Advanced Build-to-Suit 1031 Exchange Strategies: Building on Property Already Owned
A build-to-suit (improvement) 1031 exchange allows taxpayers to use exchange funds to make improvements on a replacement property before taking title. This strategy provides flexibility when the ideal replacement property does not fully match the value of the relinquished property, or when the investor wants to customize the property to meet specific needs.
An advanced scenario arises when a taxpayer wants to make improvements on property they already own. While this may seem appealing, it presents significant challenges under IRS rules governing like-kind exchanges.
IRS Requirements for Improvement Exchanges
The foundation of every 1031 exchange is that the taxpayer must receive like-kind property in exchange for the relinquished property. With a build-to-suit exchange, the IRS allows improvements to be made on the replacement property during the exchange period. However, several restrictions apply:
Title Must Be Held by the Qualified Intermediary (QI) or Exchange Accommodation Titleholder (EAT):
During the exchange period, the taxpayer cannot hold title to the replacement property if improvements are to be funded with exchange proceeds. The property must be parked with the EAT under a reverse or improvement exchange structure.
180-Day Timeframe:
All improvements that are to be credited toward the exchange must be completed, and the improved property must be transferred to the taxpayer, within the 180-day exchange period.
Property Received, Not Improvements Made, Controls:
The IRS has consistently emphasized that the taxpayer must receive the replacement property as it exists at the end of the exchange period. If improvements are incomplete, only the value of what has been completed by day 180 counts toward the exchange.
Why Building on Property You Already Own is Problematic
The IRS does not permit taxpayers to use exchange proceeds to build on land they already own. This is because the taxpayer would not be receiving new property in exchange; instead, they would be simply improving property they already possess.
IRS Revenue Ruling 67-255 and subsequent guidance reinforce that improvements made to property the taxpayer already owns do not qualify as like-kind replacement property under Section 1031.
To qualify, the replacement property must be acquired as part of the exchange, not pre-owned.
Possible Structuring Options
To navigate this challenge, investors sometimes use EAT structures to temporarily transfer ownership:
Exchange Accommodation Titleholder (EAT) Ownership:
If an EAT acquires the taxpayer’s land before improvements are constructed, and then holds title while the improvements are made with exchange funds, the taxpayer can receive the improved property back as replacement property. This requires careful structuring under IRS Revenue Procedure 2000-37, which governs reverse and improvement exchanges.
Timing is Critical:
The EAT must acquire the property before improvements begin, and the improved property must be conveyed to the taxpayer by day 180 of the exchange.
While advanced build-to-suit strategies can be used to improve property as part of a 1031 exchange, they cannot be directly applied to land already owned by the taxpayer. Instead, an EAT structure must be used to ensure that the taxpayer ultimately receives a newly improved property, rather than simply funding construction on an existing asset.
