1031 when the selling exchanger builds to suit

4 Replies

I own a lot currently worth about $850,000. I want to sell it for $1,75 mil with a contingency that I would design and build a house on the property to suit the purchaser. I would ask a down payment of $300,000 followed by subsequent payments appropriate to the degree of completion of the house. When completed, I would turn over to the 1031 intermediary $1,25 mil (= total paid to me by the purchaser less $500,000 spent on the construction of the house), and purchase a replacement rental property for $1.25 mil or more. Could this arrangement comply with 1031 requirements?

Hi @Mike Miller , unfortunately, the way you are structuring that deal you are a builder selling inventory and that would not qualify for a 1031 exchange.  Depending on how you've owned that lot and depending on your buyers needs and priorities there may be a way to structure both.  But not with you selling a lot and house after construction.

Thanks for the prompt reply. Aside from how the IRS might classify it, I am not actually selling inventory. I inherited the lot long ago and this is a one time effort to maximize the value of the lot. After the sale I will be investing in rental property. The thought was provoked by sales for the same amount next door and across the street, the houses on which were worth less. Grasping the vast difference between the value of the lots with and without a house on it, I wanted to construct a sale in which all the profit would be allotted to the lot as there would be no income from the construction of the house. Back to the drawing board as they say ....

Originally posted by @Mike Miller :

I own a lot currently worth about $850,000. I want to sell it for $1,75 mil with a contingency that I would design and build a house on the property to suit the purchaser. I would ask a down payment of $300,000 followed by subsequent payments appropriate to the degree of completion of the house. When completed, I would turn over to the 1031 intermediary $1,25 mil (= total paid to me by the purchaser less $500,000 spent on the construction of the house), and purchase a replacement rental property for $1.25 mil or more. Could this arrangement comply with 1031 requirements?

Hi Mike,

There are a lot of moving parts here.  The critical issue is your intent to hold for rental, investment or business use.  What was your intent when you inherited the property?  Can you prove that your intent was to hold for investment purposes?  It would have to be a very strong argument because the IRS would very likely argue that you intent has changed to held for sale (development).  You would have to show that you intended to hold for investment and that your intent has not changed but that you are trying to maximize the value in order to sell the investment property.  It would not be a slam dunk argument and would involve some risk if you were to get audited.

The question of when was the house sold would also be an issue.  Was it sold upfront with an installment sale as part of the deal or are the payments earnest money deposits/progress payments as you progress through the construction project?  The question really relates to when the "sale" occurred and when the 1031 Exchange deadlines commence. 

The $500,000 in construction costs would not be able to be recovered.  The full $1.75 million would have to be reinvested.  If you pull $500,000 out at the sale, it would be applied first toward your taxable gain.  There is no way to pull out cost basis, construction costs, etc., through a 1031 Exchange without incurring taxable gain.

I've just quickly hit on the major issue that I see right off the bat. 

Thank you Bill.

I bought the lot from a relative's estate and have held it with a minuscule tax base for over 35 years. Is that not inherently an investment? I will be exchanging one real estate investment for another one.

The sale and title transfer would not be completed until the contingency of completing the house was fulfilled. The first $500,000 of payments could be considered as need be per 1031 requirements, but they would be paid like usual draws per progress of construction, and used solely for that purpose. Whatever payments would be made at whatever schedule, all of the proceeds would be either used to meet the construction requirement or turned over to the intermediary.

As for recovery of the $500,000 construction cost, I preferred the thought that it might be considered to be a selling expense to be deducted like any other. But failing that possibility, would not an alternative be to keep that amount out of the reinvestment, declare it as taxable income from which I would deduct the same amount as an expense?