Can I 1031 into a construction project?

Question

I'm pretty new to bigger pockets but I love the community! I was just wondering if anyone knew if you could 1031 exchange an existing rental house into a construction project rather than an existing property. Thanks!

Dave Foster · Answer

@Larry Reisman, You can do your own construction.  It's best if you have an entity between you and the construction funds but that can be worked around.

Larry Reisman · Answer

With respect to implementing a reverse exchange, can you be your own builder if you have the know how?

Leanne Pressly · Answer

OK, good to know. I'll abandon that option then and just start looking for another option. Thanks for all your insight-- this has been really helpful.

Dave Foster · Answer

@Leanne Pressly, yep that's exactly what I meant.  You now own that lot already.  Even if you sold it but bought it back as a finished house you're in danger of creating a step transaction.  With really good legal coverage there are ways that clients have done this but you put 4 zeros in front of the legal bill to potentially make it work and give you the legal coverage you'd want.

Leanne Pressly · Answer

Thanks Dave for your reply

When you say "simply sell the lot and do a 1031 exchange" you mean to find another property entirely to replace it with?

What about my idea of selling the lot to the builder and then buying back the house/lot from him? Would the IRS see that as an illegal workaround?

Dave Foster · Answer

@Leanne Pressly, Once you actually own or if you already own the lot then there's no opportunity to exchange for the improvements on the lot.  The 1031 has to be a sale of investment property followed by a purchase of investment property.

So you could simply sell the lot and do a 1031 exchange on it.  And sell the house and do a 1031.  Or sell them as a package and do a 1031 on the entirety.  But if you want to put a structure up then your best bet  is to go ahead and have a house built on it.  then once the house if complete you could...

1. sell the new house and pay ordinary income tax on it.

2. Have the intent of holding it and put a renter in it for a while and then you could sell and 1031.

3. If the house next door is your primary residence then you could actually move into the new house and sell the old house tax free as long as you've lived there for 2 out of the 5 years prior to sale.  Then in two years you could sell the new house and once again the gain would be tax free.

Dave Foster · Answer

@David Maney, sorry for the late reply.  I was confused.  There's another Manhattan that doesn't bleed purple and white???  :0  Yes we perform both regular and reverse type exchanges.

EMAW

Leanne Pressly · Answer

I'm also interested in this discussion and would love to hear Dave's answer. I own a lot next to a house I want to sell. I have a builder but I'm not sure if he's willing to "play my game" of this 1031 exchange. Would he buy my lot at full value or some adjusted lower value? I don't think he would have the cash to front the construction as well...so how do I finance it? If he does finance it, do I essentially pay him interest on that "loan" while he's building or will he just pad in some fee (which of course has to be cheaper than what I'd pay in Capital Gains).

How do I draw up paperwork that secures my lot while he "owns" it (ie, what if he dies in an extreme example).  What other considerations do I need to take into account. And, I'd also be curious if Dave, you offer support for these transactions? Leanne

David Maney · Answer

Hey Dave,

Thanks so much for the reply! Very helpful. So it sounds like it could be done, with just a little more paperwork involved. Does your group help handle those types of transactions? Thanks a bunch!

p.s. are you in Manhattan, NY or KS? The Big Apple or the Little Apple? lol

Dave Foster · Answer

@David Maney, I hope you're enjoying the heat in NE Kansas.  I'm sitting in Manhattan and cant wait to get back to the cool of Florida!!

You can do that a couple of different ways.

1. If the new property can be complete within 180 days of when you close your sale and a builder owns the lot and is funding construction  it's no different than selling and then buying in the 1031.  You can be under contract for the new property before your old property closes.

2. If you are having to fund construction or take title to the lot ahead of time then a reverse exchange would be appropriate.  You cannot exchange into a property you already own.  And you cannot exchange into improvements on property you already own.  So your Qualified Intermediary takes title to the new lot and when construction is complete transfers ownership to you to finish up the 1031 exchange.  It's obviously a little more complicated than 2 sentences but it can be done.