Improvements to be Constructed in a 1031 Exchange

When a taxpayer plans to include improvements to be constructed in a 1031 exchange, the role of the Qualified Intermediary (QI) is extremely important. The Exchange Accommodator Titleholder (EAT) will hold the title to the property while the QI holds the cash included in the transaction while improvements are being made. The QI will then pay the vendors and contractors, and prior to the 180th calendar day post-closing on the old or new property, the EAT will convey title to the taxpayer.

In a simple, straightforward 1031 exchange, it is clear that the transaction will qualify for deferral of capital gains taxes. Many transactions, however, are not straightforward. For example, what happens if a taxpayer wants to include improvements to be constructed in a 1031 exchange transaction? The Tax Court has considered this issue over the years and has concluded that under certain circumstances a transaction such as this can qualify for Section 1031 exchange treatment.

In Bloomington Coca-Cola Bottling Co. v. C.I.R. 189, F.2d 14 (1951), the Tax Court considered a transaction where the taxpayer entered into a contract with a contractor to construct a new plant. The contractor furnished all materials and labor. The contractor was paid predominantly in cash but was also given the taxpayer’s old building and land in payment for his services under the contract. The taxpayer claimed that the transaction was an exchange, not a sale. The court disagreed. In its analysis, the Court pointed out that “The presence in a transaction of a small amount of cash, to adjust certain differences in value of the properties exchanged will not necessarily prevent the transaction from being considered an exchange… But this is not a case where the contractor exchanged a completed plant owned by the contractor for property and money, hence the contractor at no time had like property within the meaning of § 112 (b)(1) of the Revenue Act.”

On the other hand, the exchange of land for a building to be constructed on a site not presently owned, is a qualified exchange. In J.H. Baird Publishing Co. v. Commissioner, 39 T.C. 608 (1962), a taxpayer “sold” property to a contractor and then hired the contractor to build a building. The taxpayer then exchanged a second piece of property back to the same contractor. The Tax Court found this to be a like-kind exchange under Section 1031 because the two trades were viewed as parts of one transaction.

In the normal course of business, a taxpayer stands to incur capital gains taxes when property is sold and the taxpayer realizes a profit on the sale. Because the rate at which capital gains are taxed is high, taxpayers often look to alternative methods of constructing a transaction in order to avoid or defer the payment of capital gains taxes. One option is to enter into a Section 1031 exchange instead of a sale. If a transaction qualifies for 1031 exchange treatment, then any capital gains taxes that would otherwise be due are deferred.

In order for a transaction to be eligible for 1031 exchange consideration, it must meet some basic requirements. Although not an exhaustive list, the following are some of the most important requirements for a 1031 exchange:

  • The properties exchanged must be “like-kind”
  • Both the relinquished property and the replacement property must be held for productive use in a trade or business or be held for investment purposes
  • The exchange must be completed within 180 days
  • A qualified intermediary must facilitate the exchange
  • Certain types of property are specifically excluded such as personal residence, stocks, bonds, securities and property held primarily for sale

There are many types of exchanges such as a forward 1031 exchange the old property is sold before the new property is purchased. In a reverse 1031 exchange, the new property is acquired before the old property is sold. Given property planning, land or property already owned can be improved with proceeds from the sale of an old property, known as a leasehold improvement exchange. Each follows the basic five requirements stated above.

When considering whether a 1031 exchange makes sense, determine the recognized gain or tax as a starting point and if the intent is to replace, then most likely a 1031 exchange is the right choice.