Build-To-Suit Exchanges: using Exchange Funds for Improvements on your Replacement Residential or Commercial Property

A 1031 exchange is an excellent tool for financiers who desire to avoid paying tax on the gain from the sale of realty; nevertheless, in order to entirely defer the tax, an investor needs to discover one or more replacement residential or commercial properties with a total fair market value that equates to or surpasses what is being offered, and should utilize all the cash from the existing residential or commercial property and invest it in the new residential or commercial property. Many knowledgeable real estate financiers who are familiar with 1031 exchanges do not realize that a build-to-suit exchange can give them more flexibility in structuring their transactions to meet these requirements.

The build-to-suit exchange allows an owner to use the earnings from the sale of the relinquished residential or commercial property not only to get replacement residential or commercial property, however likewise to make enhancements to the residential or commercial property. For example, if a financier sells given up residential or commercial property with a reasonable market price of $1 million, debt of $200,000 and equity of $800,000, he must acquire a residential or commercial property equivalent to at least $1 million and must invest at least $800,000 into that residential or commercial property. In a build-to-suit exchange, nevertheless, the investor could acquire residential or commercial property worth just $300,000, borrow an extra $200,000 and invest the remaining $500,000 of exchange proceeds plus the $200,000 in loan funds on improvements to the residential or commercial property. This would consume the remaining cash and increase the fair market value of the replacement residential or commercial property to $1 million, leading to a fully tax-deferred exchange.

STRUCTURING A BUILD-TO-SUIT EXCHANGE

A build-to-suit exchange is achieved by having a holding entity called an Exchange Accommodation Titleholder (EAT) briefly hold title to the replacement residential or commercial property while the improvements are being made. The EAT is generally a minimal liability company owned by a Competent Intermediary (QI). The EAT is essential due to the fact that any work done to the residential or commercial property after the investor takes title to it is not thought about like kind residential or commercial property and therefore will not increase the worth of the residential or commercial property for exchange functions.

A build-to-suit exchange can be structured either as a deferred exchange where the existing residential or commercial property is offered before the new residential or commercial property is acquired, or a reverse build-to-suit, where the brand-new residential or commercial property is obtained initially. In either case, the whole transaction should be completed within 180 days.

In a delayed build-to-suit exchange, the given up residential or commercial property is dealt with and the sale continues go to the certified intermediary. The financier must recognize what is to be obtained within 45 days, consisting of a description of what will be built on the residential or commercial property. The EAT gets the residential or commercial property using the exchange funds. The investor oversees the building of the improvements and occasionally sends out billings to the EAT, who pays them using exchange funds. The replacement residential or commercial property is transferred from the EAT to the financier on the quicker of when the construction is complete, when the 180 days ends or when enough value is contributed to the replacement residential or commercial property for full tax deferral.

In a reverse build-to-suit exchange, the replacement residential or commercial property is obtained by the EAT initially, using funds from the financier or a lender. Just like a deferred exchange, the financier supervises the building and sends out invoices to the EAT, but the EAT needs to borrow cash from the lender or the financier to pay the billings. At some point throughout the 180 day duration, the given up residential or commercial property is sold and funds are transferred to the QI. If there is more building and construction needed, the exchange funds can be utilized for the building till the 180 day duration expires. Just like the postponed build-to-suit, the replacement residential or commercial property is transferred from the EAT to the investor on the quicker of when the construction is total, when the 180 days expires or when sufficient value is included to the replacement residential or commercial property for complete tax-deferral.

BENEFITS AND DRAWBACKS OF DOING A BUILD-TO-SUIT EXCHANGE

The advantages of doing a build-to-suit exchange consist of the capability to purchase residential or commercial property that is lower in worth compared to the relinquished residential or commercial property and the ability to use exchange funds instead of loan proceeds to fund building.

The primary drawback of doing a build-to-suit exchange is that the work should be done within the 180 day period in order to have any effect on the exchange. For the majority of large building jobs, this is tough; however, smaller jobs or enhancements to existing structures can frequently be accomplished within the needed amount of time. In addition, build-to-suit exchanges are more costly than regular deferred exchanges, since the EAT will take title to the replacement residential or commercial property, which leads to an extra realty transfer. Escrow fees, closing expenses and move taxes may be charged two times (as soon as when the EAT takes title and a 2nd time when the EAT transfer the residential or commercial property to the taxpayer). In addition, the exchange charges will be higher and the loan might be more pricey.

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 contract is assignable in connection with a 1031 exchange.

It is also crucial to get in touch with the EAT and any lender early in the procedure, particularly if the financier intends to borrow money to acquire the replacement residential or commercial property or for building. Since the EAT will be on title, it will be signing the loan files and the lender must be prepared to comply in the build-to-suit exchange. The EAT should have no personal liability for any loan obligations. If the loan is to be fully or partly recourse, the financier can sign a warranty.

Getting an accurate quote of the quantity of time it will take to complete the construction task is essential, as it will impact whether sufficient value can be added in the 180 day period to make the exchange beneficial. Although the building and construction does not have to be total at the expiration of the 180 day duration, the only enhancements that will affect the value of the replacement residential or commercial property for exchange purposes are the improvements that are done as of the date that the EAT transfers the replacement residential or commercial property to the investor.

Finally, financiers must seek advice from their tax advisors before doing any exchange, especially a build-to-suit exchange. By correctly structuring a build-to-suit exchange, and by utilizing a reliable competent intermediary like First American Exchange Company, the investor may have far more versatility in finding appropriate residential or commercial properties and at the very same time totally postpone all capital gains tax.