1031 Exchange Build to Suit

8 Replies

Hello all, my family is planning to do a 1031 exchange where we sell a multifamily building we own in New York, to buy a piece of land in Texas and turn it into a manufactured home community. Funds from the sale would be used to acquire the land and build the manufactured homes. I'm aware that this is a more complicated and costly version of a normal 1031, and wonder if anyone has any experience doing one of these. What kind of things should I watch out for? Thank you for any assistance!

@James Lee , A build to suit exchange is exactly what you're talking about.  It's actually a form of a reverse exchange where the QI takes title to the land and then it is improved until it is at the value it needs to be to satisfy the 1031 reinvestment requirements.  Then the client completes their regular 1031 exchange by purchasing the newly constructed property from the QI.  I'll reach out via pm to give you some more resources on the topic.  Here's the challenges

1. Financing can be trickier.  If you have cash of your own or if you wait to start the construction part until you've closed your sale then you can use the exchange proceeds for the construction.

2. Price . - yes more costly but not prohibitive.  Less than the tax on a $50K gain.  

3. Timing - The IRS handcuffs you more now.  In a regular 1031 you have 180 days to purchase your replacement.  In a reverse or build to suit you have 180 days from the day the QI takes title to the lot to complete the construction.  This is not a lot of time in construction land.

4. You post isn't clear but you'll want to remember that the 1031 is meant for property you intend to hold for productive use.  If you want to build a manufactured home community to own the lots and structures and rent them that would qualify.  If you're thinking to create finished lots and sell them or to build houses on the lots and sell them, the IRS will call that creating inventory and you'll lose your benefit of the 1031 and pay ordinary income tax on the profit.

Thanks for the info Dave, that was very helpful! I do indeed plan on renting the manufactured homes out, but does the inventory rule mean I can't ever sell the homes without triggering taxation? Or is there a waiting period? What if I sell everything as a portfolio rather than individually? Would appreciate any clarification!

Hi @James Lee

Improvement 1031 Exchange

You are referring to an Improvement 1031 Exchange, often referred to as a Build-To-Suit 1031 Exchange or a Construction 1031 Exchange.  It is not necessarily a Reverse 1031 Exchange, but legal title to the new replacement property would be acquired and held or "parked" by the Qualified Intermediary so that you would be able to make improvements to the property within the 180 calendar day exchange period. 

Parking Arrangement

The "parking" arrangement can be part of a regular Forward 1031 Exchange where you sell the relinquished property first and then subsequently acquire the replacement property through the parking arrangement and then make the intended improvements to the property, or, the "parking" arrangement can be part of a Reverse 1031 Exchange where you acquire your new replacement property first through the parking arrangement and then make the intended improvements to the replacement property before you sell your existing relinquished property within the 180 calendar day exchange period.  

Timing is the Challenge

The most challenging part of an Improvement 1031 Exchange is the short 180 calendar day exchange period during which you must acquire and park legal title to your new replacement property with the Qualified Intermediary and complete the improvements to the property.  The good news is that it is not an all or nothing proposition.  Those improvements that are both paid for and completed during the 180 calendar day exchange period will count toward your reinvestment requirements, and those that are not completed would not count.  It might mean that you end up doing a partial 1031 Exchange because you were not able to complete the entire project and you end up trading down in value or not reinvesting all of your cash equity from the sale of your relinquished property.  The minute you acquire (and receive) legal title to the improvement replacement property from the Qualified Intermediary (but not more than 180 calendar days) the Improvement 1031 Exchange ends. You might want to try, if at all possible, to begin the permitting process before you acquire and park title to the new replacement property. 

Qualified Intermediary Requirements 

There are numerous items that Qualified Intermediaries may require in order to proceed with an Improvement 1031 Exchange.  These items can include: 

  1. 1. Phase I environment inspection report.  You are asking a Qualified Intermediary to acquire and hold legal title to replacement property, so they are going to need assurances that there are no environmental contamination issues to worry about.  
  2. 2. Insurance Coverage.  The Qualified Intermediary will want to be covered by property and casualty insurance, liability insurance and in this case builders insurance/course of construction insurance, and they will want to verify that the builder/developer/contractor has workers' compensation insurance. 
  3. 3. Debt/Contruction Financing.  Generally, most traditional lenders will not allow a Qualified Intermediary to acquire and hold legal title to your replacement property if that property will be used as the collateral.  You should discuss the mechanical steps of the Improvement 1031 Exchange with any prospective lender and your Qualified Intermediary to ensure the lender fully understands what is going to be involved.  
  4. 4. Non-Recource Debt/Financing.  The Qualified Intermediary can sign, and often does sign, promissory notes secured by a deed of trust or mortgage as part of an Improvement 1031 Exchange or a Reverse 1031 Exchange.  They will require that the debt or financing being executed by them be non-recourse to them.  Many lenders today will not even consider a non-recourse loan. 

    Risk to the Qualified Intermediary and Improvement 1031 Exchange Fees 

    Improvement 1031 Exchange transactions are more complicated as you can see from the comments above.  They also pose significantly greater risk to the Qualified Intermediary since they are holding legal title to the property while construction is in process.  The fees however are worth it if you have enough taxable gain to shelter.  Improvement 1031 Exchange fees charged by reputable Qualified Intermediaries generally fall into the range of $6,000 to $9,000.  This fee should include all of the 1031 Exchange documents, all of the parking arrangement documents, a brand new limited liability company just for your transaction, unlimited consulting to get the Improvement 1031 Exchange completed, and any wrap up issues that "pop-up" after your transaction is completed.  

    Selecting a Safe and Secure Qualified Intermediary

    Remember that not all Qualified Intermediaries are created equal.  Less than 1% of Qualified Intermediaries have any kind of government oversight to protect the investor.  You need to make sure that you choose a Qualified Intermediary with government oversight, fidelity bond coverage, errors and omissions insurance coverage and substantial equity capital to safeguard your transaction.   

    Hi @James Lee

    The actual requirement is that you have the intent to hold the property for rental, investment or business use.  There is no specific holding period required other than you be able to demonstrate that you had the intent to hold for rental/investment should you be audited.  Advisors often recommend 12 months, 12 months and one day, 18 months, or 24 months, but those are opinions.  Intent is the key. 

    @James Lee It isn't that complicated. Since you're investing in a land and not directly in manufactured homes, it will qualify for a 1031 exchange. As you may know, properties involved in 1031 exchanges must be held for use in trade, business, or for investment purposes. Therefore, unless it's a primary residence, you're good to go. Since you're planning to build manufactured homes community on the purchased land, it may cost you a bit more. However, it's completely legal. You can do a typical 1031 delayed exchange in this case and reinvest the proceeds from the sale of your multifamily building in the new property and then build your manufactured homes community.

    @James Lee , once you’ve demonstrated your intent to hold you can always sell, do another 1031 and you’ll continue e to defer all tax on gain and depreciation recapture.  If you just want to sell you will pay tax on all deferred and current gain allocated to whatever unit you are selling.

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