United States Code, this behemoth is bound to inspire fear and boredom with its esoteric jargon and staggering 9,384 sections.  Yet within its seemingly endless pages are some very useful sections that deserve the attention of those who are looking to make savvy investments. This post aims to explore the implications of one of those noteworthy segments – Section 1031 – in a way that is tangible even for the legally averse.

What does Section 1031 Say?

Section 1031 of the IRC allows for the deferment of capital gains tax on the sale of an investment property if it is exchanged for a “like-kind” asset of equal or greater value anywhere within the United States. Normally any capital gain is subject to taxation at the time of sale, but under this law, the profits are not immediately taxed and can be ‘rolled over’ into the next investment.  The like-kind requirement is interpreted quite flexibly; any assets or properties of similar nature will qualify, even if you’re selling a rental home and acquiring a retail lot. This is a huge boon for the property owner, who can essentially upgrade their portfolio and increase returns on investment without losing significant capital to taxation.

Imagine you bought a house as a rental investment for $700K five years ago, and the house is now worth $1M.  If you wanted to change, upgrade, or diversify your investment without using the 1031 Exchange, you would have to pay tax on your capital gain of $300K when the building is sold. Let’s suppose for simplicity that you live in California and you are in the higher bracket for capital gains tax at 33% . ¹ You would pay $100K in taxes, and would now only have $900K to put towards your next investment.  Under the 1031 Exchange, however, the $300K profit would be tax-deferred so long as the new property was of equal or greater value.

It’s no wonder that the 1031 Exchange has become so popular since its establishment in 1954;² a 2015 report by the National Association of Realtors found that 68% of realtors had participated in one in the last four years. However, successfully qualifying for tax-deferral recognition can be tricky. Failing to complete the exchange within the following parameters means whatever profit you’ve made on the sale of your property is considered “boot” and will be taxed.

Complying with the 1031 Exchange

Only Investment Assets

First off, all properties being relinquished and acquired must be intended for productive investment purposes. This means you can’t sell your primary residence and, no, you can’t use the 1031 to flip houses.

Timeframe for the Transaction

The transaction must be completed within the given deadline. You have 45 days after the closing of the original real estate sale to identify replacement properties, and the new property must be acquired within 180 days of the former’s closing.

Equal or Greater Value

You can buy multiple properties with the funds as long as their combined value is equal to or greater than the sold property.

Exchange through a Qualified Intermediary

All 1031 Exchanges require a Qualified Intermediary (QI), or Accommodator, to facilitate the transfer of the relinquished property and the replacement property.  In order to prevent the proceeds from actually passing into the hands of the exchanger (which would void the 1031 Exchange and result in taxation), the proceeds must temporarily be held in a third-party trust or escrow with the Accommodator.

The most straightforward scenario for a like-kind exchange is the “forward exchange,” in which the relinquished building is sold before the new one is acquired. Yet there are other types of 1031s besides the forward exchange, including the “reverse exchange,” where the desired property is bought before closing, and the “improvement exchange,” where the new property is renovated or built on before exchanging.  Also known as a “build-to-suit,” the improvement exchange allows the exchanger to tailor a building to their needs before acquiring it, and qualifies for 100% tax-deferral if the total cost of the new purchase is equal to or greater than the one sold when including the real estate and the construction.

Understanding the Build-to-Suit Exchange

In an ideal world, a perfect property would appear just as you’ve found a buyer for yours. The values of the real estate would be comparable, and the whole exchange would happen without a hitch.  In reality, this is rarely the case.

Let’s take our imaginary house from the earlier example.  You’re looking for a good investment to exchange your current $1M property for, but all the promising options are significantly more expensive and you’re not willing to invest more capital or take out more loans. On the other hand, buying a property of lesser value means the difference gets taxed.  This is where the build-to-suit exchange would be useful. You could buy a less expensive lot for $850K, then spend $150K or more fixing it up to build your ideal house that would be 100% tax-deferred!

The caveat here is that all of the rules mentioned above still apply in a build-to-suit, including the 45/180 day deadlines. Only completed construction will be considered for tax-deferment, as a contract for future work or building materials are not considered a like-kind exchange.  That doesn’t mean you have to rush to finish all improvements by the 180-day mark; you just need to complete the portion of the construction that qualifies for tax-deferment.  If you only spent $100K to fix up your home, you wouldn’t reach an equal exchange and the difference ($50K) would be taxable as boot.

The build-to-suit exchange also adds another level of complexity, in that the exchanger cannot hold the title to the property while the improvements are being made. The moment the exchanger is in possession of the receipt of sale or the title to the new property, the transaction is complete and any profit at that time will be taxed. This means that in an improvement exchange, the deed must be temporarily “parked” in a EAT, or Exchange Accommodation Titleholder that will hold the legal title to the replacement property until it’s conveyed to the exchanger.  A corollary requisite is that a fund be established with the EAT, from which all contractor invoices will be paid.

Because the Improvement Exchange is more complicated, it is also more expensive. An average QI may charge less than a thousand dollars for drawing up documents and managing escrows accounts in a forward exchange, but fees can increase beyond five thousand dollars for an improvement exchange.

Best Practices for an Improvement Exchange

All of this may sound a bit daunting, but if you think a build-to-suit is the right way to go, there are a few ways to ensure you’re prepared for it.

Spend time vetting your Qualified Intermediary

Some states regulate QIs, but most states do not require a special license to be an Accommodator. It’s up to you to do your due diligence to ensure that they are experienced with the more complex improvement exchange, as they will be your guide through the proper legal procedures. Choosing the right QI can help you avoid headaches or legal pitfalls down the road.

Find a professional and cooperative contractor

You only have 180 days to complete construction, so it’s especially crucial to find a reliable contractor that can stay on schedule and is highly responsive before you move too far ahead with the 1031. Have thorough discussions with possible contractors and as always, ask for multiple bids to compare prices and experiences. Have they worked on an improvement exchange before, and are they willing to work with and be paid by the QI? Make sure they’re not overbooked with projects that could bump yours further down their priority list.

Know the scope of the work before you close

Maximize the time you have for construction by scoping out the project beforehand. You should have a clear plan with your contractor for what needs to be done to renovate your perfect property, as well as the timeline for achieving it so you can hit the ground running on Day 1.

Building or renovating your next investment property certainly requires more coordination than exchanging for it, but in some ways can offer more flexibility to shape your perfect investment. Hopefully this post has given you a basic understanding of how the 1031 Exchange and build-to-suit works. Happy building!

Footnotes

1. The capital gains tax rate varies by income bracket, marriage status, and state. An additional 3.8% Net Investment Income Tax may be applicable for those with income above $200K for single / $250K married filing jointly.
2. The first tax-deferred like-kind exchange was codified in The Revenue Act of 1921 as Section 202(c) of the Internal Revenue Code. After several adaptations and changes in numbering, the relevant law was changed to Section 1031 of the IRC in 1954. See this page for more about its history.

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