Improvement and Build-to-Suit Exchanges

The two additions are stated plainly and are worth having in mind before the mechanics. The taxpayer must receive real property rather than a promise that real property will exist. And only what exists at the moment of transfer counts, which converts a construction problem into a valuation problem with a hard deadline.

31.1 Constructing on property the taxpayer does not yet own

The regulation permits the structure in a single sentence. A transfer of relinquished property in a deferred exchange will not fail to qualify for nonrecognition merely because the replacement property is not in existence or is being produced at the time the property is identified as replacement property.¹ The terms produced and production carry the meanings given by section 263A(g)(1) and the regulations under it.²

Two structural requirements follow from that permission, and everything in this chapter is an elaboration of one or the other.

Someone else must own the land while the improvements are constructed. This follows from the rule examined at 31.4, that a taxpayer cannot exchange into improvements on property the taxpayer already owns. The mechanism is the parking structure of Chapter 30, and 31.5 develops it.

What the taxpayer receives must be property, not services. The regulation is categorical. The transfer of relinquished property is not within the provisions of section 1031(a) if the relinquished property is transferred in exchange for services, including production services.³

That second requirement defeats the arrangement a client will propose. A taxpayer who transfers relinquished property and receives in return a contractual undertaking that a building will be constructed has exchanged property for a promise of services. The exchange is not saved by the building's eventual completion, and the regulation says so in its next sentence: any additional production occurring with respect to the replacement property after the property is received by the taxpayer will not be treated as the receipt of property of a like kind.⁴

The identification rules for property to be produced, including the requirement that the land be described with ordinary precision and the improvements in as much detail as is practicable, are examined at 25.8. The receipt rules are the subject of the next two sections.

31.2 Valuation at the moment of transfer

The consequence of the services rule is a valuation rule, and it is the single most important economic fact about improvement exchanges.

The exchange is measured at the moment the taxpayer receives the replacement property. Construction performed after that moment is outside the exchange entirely, because additional production after receipt is not treated as the receipt of like-kind property.⁵ The taxpayer receives credit for the real property that exists when title passes, and for nothing else.

The arithmetic is unforgiving and should be run at the outset rather than discovered at the end. Suppose a taxpayer relinquishes property for $3,000,000, a titleholder acquires the land for $800,000, and the plan contemplates a finished building worth $2,400,000. If, at the moment of transfer, $900,000 of construction is in place, the taxpayer has received $1,700,000 of real property. The remaining $1,300,000 of exchange proceeds has not been invested in like-kind property, and Chapter 33 quantifies the result.

Two corollaries deserve emphasis because both are counterintuitive to clients.

Prepayment does not help. Funds advanced toward work not yet performed are not real property received. Money sitting in a construction escrow on the last day of the exchange period is money, and the taxpayer's having irrevocably committed it changes nothing.

Completion after the deadline is worthless for exchange purposes. The building will be finished, the taxpayer will own it, and its cost will be in basis. What it will not be is replacement property received in the exchange.

The planning consequence is that an improvement exchange is not a question of whether the project will be built. It is a question of how much real property will exist on a particular date, and that question should be modeled with the contractor before the relinquished property closes.

31.3 The one-hundred-eighty-day construction ceiling

The receipt rules for property to be produced modify the substantially the same standard of 26.1 in two directions.

Variations due to usual or typical production changes are not taken into account, so ordinary construction adjustments do not defeat the identification. If substantial changes are made in the property to be produced, however, the replacement property received will not be considered substantially the same property as identified.⁶

The rule for unfinished real property is the operative one, and its second sentence is where the ceiling comes from. If the identified replacement property is real property to be produced and production is not completed on or before the date the taxpayer receives the property, the property received is considered substantially the same property as identified only if, had production been completed by that date, it would have been considered substantially the same. Even so, the property received is considered substantially the same only to the extent the property received constitutes real property under local law.⁷

The regulation's example makes the mechanics concrete. A taxpayer was to receive real property M, on which the other party was constructing improvements. On the last day of the exchange period, construction was twenty percent complete, and under local law the property constituted real property to the extent of the underlying land and the twenty percent of construction completed. Property M was considered substantially the same as identified to the extent of the land and that twenty percent. Any additional construction performed after that date was not treated as the receipt of like-kind property.⁸

Three practical points follow from the local law limitation, and each is a place where value is lost.

Materials are not real property until they are incorporated. Lumber stacked on the site, fixtures in a warehouse, and equipment awaiting installation are ordinarily personal property. The test is what the law of the jurisdiction treats as part of the realty, and the question should be put to local counsel rather than assumed.

Pay for work in place rather than for materials. A draw schedule that funds deliveries produces exchange proceeds converted into personal property. A schedule that funds installed work produces real property.

Document what exists on the transfer date. An architect's certificate of percentage completion, a title company inspection, or a contemporaneous photographic record establishes the value in place. Reconstructing it later, against a finished building, is close to impossible.

Finally, the exchange period is not extended for construction. Everything in Chapter 26 applies without modification, including the return due date limitation, so a fourth quarter relinquishment shortens an already short construction schedule unless an extension is filed.

31.4 Improvements on property already owned

The rule that shapes the entire structure is that a taxpayer cannot exchange into improvements on land the taxpayer already owns. An exchange of real estate owned by a taxpayer for improvements on land owned by the same taxpayer does not meet the requirements of section 1031.⁹ The Service reached the parallel conclusion for a building constructed on land the taxpayer owned, holding it not of a like kind to involuntarily converted land of the same taxpayer.¹⁰

The reason is not technical. Improvements affixed to the taxpayer's land become the taxpayer's by operation of law. There is nothing to receive, and an exchange requires a receipt.

The obvious workaround is to deed the land to an accommodation party, have the improvements built, and take it back. The safe harbor forecloses it. The revenue procedure does not apply to replacement property held in a qualified exchange accommodation arrangement if the property is owned by the taxpayer within the one hundred eighty day period ending on the date of transfer of qualified indicia of ownership of the property to the exchange accommodation titleholder.¹¹

Read the limitation precisely. It is not confined to property the taxpayer owns at the time of parking. It reaches property the taxpayer owned at any point in the preceding one hundred eighty days, which means a taxpayer cannot cure the problem by conveying the land shortly before the structure begins. That limitation was added in 2004 in direct response to taxpayers reading the original revenue procedure to permit exactly this.¹²

One variant occupies genuinely unresolved ground, and it should be described as unresolved rather than as either permitted or prohibited. The revenue procedure that added the limitation stated that the Service and Treasury were continuing to study parking transactions, including transactions in which a person related to the taxpayer transfers a leasehold in land to an accommodation party, the accommodation party makes improvements to the land, and the accommodation party transfers the leasehold with the improvements to the taxpayer in exchange for other real estate.¹³

That sentence describes a structure practitioners use. Its architecture avoids the prohibition on its face, because the land is owned by a related person rather than by the taxpayer, and what the taxpayer receives is a leasehold with improvements. Where the leasehold has thirty years or more remaining, it is of like kind to a fee under the analysis at 16.2.

Three cautions belong in any advice that contemplates it.

The structure rests on the absence of adverse authority rather than on the presence of favorable authority. The Service announced that it was studying the question and did not answer it, and a practitioner should confirm the current state of published guidance before relying on the structure rather than treating a 2004 statement as the last word.

The related party rules of Chapter 40 apply on their own terms and are not addressed by anything in this chapter. A structure that solves the ownership problem by using a related person's land has created a related party question.

The general anti-abuse doctrines examined in Chapter 42 apply as well, and a structure whose only function is to place a formal owner between the taxpayer and improvements on land the taxpayer's affiliate controls is the kind of arrangement those doctrines are addressed to.

31.5 Combining reverse and improvement structures

The workable improvement exchange is a reverse exchange with construction, and the safe harbor of Chapter 30 supplies every permission the structure requires.

The sequence is this. The exchange accommodation titleholder acquires the land, ordinarily through a single member limited liability company as 30.3 describes. Within forty-five days the taxpayer identifies the relinquished property. Construction proceeds while the titleholder holds qualified indicia of ownership. Within one hundred eighty days the titleholder transfers the improved property to the taxpayer, directly or through a qualified intermediary, and the relinquished property is transferred as part of the exchange.

Four of the permitted arrangements do the work.

The taxpayer, or a disqualified person, may loan or advance funds to the titleholder or guarantee a loan or advance to it, which is how construction gets funded.¹⁴

The taxpayer, or a disqualified person, may manage the property, supervise improvement of the property, act as contractor, or otherwise provide services to the titleholder with respect to the property.¹⁵ This is the provision that permits the taxpayer to run its own construction project on property it does not own.

The property may be leased by the titleholder to the taxpayer, which addresses occupancy during construction where that is needed.¹⁶

A titleholder that satisfies the qualified intermediary safe harbor may also serve as the qualified intermediary in the exchange, so a single provider can occupy both roles.¹⁷

Two ceilings then bind simultaneously, and they are independent of each other.

The holding ceiling is administrative. The combined time period that the relinquished property and the replacement property are held in a qualified exchange accommodation arrangement may not exceed one hundred eighty days.¹⁸

The value ceiling is substantive and comes from 31.2 and 31.3. Only real property in place at the moment of transfer counts, regardless of how the holding period is managed.

A project that cannot be substantially built in under six months therefore cannot be fully sheltered inside the harbor. That is not a defect in the drafting; it is the harbor's design. The alternatives are to accept partial deferral, computing the shortfall in advance, or to park outside the harbor and accept the exposure described in Chapter 30. It bears noting that the leading non-safe-harbor case was itself a construction exchange in which the facilitator held title for seventeen months, which is precisely the fact pattern the Service's announced position targets.

A short operational checklist closes the chapter, because improvement exchanges fail on execution more often than on doctrine.

Confirm before closing that the lender will lend to the titleholder or to its single member company, and that existing financing on the relinquished property contains no impediment.

Confirm that the general contractor will accept the titleholder as the owner on the construction contract, and that draws are documented as payments by the owner rather than by the taxpayer.

Confirm mechanic's lien priority and title insurance arrangements for an owner the parties have not dealt with before.

Model the value in place at the projected transfer date, in writing, before the relinquished property closes, and give the client the resulting boot figure while the transaction can still be restructured.