In a real property exchange, can proceeds from the relinquished property sale be used to acquire replacement property and improvements thereon? Yes. This type of exchange often falls under the moniker of construction exchange, improvement exchange or more commonly known as a build to suit (BTS) exchange.

While highly complex, the BTS exchange provides the taxpayer exchanger an opportunity to invest his or her exchange funds into replacement property and improvements thereon. This exchange structure can be attained through a forward or reverse exchange, allowing taxpayers the benefit of this tax deferral strategy while providing more flexibility to either renovate an existing improved property or construct new improvements on raw land. The delayed build-to-suit exchange begins when the taxpayer exchanger sells his/her relinquished property and acquires the identified replacement property, only after it has been improved, with the proceeds from the sale of the relinquished property.

Under the safe harbors noted in Revenue Procedure 2000-37, the entity created to hold title to the replacement property, during the exchange period, is referred to as the Exchange Accommodation Titleholder (EAT). The replacement property is parked with the EAT during the exchange period and while improvements are made. The EAT will typically be a special purpose entity like an LLC. The Qualified Exchange Accommodation Agreement (QEAA), the contractual agreement between exchange parties, will be created between the taxpayer exchanger, the EAT and the Qualified Intermediary.

The QEAA will allow the EAT to use exchange proceeds to acquire the replacement property and make any identified improvements made thereon. Typically, the contractor will arrange for the construction contract to spell out the construction details to take place during the exchange period. The EAT is party to the construction contract as the entity with qualified indicia of ownership of the property being improved. The QEAA also provides for the taxpayer exchanger to act as project manager to oversee all aspects of the construction during the exchange period. The taxpayer will approve and confirm improvements have been made to the real property and submit approved invoices for payment to the EAT. In the event the taxpayer exchanger secures a construction loan from a lender, the taxpayer or his/her counsel should clearly communicate the details of the exchange to the lender. The lender must be aware of the EAT holding title to the collateral property.

During the exchange, there may be many fees and disbursements that need to be monitored carefully by the EAT and QI. Most build-to-suit exchanges are burdened with architect's fees, permit fees, demolition expenses, debris removal, etc., all before any improvements are actually constructed. Without payment of those fees, the project would not get underway. It is crucial to remember, however, that even if it is permissible to disburse proceeds (either sale or loan proceeds) for these expenses, the expenditures themselves pre-construction do not improve the fair market value of the property. Taxpayers would be well cautioned to remember that even if they use all of their exchange proceeds during the 180-day construction period, the IRS may not view the exchange as one in which proceeds can be fully deferred if the fair market value of the replacement property does not exceed the fair market value of the relinquished property. An exchange that is fee-heavy on non-construction items may not yield the value expected, and needed, by the taxpayer.

Upon the earlier of the 180-day exchange period or construction project completion, the EAT conveys the deed to the replacement property, with improvements, to the taxpayer exchanger to complete the exchange. Any construction to be included in the exchange must be affixed to the real property prior to the replacement property being conveyed from the EAT to the taxpayer exchanger. It is important to note that any improvements made to the replacement property after the deed to the replacement property is transferred to the taxpayer will not be considered like kind to property sold in the exchange. Similarly, sale proceeds remaining after the replacement property is conveyed to the taxpayer will be treated as taxable boot.

The BTS exchange can also be facilitated when the taxpayer exchanger must acquire the replacement property to be improved prior to selling his/her relinquished property. This is a reverse BTS exchange. In a reverse BTS, the taxpayer's relinquished property does not close until later in the exchange period. In this structure, there are no exchange funds to draw from, so typically a lender will provide the funds to the EAT to acquire and improve the replacement property.

While the EAT takes title to the replacement property, the taxpayer exchanger must still appropriately identify the replacement property, including any improvements, he or she will take title to at the conclusion of the exchange. This identification must be submitted in writing, no later than midnight of the 45th day from the first closing, to a party not associated with the exchange, most commonly to the Qualified Intermediary. If the BTS exchange is conducted as a reverse build-to-suit, the relinquished property identification rules apply.

It is always wise to seek tax counsel before applying for any type of tax relief, particularly a BTS exchange. So many variables can affect this structure (weather, construction delays, permits, subcontractors, compliance issues, etc). The tax code provides only 180 days from closing on the relinquished property to acquire the replacement property. While there is great risk in whether that can be accomplished, not all improvements must be completed within the 180 day period. The challenge is to ensure the taxpayer takes title to property substantially similar to what is formally identified.

One of the best ways to accomplish the taxpayer's goal in this process is to ensure all parties involved have a clear understanding of the taxpayer's intent. The taxpayer, taxpayer's legal counsel, taxpayer's tax counsel, general contractor and QI should all have a clear understanding of the roles, responsibilities and timeframes involved in this process. Communication and education on the front end will help prove less complication and frustration on the back end.

1984 was a pivotal year for the 1031 Industry. It was that year that the 9th Circuit Court of Appeals issued the appellate decision (Starker, 602 F2d 1341 (9th Cir. 1979) providing the structure for non-simultaneous (delayed) exchanges. Up until that time, the IRS Code Section 1031 was predicated on simultaneous swaps of land. Several iterations were made since that time providing further clarify and guidance. These iterations included the introduction of guidelines known as the safe harbors for structuring a 1031 tax deferred exchange. These safe harbors include:

Safe Harbor time limits must be followed
There are two strict deadlines that must be met in order for the exchange to remain within the safe harbor guidelines:

• Identification Period. The taxpayer has 45 days after the first closing (whether it was a purchase or sale) to identify property for the second closing. The identification must be made in writing and sent to the intermediary or someone else who is not closely associated with the taxpayer. The taxpayer can identify up to three replacement properties without regard to value; or can identify more than three as long as the aggregate fair market value does not exceed 200% of the fair market value of the relinquished property.
  
  
• Exchange Period. The taxpayer has a total of 180 days for the entire exchange period. In other words, all properties must be closed within 180 days from the first closing

The property exchanged must be qualifying property
Qualifying property in a land exchange is defined as real property held for productive use in trade or business, property acquired for investment and/or income generating property. The following items do not qualify:

• Stock in trade or other property held primarily for sale,
• Stocks, bonds, or notes,
• Other securities or evidence of indebtedness or interest,
• Interests in a partnership,
• Certificates of trust or beneficial interests

Property use must be qualified as being held for use in trade, business and/or investment.
This eliminates properties used for:

Replacement property must be like kind to relinquished property
Real property is like kind to real property, regardless of character or structure. That allows taxpayers to exchange farmland for a rental unit, commercial complex for vacant land, etc.

IRS Code Section 1031 also permits exchange benefits for personal property such as airplanes, office furniture, trucks, livestock, art, collectibles and more. The definition of what is considered like kind is much more narrowly defined for personal property exchanges. The Standard Industrial Classification (SIC) Codes published by the Office of Management and Budget dictate the bands of property considered like kind.

The taxpayer cannot be in receipt of money from the sale
This rule is a key element of the tax code requirements. The purpose of this rule is fairly simple and is the underlying reason why the IRS permits favorable tax treatment in an exchange. Taxpayers swap properties and show that profits from the sale of one property went directly to the purchase of another, which effectively places the taxpayer in the same financial situation. Therefore, if a taxpayer wants to successfully defend the position that he/she is not financially better off than if he/she had not sold the property, the taxpayer cannot benefit from receiving the proceeds of the sale.

Same taxpayer must be on the both legs of the exchange
1031 Tax Deferred Exchange protection is valid only if the identical taxpayers or legal entities both buy and sell property. For example, taxpayers may not sell relinquished property vested in their individual names and take title to the replacement property in the name of a trustee for their revocable living trust. However, if taxpayers are the sole member of a Limited Liability Company (LLC), they can sell relinquished property vested in their name and take title to the replacement property in the name of the LLC. This is because a single member LLC is considered a ‘flow-through’ entity for tax purposes and does not need its own taxpayer identification if it has elected to not be taxed as a corporation. Similarly, if the relinquished property was vested in the names of both husband and wife, then both parties must take title to the replacement property to avoid potential tax consequence.

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