Finalizing the sale of a new construction, can I 1031 into another new construction?

Question

Hey BP community. I've spent the last week or so trying to get the answer, but I can't get to the bottom of it. Here's a quick summary of my scenario:

I just completed a new construction and expect to close the sale within the next 30-45 days. I plan on reinvesting the profits into another new construction, so I'm wondering if I can do a 1031 to avoid paying the capital gains tax.

Dave Foster · Answer

@Josh Garcia, It's all going to come down to your intent! Property that qualifies for 1031 treatment is property you purchase (or build) with the intent of holding for productive investment use. Fix n flips and new construction where your intent is primarily to resell do not qualify for 1031 treatment.

There is no statutory holding period although most folks feel that anything more than a year is perfectly fine. There could always be circumstances where a hold period of less than a year might be fine. It's all about your intent and how you can demonstrate it.

I was just dealing with a client today on the exact same issue. His intent had been to build a duplex to hold and rent. Construction ran over budget and time. And now rents will not suppport the expense of the asset. Because he has a pattern of holding, he has correspondance with his accountant. And he has a management team in place managing his other properties in the area. He feels like he could demonstrate his intent and that his intent had changed.

If you're a builder just looking to get out of taxes the 1031 won't work for you. But if you really had the intent to hold then you might think about a 1031. Because, while it's possible for an accident to happen once in a while, it starts to look a little less accidental when it happens several times a year.

Sean Ross · Answer

@Josh Garcia, yes, that likely is going to be true. If you're willing to bend your timeline a little to give yourself the best shot at qualifying for 1031 exchanges and being super tax efficient with your properties, you could try doing the following:

- Hold each successive property for at least 12 months before selling

- make sure that you acquire property in one tax year and then don't sell that same property until the following tax year

I want to stress that you do not automatically lose out on 1031 treatment by not taking these steps, and similarly you don't automatically qualify for 1031 treatment by simply taking these steps. Since you're in a grey area, what you want to do is build up the best possible case to argue that you should qualify.

1031 rules are complex, arbitrary, and disjointed. Very little is truly set in stone. It's a great jobs program for attorneys, accountants, and QIs like us.

Josh Garcia · Answer

@Sean Ross, thanks for breaking this down. Based on your explanation, it looks like I fall into category 1 since I plan on repeating this strategy at least 2-3 more times.

Sean Ross · Answer

@Josh Garcia, it is possible to 1031 exchange out of a property that you've built and reinvest into another construction project.

There are two issues I want to point out at the jump:

1) 1031 exchanges are designed for long-term investors. You'll often read that you want to own a property for at least 12-24 months before engaging in a 1031 exchange. There is no statutory rule enforcing this, but it's normally good advice. What the regulators care about is intent. For an exchange, they want your intent to be that you hold the property for long-term business or investment use (for both the property you sell and the property you buy). If you don't look like a long-term investor to the IRS, there is a chance that they could label you a "developer/flipper" and treat your property as inventory rather than as a depreciable capital asset. If your property is labelled as inventory, then you can't qualify for a 1031 exchange. I'm concerned that with your investment pattern as described here.

Do you already have a history of building and then immediately selling property prior to this? Do you plan to repeat this strategy consistently in the future?

2) Let's ignore for a moment the issue I raised above. If you do a 1031 exchange into a new construction project, it matters a great deal whether or not you need to finance the new build using proceeds from your previous property. For example, If the new construction property is being financed/built by another party and you plan to close on the newly completed property once it's been built, then you can simply perform a normal 1031 exchange. However, if you intend to buy a lot and then use the proceeds from your prior sale to build the new property after you've taken title, then you need what's called a "construction" or "build-to-suit" 1031 exchange, which is more costly and complicated.

The punchline here is that your 1031 is possible, but we'd need more details to flesh that out. And even if it is possible, it could either be simple or a little more complex.

Finalizing the sale of a new construction, can I 1031 into another new construction?

Finalizing the sale of a new construction, can I 1031 into another new construction?

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