New developments suitable for 1031 like-kind exchange

Gary Powell is a member of the Tax & Estate Planning Practice Group with Husch & Eppenberger LLC in Springfield. He concentrates in the areas of business law, taxation and estate planning.

The like-kind exchange under Section 1031 of the Internal Revenue Code is a common tax strategy used by real estate investors to defer capital gain tax when they sell real property and purchase other real property with the proceeds. Although the federal long-term capital gain rates are currently very low (a maximum 15 percent rate on unimproved real property and a maximum 25 percent rate attributable to depreciation claimed on depreciable real property), to many investors these rates are still fairly high, especially if they desire to roll their sale proceeds into other investment real estate.

While the legal test of what constitutes "like-kind" property with respect to real estate is fairly broad under the regulations and rulings, actually locating suitable replacement real property within the tight timeframe of the like-kind exchange regulations (180 days from the date of the sale of the relinquished property) is often very difficult.

An investor may want to make improvements to replacement property and have the improvements considered as additional replacement property. Improvements constructed after the investor has acquired the replacement property do not qualify as like-kind replacement property. Therefore, the improvements must be constructed prior to the investor's receipt of the replacement property.

There are several choices of who can actually complete the improvements prior to the time the investor receives title to the replacement property. These choices include the seller of the replacement property land, a contractor who will construct the improvements, or a "qualified intermediary" as defined in IRS regulations.

A common misconception is that the improvements must be completed at the time the replacement property is transferred to the investor. The rule is that the improvements can be partially completed at the time the investor takes title to the replacement property, but the value of the improvements constructed by the investor after the transfer do not apply toward the exchange value of the replacement property. For example, if the building is 50 percent complete at the time of the transfer of the replacement property to the investor, that 50 percent is like-kind replacement property and the remaining 50 percent of the construction by the investor is non-like-kind property.

The investor may want to exchange into improvements to be built on land the investor already owns. A taxpayer cannot construct improvements on property the taxpayer already owns in the exchange because the taxpayer must receive property from the other party to the exchange and not construction materials and services.

There are several solutions to this problem. One possible solution is to have the investor lease the land to the contractor or the qualified intermediary for a term in excess of 30 years, with the contractor or qualified intermediary constructing the improvements on the leasehold and then conveying the ground lease and the ownership of the improvements to the investor as replacement property (with at least 30 years remaining on the lease on the date of conveyance).

A taxpayer may want to acquire a replacement property before the disposition of the relinquished property.

Acquiring the replacement property even before the sale of the relinquished property is commonly referred to as a reverse exchange (as opposed to a typical deferred exchange, where the relinquished property is sold first, and the replacement property is subsequently acquired).

Reverse exchanges are generally accomplished through "parking" arrangements. Under a typical parking arrangement, an accommodator and the taxpayer enter into a contract, under which the accommodator will acquire the replacement property. Generally, the accommodator will borrow funds from a bank or the taxpayer in order to acquire the replacement property. When the taxpayer sells the relinquished property under an exchange agreement with a qualified intermediary, the qualified intermediary uses the sale proceeds to purchase the replacement property from the accommodator. The accommodator uses the sale proceeds to repay the acquisition loan with respect to the replacement property.

The IRS has issued Rev. Proc. 2000-37, which provides a "safe harbor" for a parking-style exchange. Under this revenue procedure, an exchange accommodation titleholder can acquire the replacement property in an exchange and hold it for up to 180 days while the taxpayer attempts to sell the relinquished property.

One of the major problems with this revenue procedure is the 180-day requirement. If the replacement property is to consist wholly or partially of improvements to be completed, then 180 days may not be sufficient. The IRS recognizes that parking arrangements can be accomplished outside of the safe harbor of Rev. Proc. 2000-37. However, a parking arrangement outside of the safe harbor needs to be carefully structured, and entails a greater risk to the taxpayer that the structure may not be recognized as a like-kind exchange if challenged by the IRS.

There are solutions to the vexing problem of finding suitable replacement property in a like-kind exchange. The keys are proper planning and properly structuring the transaction.