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Can new construction ever qualify for 1031 Exchange?

Yes, you can 1031 Exchange into a property that has not been built yet. There are rules and information about this can be found inside our 1031 Exchange Knowledge Base about property to be produced. Here is an excerpt from that article:

One of the greatest stipulations in the final deferred exchange regulation permits you to exchange for real estate that has not been built yet. Exchangers are still smacking their lips over this one.

A transfer of Relinquished Property in a deferred exchange will not fail to qualify for nonrecognition of gain or loss under §1031 merely because the Replacement Property is not in existence or is being produced at the time the property is identified as Replacement Property.

Replacement Property to be produced must be identified. For example, your identified Replacement Property consists of improved real property where the improvements are to be constructed. The description of the Replacement Property will satisfy the requirements if a legal description is provided for the underlying land and as much detail as is practicable at the time the identification is made is provided for construction of the improvements. Two examples of identification of the property to be produced are blueprints and the contract with the builder.

For the 200-percent and incidental property rules, the fair market value of the Replacement Property to be produced is its estimated fair market value as of the date you expect to receive it.

For property to be produced, variations due to usual or typical production changes are not taken into account. However, if substantial changes are made in the property to be produced, the Replacement Property received will not be considered to be substantially the same property as identified.

If identified Replacement Property is real property to be constructed and the construction is not completed on or before the date you receive the property, the property received will be considered to be substantially the same property as identified only if it is real property, and it would have been considered to be substantially the same property as identified had construction been completed on or before the date you received it.

The value of the Replacement Property must be figured on the day of transfer. Construction work completed after the day of transfer will not be treated as part of the exchange.

IRS Letter Ruling 9149018 is an excellent guide for planning and “building” a §1031 exchange involving construction and packaging of Replacement Property by the “buyer” of your client's property. Here's what happened:

Needing additional office space, Taxpayer was looking for new property. To avoid taxable gain, he wanted to exchange his old property instead of selling it. He found land owned by LM that was perfect for his new building. LM leased the land to Buyer. The lease was a 30-year lease and gave Buyer the right to build on the property. In addition, Buyer and successors were given an option to buy the land from LM.

Taxpayer and Buyer agreed that Buyer would build a building on the land. Buyer approved the plans, the costs of construction, and the architect, contractors, and other parties involved in the construction. The taxpayer provided the construction financing in the form of a nonrecourse mortgage.

After completion of the building, Taxpayer would exchange his old property for Buyer's leasehold interest in the land and new building. At the closing, a portion of the mortgage would not be repaid to balance the equities.

The IRS said the exchange of Taxpayer's old property for the long-term lease plus the new buildings were interdependent parts of an overall plan resulting in a like-kind exchange. It qualified for §1031 non-recognition of gain treatment. It was not a transfer of the old property for cash followed by a separate and unrelated purchase of the new property. IRS noted Buyer bore risks of ownership before the exchange and had the obligation to build the building. In addition, Buyer was obligated under the lease with LM.

Related Info: qualify, construction, replacement, buyer, identified, produced, building

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