What is a construction exchange?
A: The reason many taxpayers consider doing a construction exchange is because they have a value problem. As discussed in our earlier blog, the value of your replacement property must equal or exceed the value of your relinquished property and you must use all of the cash proceeds to have total gain deferral.
For example: Mr. Smith sells a relinquished property with a basis of $200,000 for $800,000, leaving $600,000 of potential gain. He wants to do an exchange and build a custom office for his small company as his replacement property. He has found a $200,000 lot and his contactor estimates that what he wants to build will cost approximately $600,000. Though the values match up, timing is a problem. Once Mr. Smith takes title to the $200,000 lot, then his exchange is complete. He cannot take leftover exchange proceeds and build improvements on land he now owns. Somehow, he needs to put $600,000 in improvements on the land prior to taking title, so that the value of both the land and improvements will equal the value of the property he has relinquished ($800,000). In short, the improvements must be completed within 180 days of the sale of his relinquished property for Mr. Smith to defer all potential tax.
The answer is a construction exchange. In order to accomplish this, someone must assist Mr. Smith in taking title to the property, immediately build the improvements and then sell the property in its improved, more expensive condition to Mr. Smith as his replacement property. While there are limited instances where investors have used a contractor or other third-party, the usual party that serves in this role is a 1031 specialist that provides Accommodation Titleholder (AT) services. In essence, the AT facilitates the process and is tied into the transaction so that the money held by the qualified intermediary (QI) can be used not only for the lot acquisition, but also to fund the improvements. (Guidance for these transactions was issued by the Internal Revenue Service in Revenue Procedure 2000-37.
Please be sure to check out our current newsletter for a more detailed discussion of construction exchanges.