What A Taxpayer Should Know Before Deciding Not To Enter Into A Section 1031 Exchange*
 
Typically, taxpayers who prefer to defer income tax by exchanging their real estate for like-kind property will often attempt to locate property before listing their relinquished property for sale. Unfortunately, such taxpayers often have difficulty locating suitable replacement property in the area where they want to relocate that ultimately causes them to refuse to sell their relinquished property or settle for less than suitable replacement property. Rather than not selling their relinquished property or settling for less than suitable replacement property, taxpayers may purchase vacant land and construct their own building. Alternatively, such taxpayer may purchase less than suitable property and make any necessary repairs and renovations to qualify for tax deferred treatment under Section 1031 of the Internal Revenue Code.
 
Similar to the traditional 1031 exchange, construction exchanges may be simultaneous or deferred, forward or reverse as well as structured in various ways. Many of the rules that apply to a traditional 1031 exchange will also apply to a construction exchange. However, the taxpayer, in deciding whether to undergo a construction exchange, will encounter and attempt to resolve several issues that are discussed below.
 
1. Who should own the replacement property while the construction occurs?
 
If an exchange is organized using a party other than a qualified intermediary to make the improvements to the replacement property, agency issues will likely arise. A party other than a qualified intermediary may include a related party, contractor or other third party who purchases the replacement property and constructs its improvements at the bequest of the taxpayer. In the event that this is the case, the Internal Revenue Service may assert that the taxpayer's level of control over the other party is such that the taxpayer is in constructive or actual receipt of the exchange proceeds. If this, in fact, is true, the transaction will fail to qualify for 1031-tax deferral treatment. Notwithstanding the foregoing issues, the Internal Revenue Code does not prohibit such an arrangement with a non-qualified intermediary. Rather, the employment of a non-qualified intermediary merely complicates the proposed construction exchange. In light of the shortcomings associated with using a party other than a qualified intermediary, a taxpayer should retain the services of a qualified intermediary as such intermediary is not considered to be the agent of the taxpayer if the intermediary otherwise is qualified and the intermediary explicitly restricts the taxpayer's access to proceeds being held by the intermediary.
 
2. May an unconstructed building be identified as replacement property?
 
In the event that the replacement property does not exist or is being constructed at the time the property is identified as replacement, a transfer of relinquished property in a deferred exchange will still qualify for 1031-tax deferral treatment. In any case, however, a taxpayer must identify replacement property with great specificity. Such identification must include a legal description for the underlying land and as much detail pertaining to the construction of the improvements as is practicable at the time the identification is made, including, but not limited to, detailed plans and specifications for the structure to be built or repaired.
 
Variations as a result of usual or typical construction changes are not considered in assessing whether the replacement property received by the taxpayer is substantially the same property as identified where the identified replacement property is property to be constructed. If, however, substantial changes are made in the property to be produced, the replacement property received will not be considered to be substantially the same property as identified and the exchange will thus fail.
 
3. Must the construction of the building be completed within the exchange period?
 
As long as the taxpayer would have received substantially the same property had the construction been completed within the exchange period, the replacement property will not, by itself, constitute a substantial variation from the property identified if the construction of the replacement property is not completed by or at the time of the exchange.
 
Even if the construction on the replacement property is not completed within the exchange period, the exchange may still go forward, but the exchange value of the replacement property will only include the land and construction work completed prior to its receipt. Thus, in the event that net proceeds of the sale of the relinquished property are completely expended on the construction prior to the end of the 180-day exchange period, the exchange may then be consummated despite the incomplete construction, subject, of course, to the liability netting rules (any debt on the relinquished property should be matched by an equal amount of debt on the replacement property to avoid taxable gain to the taxpayer). Improvements constructed subsequent to the acquisition of the replacement property by the taxpayer do not constitute like-kind replacement property.
 
4. How much control may the taxpayer exert over the construction process?
 
The taxpayer is not completely restricted from participating in the construction process. Based upon various Internal Revenue Service letter rulings and pertinent case law, the taxpayer has been permitted to take the following actions with respect to construction exchanges: (1) supervise construction of the improvements; (2) review and approve payment of invoices/draw requests; (3) provide funds to finance the construction of the improvements; (4) take on the responsibility of cost overruns; and, (5) allow a party related to the taxpayer act as the contractor in building the improvements. Greater control may be exerted by the taxpayer over the construction process, even acting as the general contractor on the condition that the taxpayer does not make a profit in that role, if the construction exchange is structured to satisfy the safe harbor provisions of Revenue Procedure 2000-37.
 
5. May the taxpayer, if necessary, engage in a reverse construction exchange by purchasing the replacement property and constructing the improvements prior to selling the relinquished property?
 
A reverse construction exchange occurs when the taxpayer requires the construction of replacement property to be completed prior to the sale of the relinquished property. Revenue Procedure 2000-37 issued by the Internal Revenue Service provides guidance as to how to structure valid reverse exchanges. In carrying out a successful reverse construction exchange under the applicable Revenue Procedure, a taxpayer will normally engage in "parking" or "warehousing" transactions. "Parking" transactions are usually designed to "park" the desired replacement property with a qualified intermediary until such time as the taxpayer arranges for the transfer of the relinquished property to the ultimate buyer in a simultaneous or deferred exchange. Generally, in a reverse construction exchange the qualified intermediary would take title (i.e., park) to the replacement property through a single asset special purpose entity usually, a LLC and enter into a construction agreement with the taxpayer's general contractor to construct the improvements. Because of the difficulties presented in financing the construction or acquisition of the replacement property, the relinquished property, if necessary, may be "parked" and the taxpayer may take title to the replacement property and construct the improvements.
 
Very often, a reverse construction exchange cannot be completed by the end of the 180-day safe harbor period permitted in Revenue Procedure 2000-37. Such Procedure merely provides a safe harbor for reverse exchanges that satisfy its requirements. However, Revenue Procedure 2000-37 recognizes that "parking" transactions may be accomplished outside the safe harbor period. Thus, a non-safe harbor exchange may be completed successfully if such exchange is structured correctly so that the qualified intermediary has enough of the benefits and burdens pertaining to the property that the qualified intermediary, in effect, will be regarded as the owner for federal income tax purposes.
 
John M. Iacoi, Esquire
The Law Office of John M. Iacoi &Associates
Lewis Wharf, Bay 215
Boston Massachusetts 02110
Tel: 617.723.3777
Fax: 617.723.7876
Email: jmiacoi@brahmacom.com
 
*This Article is based upon a combination of research from the Law Office of John M. Iacoi & Associates and information provided by "All States Exchange Facilitator, LLC"