Build-to-Suit Exchanges May Offer More Flexibility

A Section 1031 exchange is a powerful tool for investors to defer tax on the gain from the sale of real estate. However, to completely defer the tax, an investor must find replacement properties with a total fair market value equal to or exceeding what is being sold.

A build-to-suit exchange can give investors more flexibility in structuring their transactions to meet these requirements.

What is a build-to-suit exchange?

A build-to-suit exchange allows an owner to use the proceeds from the sale of the relinquished property to acquire replacement property and make improvements to it. This can increase the fair market value of the replacement property, resulting in a fully tax-deferred exchange.

A build-to-suit exchange is accomplished by having an Exchange Accommodation Titleholder (EAT) temporarily hold title to the replacement property while the improvements are being made. The EAT is typically a limited liability company owned by a qualified intermediary (QI).

The entire transaction must be completed within 180 days.

Options for build-to-suit exchanges

There are two types of build-to-suit exchanges: deferred and reverse.

1. Deferred exchange

• Relinquished property is disposed of and the sale proceeds go to the qualified intermediary
• The investor must identify what is to be acquired within 45 days
• The EAT acquires the property using the exchange funds
• The investor oversees the construction of the improvements and sends the invoices to the EAT, who pays them using exchange funds
• The replacement property is transferred from the EAT to the investor on the earlier of:
  • When the construction is complete,
  • When the 180 days expires, or
  • When enough value is added to the replacement property for full tax deferral

2. Reverse exchange

• Replacement property is acquired by the EAT first, using funds from the investor or a lender
• The investor supervises the construction and sends invoices to the EAT
• At some point during the 180-day period, the relinquished property is sold and funds are transferred to the QI
• The replacement property is transferred from the EAT to the investor on the earlier of:
  • When the construction is complete,
  • When the 180 days expires, or
  • When enough value is added to the replacement property for full tax deferral 

Why do a build-to-suit exchange?

The benefits of doing a build-to-suit exchange include the ability to buy property lower in value compared to the relinquished property and the ability to use exchange funds rather than loan proceeds to fund construction.

Additionally, consider the inherent advantages of a custom-built property, like efficiency of layout and design, potential cost savings from avoiding future renovations or modifications, and possible increased value in the market due to specialized requirements of the tenants.

The principal drawback is that the work must be completed within the 180-day period in order to have any effect on the exchange. Build-to-suit exchanges also tend to be more costly than regular deferred exchanges.

How we can help

Careful planning is essential for those intending to do a build-to-suit exchange. If you have questions about the process, our real estate professionals are available to provide answers and support across all phases of the real estate investment life cycle.

For related information, watch our on-demand webinar on Tax Strategies for Section 1031 Exchanges.