1031 Exchange and New Construction/Not yet constructed?

Question

Hey All,

I'm wondering if anyone knows if it's possible or if there is a way to perform a 1031 exchange for a property that has yet to be built? My Dad will be selling his properties up North and wants to exchange for properties here in Florida as he will be moving here next year. However at this point it's almost as expensive to buy a resale property that is 15-20 years old than it is to build new. I'm guessing the exchange has to be with existing property/properties? I know you can diversify i.e. buy a house and several lots of land for example, but I'm wondering if there is a way to make something like this happen? Would the construction already have to be underway-- would the property already have to have it's parcel/strap #?.... Or maybe someone could start the construction with a builder so there is actually something to buy and then come in with a 1031 exchange? Anyone have any experience, thought or ideas? Thanks!

Dave Foster · Answer

@Fausto Carosella, Right on the earnest.  The only potential fly in the ointment is that the contract and terms need to be written as a contract for sale and not a contract for construction.  "Risk of loss" cannot be construed as passing by virtue of the strength of the contract.  But it's OK to structure periodic releasable earnest money payments.

Fausto Carosella · Answer

Thanks guys! That's exactly the answer I was looking and hoping for @Dave Foster. We'll definitely have an attorney help us as well, it's Dad's hard earned retirement so that investment for peace of mind is always well worth it @Robert Hetsler. So Just to clarify a bit: I'm assuming the escalating earnest money you're referring to is much like any other project that takes draws at certain milestones? Would It be acceptable for that earnest money to come from my Dad's end, or would that have to go through the intermediary as well? If I'm understanding it correctly in a nutshell we're basically hiring the EAT to act in our stead for the whole construction project, then when it's all finished (or close to) we sell up north and close on the finished construction product within 180 days of the closing of the relinquished property? We'd also already have to have enough cash in the bank, not locked up in the properties in order to commence a construction project to have this scenario work?  Thanks Again!

Robert Hetsler · Answer

@Dave Foster articulated a great and comprehensive response and the only addition to that answer is that, like Dave mentioned, these types of transactions must be planned out well in advance and if you were to find yourself in a situation where a reverse exchange would be required, please spend the money and get counsel involved as it is always worth it but ensure they are experienced and well versed in this field of law.

Dave Foster · Answer

@Fausto Carosella, there's several ways to accomplish that.  Some easier some less expensive.  All depends on the particulars.  Here's some keys:

1. The order of the 1031 must be sell followed by purchase.  You cannot take title to the new property before selling the old properties.  Many times it is possible in new construction to go into contract with a builder without taking title to the lot and simply providing escalating earnest money while the builder completes.  This is especially easy with spec builders like we're seeing a lot of down here now where you like what they're building and go into contract for the finished product.  In this case, your father just needs to be able to close the purchase of his new property within 180 days of the closing of his properties up north.  He does regular 1031 exchanges on them into the new property and he's done.

2. If he has to take title to the lot prior to construction then the process of a reverse exchange would apply.  The statutory order of sell followed by purchase does not change.  But the qualified intermediary sets up a holding entity called the Exchange Accommodating Title holder (eat) and holds title to the lot until the construction is complete and then your father sells up north and buys to finish his 1031.  He is just buying from a different entity who has been set up to hold the property for him.  This process is quite a bit more complicated and expensive but would work well.

Let's see, Person get's tired of winter and shoveling snow at rentals.  Decides to move to Florida. Likes having their rental portfolio in mild geography close to hand.  Sells up north and 1031s down here - Yep seen a few of these.  Great strategy.  And if he can be patient he can turn one or more of those 1031 properties into a killer retirement house at some point and defer or eliminate the gain on it all together.