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Improvements Made with Exchange Funds in a Deferred Exchange

Improvements Made with Exchange Funds in a Deferred Exchange
By: Diane Schaefer, President of Exchange Solutions, Inc.
(NYRE Journal 7/15/03)

From time to time, after the first leg of a 1031 tax deferred exchange, a taxpayer seeks to make improvements or construction on a replacement property with sale proceeds. This is permissible provided it is done before the acquisition of the replacement property.

For example, a taxpayer may desire to acquire a lower cost replacement property or vacant land and utilize the remaining exchange funds to construct improvements. Revenue Procedure 2000-37 permits the taxpayer to construct improvements with exchange funds on replacement property by first parking the replacement property with an Exchange Accommodation Titleholder (EAT). While the Qualified Intermediary is holding the exchange funds, as is typical, the taxpayer identifies the replacement property within the 45 days from the date of the sale of the relinquished property closing. The identification must be specific to the property “as is” at the time the property will be acquired. The taxpayer may possibly be in contract to acquire the replacement property, however, the contract needs to be assignable to the EAT as the new purchaser. The EAT prepares a Qualified Exchange Accommodation Agreement which is entered into by both the EAT and the taxpayer. The agreement states that the EAT is parking the property on behalf of the taxpayer in order to facilitate a Section 1031 exchange and that the arrangement will abide by Revenue Procedure 2000-37. The EAT forms a single purpose entity, acquires legal title to the replacement property with the exchange funds, and is the owner of the property for federal income tax purposes. It is imperative the taxpayer assign the Qualified Exchange Accommodation Agreement to the Intermediary before any exchange funds are loaned to the EAT for either acquiring the property or constructing improvements. The taxpayer could be liable for constructive receipt of the exchange funds under Section 1.1031(k)-1(g)(4). Furthermore, the replacement property should not be leased back to the taxpayer while in the EAT’s possession nor should the property securitize the loan to the EAT.

While the property is being held by the EAT, improvements are constructed in accordance with the general contractor and/or the taxpayer. The Intermediary or the EAT would pay the parties directly responsible for services, labor or materials. Since the exchange period of 180 days originated at the time of the sale closing, the property must be conveyed to the taxpayer either by the 180th day or at the time the exchange funds are exhausted. The Qualified Intermediary assigns its rights as purchaser to the taxpayer, and the EAT conveys the property at its original purchase price plus improvements, directly to the taxpayer. Any interest during the construction period could be considered funds loaned to the EAT and could increase the purchase price. If property tax is owed during the time the EAT parked the property, it would also be added to the basis of the property. The EAT is also responsible for reporting on payments over $600 to any noncorporate payee for construction services rendered while the property was in its possession.

Be aware, that a taxpayer cannot exchange real property for improvements on land previously owned by the taxpayer. Real property is “like kind” only to real property whether it be improved or vacant land, but improvements are not considered like kind under Section 1.1031(a)-1(b).

Remember, if the exchange funds have not yet been exhausted and the 180th day is approaching, the taxpayer cannot prepay costs, place funds in escrow or buy materials and attempt to increase the purchase price. These items would be considered boot if funded after the 180th day. A taxpayer should always consult with a tax advisor while engaging in a tax-deferred exchange and inquire when payments made by the Qualified Intermediary would and would not taint the exchange.

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