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CHICAGO | NEW YORK | SAN DIEGO | SAN FRANCISCO |
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STRUCTURING A BUILD-TO-SUIT EXCHANGE UNDER CODE SECTION 1031
Since the Tax Reform Act of 1984 codified the 180-day Exchange Period under Code Section 1031, real estate investors have wrestled with the provision that requires that any Replacement Property acquired in a like-kind exchange be received by the Taxpayer within 180 days from the date the Relinquished Property is transferred.
This deadline is even more vexing to the Taxpayer who is trying to complete construction during the Exchange Period. Any number of factors can contribute to construction delays including zoning variances, delayed building permits, financing, and inclement weather. And because the rules regarding construction are fairly stringent - any improvements made to the property after the property is received by the Taxpayer are not considered "like-kind" to real estate - Taxpayers often find they are racing against the clock to complete a project.
A Taxpayer can consider several techniques to maximize the value of the Replacement Property while minimizing the tax and business risks.
1. Third party seller constructs improvements and transfers improved property to Taxpayer.
The Replacement Property seller constructs the improvements and then transfers the improved property to the Taxpayer within the Exchange Period. The upside: the Taxpayer can use sale proceeds to make progress payments as the property is improved. The downside: It is unlikely you'll find a seller who is willing to undertake construction on property he is trying to sell. If you are lucky enough to find an accommodating seller, you still may not be able to secure your interest in the property during the Exchange Period.
2. Professional developer/builder acquires property from third party seller
and constructs improvements.
In this structure, legal title to the property is transferred to a professional developer who manages the construction within the Exchange Period. The upside: the Taxpayer can use exchange proceeds to pay for the land to be transferred from the seller to the developer, as well as to fund the cost of the improvements. The construction process is managed by a professional, which should result in greater efficiency. The Taxpayer may be able to secure its interest in the property by recording a mortgage against the property for the value of the land. The downside: Increased costs include double transaction costs and fees to the developer. Additionally the Taxpayer may not have a security interest in the value of the improvements during the Exchange Period.
3. Qualified Intermediary acquires property from third party seller.
In this scenario, the Taxpayer manages the construction process. The seller transfers the Replacement Property to a special purpose entity (SPE) owned by the Qualified Intermediary. The SPE acquires the property with exchange proceeds and enters into a construction management agreement with the Taxpayer. The Taxpayer then oversees the construction process either directly or through a separate entity. The upside: the Taxpayer has direct control over the project and may have a security interest in the property by appointment to the board of directors of the SPE that owns the property. The position allows the Taxpayer to block any voluntary bankruptcy proceedings brought by the SPE. The Taxpayer has ready cash to fund the acquisition of the land, and often, some percentage of the improvements. The downside: Increased costs include transaction costs, additional fees to the Qualified Intermediary, and fees to the developer.
4. Taxpayer structures a "parking arrangement" under Revenue
Procedure 2000-37.
The Exchange Accommodation Titleholder (EAT) holds property while improvements are constructed. Similar to the scenario described in number three, the seller transfers the Replacement Property to an SPE that is owned by EAT, and the EAT leases the property back to the Taxpayer. The EAT retains ownership of the property, but in all other respects, the Taxpayer has complete control over the property and the project. The upside: the Taxpayer can make improvements to Replacement Property prior to selling the old property - a desirable result when the Taxpayer needs to construct and move into a new operating facility prior to moving out of an existing facility. In these transactions, as additional protection against bankruptcy filing, the Taxpayer can be named as a second non-economic member of the SPE that is owned by the EAT. The downside: Since the Taxpayer has not yet sold the Relinquished Property, it may have difficulty arranging financing for the purchase of the new property without available cash. Also, if the Taxpayer cannot sell its Relinquished Property within 180 days from the date the EAT acquires the new property, the EAT puts the property back to the Taxpayer, resulting in no exchange and no tax benefit.