What Exactly Is a “Build-to-Suit” 1031 Exchange?

A “build-to-suit” 1031 exchange is a specific type of like-kind exchange that involves both purchasing and improving a replacement property while maintaining indefinite tax deferral under Section 1031 of the Internal Revenue Code (IRC). These like-kind exchanges can be highly desirable for businesses and real estate investors seeking to buy properties that are not presently suited to their intended use. But, strict rules and restrictions apply, and parties seeking to conduct a build-to-suit exchange must work with a 1031 qualified intermediary during the process.

Avoiding Immediate Tax Liability with a Build-to-Suit 1031 Exchange

As a general rule, any funds received from the sale of a “relinquished” property in a 1031 exchange must be used for the purchase of a “replacement” property in order to achieve indefinite tax deferral under the IRC. Any funds that are not reinvested in a replacement property are classified as “boot,” and these funds are generally subject to immediate federal income taxation.

As a result, with a “normal” 1031 exchange, the excess funds that are available to make improvements to a replacement property will be reduced as a result of the exchanger’s immediate tax liability.

Executing a build-to-suit 1031 exchange avoids this undesirable outcome.

With a build-to-suit exchange, proceeds from the sale of a relinquished property are used to make improvements before the exchanger takes possession of the replacement property. The exchanger’s 1031 qualified intermediary holds the title to the replacement property during the buildout process through an exchange accommodation titleholder (EAT), and at the end of the buildout process, the exchanger takes ownership of the improved replacement property while also maximizing the benefits available under Section 1031.

Required Steps for Conducting a Build-to-Suit 1031 Exchange

Given that the improvements must be made before the exchanger takes title to the replacement property, working with a 1031 qualified intermediary is essential for conducting a build-to-suit 1031 exchange. Here is a brief overview of the major steps—and the timing—involved:

Sale of the Relinquished Property

Unless a build-to-suit exchange is combined with a reverse exchange, the first step is to sell the relinquished property. This will allow for the determination of the amount of potential tax deferral (based on the sale price and the exchanger’s basis), which will, in turn, allow for a determination of the necessity of conducting a build-to-suit exchange.

Identification of a Replacement Property

Once the relinquished property is sold, the clock starts ticking. As a result, in many cases, exchangers will want to identify a replacement property before beginning the exchange process. If the replacement property has not been identified in advance, it will need to be identified by the deadline prescribed by Section 1031.

Acquisition of the Replacement Property By the EAT

After identifying the replacement property, the next step is for the exchanger’s 1031 qualified intermediary to facilitate the acquisition of the property by the EAT. The 1031 qualified intermediary will also manage the funds involved (both the funds used for the acquisition and the funds to be used for improvements) to ensure that the exchanger does not lose eligibility for tax deferral under Section 1031.

Buildout of the Replacement Property

After the EAT’s acquisition of the property, improvements can begin. The EAT must make all payments related to the buildout process from the relinquished property’s sale proceeds (or from additional funds contributed by the exchanger) in order to ensure maximum tax deferral.

Transfer of Title from the EAT to the Exchanger

Once the buildout is complete, or once maximum tax deferral has been achieved, the EAT can then transfer title to the exchanger. This, too, must be managed by the exchanger’s 1031 qualified intermediary.

In terms of timing, all of the deadlines that apply to other types of like-kind exchanges apply to build-to-suit 1031 exchanges. This means that the exchanger must identify the replacement property within 45 days of selling the relinquished property, and the exchanger must take title to the replacement property within 180 days of the relinquished property’s sale. However, by working with a 1031 qualified intermediary to combine a build-to-suit strategy with a reverse exchange, exchangers can effectively extend the buildout timeframe when necessary.

Inquire About Our 1031 Qualified Intermediary Services for Build-to-Suit Exchanges

If you are interested in learning more about the steps involved in conducting a build-to-suit 1031 exchange, we invite you to get in touch. Give us a call at 888-872-1031 or get in touch online to schedule a complimentary initial consultation at 1031 National Services.