Deferred Like-kind Exchange & New Construction
Generally, you recognize no gain or loss on the exchange of property you held for the productive use in a trade or business or for investment if you exchange that property solely for property of "like kind" that you also plan to hold either for productive use in a trade or business or for investment. Such an exchange is referred to as a "like-kind exchange" or "1031 exchange" [named after a section of the Internal Revenue Code (IRC)]. Under a like-kind exchange, the gain you realize on the exchange of property for replacement property does not escape tax - the tax on the gain is only deferred until the replacement property is sold.
A deferred like-kind exchange is an exchange in which, under an agreement, you transfer property that you held for productive use in a trade or business or for investment (the "relinquished property") and subsequently receive property to be held either for productive use in a trade or business or for investment (the "replacement property") that is substantially similar to the relinquished property.
For a deferred exchange to qualify as a like-kind exchange under IRC Section 1031, (1) you must identify the replacement property within 45 days after the closing of the sale of the initial property, and (2) you must receive the replacement property within 180 days of the closing of the sale of the initial property, or by the extended date of your federal income tax return for the year in which the initial sale occurred, whichever date is earlier.
The 45-day identification period begins on the date you transfer the relinquished property and ends at midnight on the 45th day thereafter. Generally, for replacement property to be treated as identified before the end of the identification period, you must designate it as replacement property in a written document signed by you and hand delivered, mailed, faxed, or otherwise sent before the end of the identification period to either the person obligated to transfer the replacement property to you or any other person involved in the exchange other than you or a disqualified person. Also, the replacement property must be unambiguously described in that written document or agreement.
The 180-day exchange period begins on the date you transfer the relinquished property and ends at midnight of the earlier of the 180th day thereafter or the due date (including extensions) for your federal income tax return for the tax year in which the transfer of the relinquished property occurs. In the case of a deferred exchange, the identified replacement property is received before the end of the exchange period only if: (1) you receive the replacement property before the end of the exchange period; and (2) the replacement property you receive is substantially the same property as identified.
Except in the case of certain federally declared disasters, military actions, and terrorist actions, there are no rules for extending the 45-day identification period or the 180-day exchange period. If an exchange does not meet those requirements, it is treated as a normal taxable sale.
"IMPROVEMENT", "CONSTRUCTION", or "BUILT-TO-SUIT" LIKE-KIND EXCHANGE
Quite frequently, a taxpayer sells the relinquished property for a greater value than the cost of the replacement property. This excess value, if not otherwise reinvested into a like-kind property, will be taxable and referred to as "boot". If the replacement property is a land suitable for new construction or is a property that requires further improvements, it is possible for the improvements to qualify as like-kind if certain safe-harbor provisions are followed.
It is important to emphasize that, in and by itself, an exchange of real estate for "construction services" does not qualify under Section 1031. Hence, any construction or other production occurring with respect to the replacement property after the land or unimproved property is received by the taxpayer will not be treated as a qualifying like-kind property [Reg. §1.1031(k)-1(e)(4)].
Fortunately, in 2001, the IRS issued Rev. Proc. 2000-37, which created a safe harbor under which improvements could be made to the property if certain procedures were followed. The safe harbor requires the use of "Exchange Accommodation Titleholder" (EAT) to complete the exchange. EAT is typically a limited liability company owned by a qualified intermediary and, for purposes of Section 1031, is considered the owner of the property for tax purposes, but the investor can control the construction and use exchange funds to build the improvements. It is necessary to have the EAT hold title to the property while the improvements are being made because only the improvements that are made before the investor takes title will increase the value of the property for exchange purposes. In other words, improvements made or costs incurred after the taxpayer takes title to the replacement property are not considered of like kind to real estate. There are special identification rules that apply when the replacement property will be improved between the date of the identification and the date the investor takes title. The investor must identify not only the legal description or address of the property, but also what will be built on it, with as much specificity as is possible and practical [Reg. 1.1031(k)-1(e)(2)].
It is not necessary to complete all improvements during the 180-day exchange period; however, only the value of improvements that are in place at the time the taxpayer takes direct ownership (generally at the expiration of the 180-day period) will be considered like-kind property. Any subsequent costs incurred will not be considered like-kind but will not disqualify the exchange.