A 1031 exchange is a fantastic tool for investors who desire to avoid paying tax on the gain from the sale of real estate; however, in order to entirely delay the tax, an investor should discover one or more replacement residential or commercial properties with a total fair market worth that equals or exceeds what is being offered, and need to utilize all the money from the existing residential or commercial property and invest it in the new residential or commercial property. Many knowledgeable investor who recognize with 1031 exchanges do not recognize that a build-to-suit exchange can provide more flexibility in structuring their deals to fulfill these requirements.
The build-to-suit exchange permits an owner to utilize the earnings from the sale of the relinquished residential or commercial property not only to get replacement residential or commercial property, however also to make enhancements to the residential or commercial property. For instance, if an investor offers given up residential or commercial property with a fair market price of $1 million, financial obligation of $200,000 and equity of $800,000, he must obtain a residential or commercial property equal to at least $1 million and needs to invest a minimum of $800,000 into that residential or commercial property. In a build-to-suit exchange, nevertheless, the investor might get residential or commercial property worth just $300,000, borrow an additional $200,000 and spend the remaining $500,000 of exchange profits plus the $200,000 in loan funds on enhancements to the residential or commercial property. This would consume the remaining cash and increase the reasonable market price of the replacement residential or commercial property to $1 million, leading to a totally tax-deferred exchange.
STRUCTURING A BUILD-TO-SUIT EXCHANGE
A build-to-suit exchange is accomplished by having a holding entity called an Exchange Accommodation Titleholder (EAT) momentarily hold title to the replacement residential or commercial property while the improvements are being made. The EAT is usually a restricted liability company owned by a Qualified Intermediary (QI). The EAT is required due to the fact that any work done to the residential or commercial property after the financier takes title to it is not considered like kind residential or commercial property and for that reason will not increase the worth of the residential or commercial property for exchange purposes.
A build-to-suit exchange can be structured either as a deferred exchange where the existing residential or commercial property is sold before the new residential or commercial property is acquired, or a reverse build-to-suit, where the brand-new residential or commercial property is acquired initially. In either case, the whole deal should be completed within 180 days.
In a delayed build-to-suit exchange, the given up residential or commercial property is disposed of and the sale proceeds go to the qualified intermediary. The financier must determine what is to be obtained within 45 days, including a description of what will be constructed on the residential or commercial property. The EAT gets the residential or commercial property using the exchange funds. The financier supervises the construction of the improvements and periodically sends billings to the EAT, who pays them using exchange funds. The replacement residential or commercial property is transferred from the EAT to the investor on the earlier of when the construction is complete, when the 180 days expires or when adequate worth is contributed to the replacement residential or commercial property for complete tax deferral.
In a reverse build-to-suit exchange, the replacement residential or commercial property is gotten by the EAT first, using funds from the financier or a lender. Similar to a deferred exchange, the financier supervises the building and construction and sends out invoices to the EAT, but the EAT must borrow money from the loan provider or the investor to pay the billings. Eventually throughout the 180 day duration, the given up residential or commercial property is sold and funds are moved to the QI. If there is more construction required, the exchange funds can be used for the building and construction till the 180 day duration ends. Just like the delayed build-to-suit, the replacement residential or commercial property is transferred from the EAT to the financier on the earlier of when the construction is complete, when the 180 days expires or when adequate value is included to the replacement residential or commercial property for full tax-deferral.
BENEFITS AND DRAWBACKS OF DOING A BUILD-TO-SUIT EXCHANGE
The advantages of doing a build-to-suit exchange include the ability to purchase residential or commercial property that is lower in worth compared to the relinquished residential or commercial property and the ability to utilize exchange funds rather than loan proceeds to fund construction.
The principal downside of doing a build-to-suit exchange is that the work needs to be done within the 180 day period in order to have any impact on the exchange. For a lot of big building and construction tasks, this is tough; however, smaller sized tasks or improvements to existing structures can often be achieved within the needed time frame. In addition, build-to-suit exchanges are more costly than routine deferred exchanges, because the EAT will take title to the replacement residential or commercial property, which results in an additional realty transfer. Escrow costs, closing expenses and move taxes may be charged twice (as soon as when the EAT takes title and a 2nd time when the EAT move the residential or commercial property to the taxpayer). In addition, the exchange costs will be higher and the loan might be more expensive.
PLANNING FOR A BUILD-TO-SUIT EXCHANGE
For those intending to do a build-to-suit exchange, planning ahead is essential. First, include an arrangement in the agreement to purchase the replacement residential or commercial property that the agreement is assignable in connection with a 1031 exchange.
It is likewise important to get in touch with the EAT and any lender early while doing so, particularly if the investor plans to obtain money to get the replacement residential or commercial property or for building. Since the EAT will be on title, it will be signing the loan documents and the loan provider should want to comply in the build-to-suit exchange. The EAT needs to have no personal liability for any loan responsibilities. If the loan is to be fully or partially option, the investor can sign a warranty.
Getting a precise estimate of the amount of time it will require to finish the building and construction task is very important, as it will affect whether sufficient worth can be included the 180 day duration to make the exchange worthwhile. Although the building and construction does not need to be complete at the expiration of the 180 day duration, the only enhancements that will impact the value of the replacement residential or commercial property for exchange purposes are the improvements that are done since the date that the EAT transfers the replacement residential or commercial property to the investor.
Finally, financiers ought to consult with their tax advisors before doing any exchange, particularly a build-to-suit exchange. By effectively structuring a build-to-suit exchange, and by utilizing a trusted certified intermediary like First American Exchange Company, the financier may have far more flexibility in finding suitable residential or commercial properties and at the same time completely defer all capital gains tax.
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