When a taxpayer sells property outright, any gain realized on the sale of the property is potentially subject to the typically high capital gains tax rates. One option for a taxpayer who wishes to avoid incurring a capital gains tax obligation is to enter into a “like-kind” exchange instead of a traditional sale. Under the Internal Revenue Code, Section 1031 allows such an exchange if all relevant conditions are met. In a simple Section 1031 Exchange, a taxpayer must designate a property to be relinquished as well as a replacement property to be exchanged. A Qualified Intermediary, or QI, is then used to facilitate the exchange, which must be completed within 180 days. Additionally, the properties involved in the transaction must be held either for productive use in a trade or business or for investment.
Improvement Exchange
Over the years since Section 1031 was created, like-kind exchanges have taken on many complicated forms that have required the Tax Court to rule on their eligibility. One such evolution is known as the “improvement exchange,” “built-to-suit exchange,” or “construction exchange.” In this type of exchange, improvements are made to the replacement property as part of the exchange. Often, an improvement exchange contemplates improvements made on real property that is already owned by the taxpayer in what is recognized as a Leasehold Improvement Exchange. Because Internal Revenue Service Revenue Procedure 2000-37 prohibits a taxpayer from simultaneously owning both the relinquished property and the replacement property, this type of exchange requires the replacement property to be “parked” with an Exchange Accommodation Titleholder, or EAT, throughout the 180 day period during which the improvements are taking place. One issue that a taxpayer may face when participating in an improvement exchange relates to “soft costs.”
Soft Costs
The overall goal of a Section 1031 Exchange is to avoid receiving any cash or assets directly, thereby avoiding capital gains taxes. If any money or property is received by the taxpayer, either directly, indirectly, or constructively, it is considered “boot” and is taxable. In an improvement exchange, there are a number of costs that could be considered boot. Understanding which of these “soft costs” are tax-deferred and which are considered “boot” is critical for a taxpayer contemplating an improvement exchange.
I.R.S. Private Letter Ruling 200329021 analyzed an improvement exchange where taxpayer was attempting to make improvements to land in which taxpayer had an ownership interest. In that case, taxpayer set up the transaction using both a QI and an EAT to facilitate the transaction, which allowed the replacement property to be “parked” during the improvement stage. The improvements were scheduled to be completed within the 180 day time frame. The ruling allowed the transaction and found that taxpayer would not be in possession of money or property that would subject taxpayer to payment of capital gains taxes, provided that the improvements were completed on time. In the event that improvements were made subsequent to the 180 day period, the value of those improvements would be considered boot and, therefore, be taxable. In addition, “to the extent the estimated cost of the Improvements is less than the qualified funds held by QI, if Taxpayer does not timely identify and acquire additional like-kind replacement property Taxpayer will receive the remaining qualified funds as boot.”
In a footnote, on page three of subject Private Letter Ruling, “soft costs,” including architectural and engineering fees, permit fees, attorney and CPA fees, incurred and paid months in advance of the EAT’s purchase of the replacement property, can be reimbursed to the Taxpayer by the EAT. Planning costs should be capitalized into the replacement property per Internal Revenue Code § 263(a)(1). Finally, improvements must actually be made to the existing structure, meaning that the value of raw materials that are simply delivered to the site and not installed are not tax-deferred.
As with all Section 1031 Exchange transactions, be sure to consult with an expert prior to moving forward to ensure that your transaction will meet the often complicated eligibility requirements.
We Can Help
Atlas 1031 Exchange has been accommodating tax-deferred exchanges of all kinds for more than 17 years. We are fluent in the rules and regulations of IRC Section 1031 and able to help you navigate your exchange.
Contact us today to discuss any questions you may have. Call our office at 1-800-227-1031, email us at info@atlas1031.com, or submit your question through the online form at the top of this page.
