1031 construction exchange

9 Replies

Once I build myself my first house, I want to sell it and put the profits towards building a fourplex. But I can't find a definitive answer on whether I can use a 1031 exchange to build a building or not or how easy would be to do. Does anyone know anything about this?

Construction Exchanges are very possible and very useful. The biggest issue with Construction Exchanges are the time requirements. Once the Relinquished Property is sold, you must use the Exchange Proceeds on the property within 180 days. This can work if your property is shovel ready. There are more creative ways to allow for this, but at the end of the day you need to spend all of your exchange proceeds within 180 days, which sometimes is difficult when it is ground-up. 

@Mathew Burnett any outside money (non Exchange Proceeds) you bring in are totally ok. But usually the issue is spending the Exchange Proceeds quick enough. You cannot just buy drywall and have it sit in the house- the proceeds need to be used and a part of the property by Day 180. Other funds can be used at any other point to fill a shortfall. 

@Mathew Burnett , Think of the construction part as a second and separate process that is in addition to the regular 1031 exchange.  You are completing an investment property right now that you'll be using for investment for a while and then you'll want to sell it and 1031 into a newly built 4 plex (that you build).  That's the regular 1031 exchange part.  The other part is the "reverse construction part where your QI takes title to the lot you want to build on and holds it until the value is high enough to absorb your 1031 amount.

In order to defer all tax you must purchase at least as much as you sell and use all of the proceeds in the 1031.  So as long as the construction and land acquisition value (not appraisal - actual hard costs) are equal to or greater than the net sales price of your current house you'll defer all tax.  You can add funds to that from any source.  Say your current home sells for $200K and the completed cost of the 4 plex is $400K.  You can bring that other $200K from any source - cash or leverage.  That parts no problem.

What is the most difficult issue is getting your construction done within the time limits.  A construction exchange is really just a form of a reverse exchange.  You'll find the lot you want to purchase and the QI will take title to it.  You will then start construction and from the day that the QI takes title to the lot you have 180 days to complete construction (or at least enough construction to absorb your 1031) and close the sale of your old property.

180 days sometimes cuts it thin since things like permitting and architecture take a lot of time but don't involve a lot of cost.  So you may want to explore with the seller of the lot some ways to let you get further down the road on the permitting process before having the QI take title.

@Dave Foster Awesome! That pretty much answered all of my questions about it but one. Since you have to own it for at least 2 years before you can sell it, let's say that I owned a vacant lot for 1 year. I spend 6 months building the home, and then keep it for another 6 months after it's built. Technically I've owned the property for 2 years at that point, but there's only been a house for 6 months. Am I still able to 1031 exchange it at that point? Or does there have to be a house on the property for 2 years?

@Mathew Burnett , First we've got to start with the actual holding period - there isnt a statutory holding period that qualifies your property as investment and eligible for a 1031.  The standard is your intent.  If your intent was to hold the property for productive investment use then it qualifies for a 1031.  Most folks feel comfortable at any period more than a year.  The mantra in the industry used to be "one year and one day". But there could always be situations where a shorter or longer hold period is appropriate.  It's all about your intent and how you can demonstrate that intent.

Now enter the reverse exchange.  There's some issues with your scenario

1. You  can't have owned the vacant lot for a year.  You cannot 1031 into property you already own.  In order to do a reverse exchange the QI has to take title to the lot you want to build on before you do.  That way that lot still qualifies for you to sell your old property and purchase the lot now with a . house on it to complete your 1031 exchange.  That's the reverse part.  It's like you purchase your new property first but you really don't.  You just control it so you can build on it.

2. When you build on that lot you are changing the nature of the property from vacant land to a structure.  So you must demonstrate your intent as it is to the new construction.  If you complete it and immediately sell and 1031 again why did you build that house - did you do it to hold or primarily for resale?  Hard to say isn't it.  So what you really must do is get the property built.  Then establish your intent to hold that new construction (again a year feels pretty good).  And then you could sell and 1031.

the order of a reverse construction exchange will be

1. QI takes title to the lot.

2. You build on the lot (no more than 180 days from the day the QI takes title to the lot)

3. You sell your old property

4. You buy the lot and construction from the QI to complete the exchange. (again no more than 180 days from the day the QI takes title to the lot).

If you followed those steps and then immediately sold the new house what was your intent when you did the process - to build a house to hold??  Or to build a house to sell.  It's hard to establish and defend an intent on a very short holding period of new construction unless you have something like an unsolicited offer to sell.  That's kind of the gold standard.  You weren't going to sell.  Your intent was to hold.  But someone made you an offer you couldn't refuse.

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