Construction Exchange Frequently Asked Questions

It is advantageous to utilize the services of a qualified intermediary because a qualified intermediary is presumptively deemed not to be the agent of the taxpayer. Treasury Regulations specify that a qualified intermediary is not the agent of the taxpayer if the intermediary otherwise is qualified and the exchange agreement between the taxpayer and the intermediary expressly limits the taxpayer's access to proceeds being held by the intermediary.

Due to the magnitude and complexity presented by most construction projects, issues of control over the construction process concern many taxpayers. IRS rulings and case law have provided that a taxpayer may remain actively involved in the construction process without jeopardizing the exchange (see Section 4 below). Any issues concerning the capability of the qualified intermediary to handle the construction exchange can be satisfied by reasonable due diligence. To protect the project from unforeseen liabilities, it is important for the taxpayer to insist that the qualified intermediary to form a single member limited liability company to hold the replacement property protecting the taxpayer from any liabilities arising from any of the other properties held by the qualified intermediary (this is the standard operating procedure of All States 1031).


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2. How do you identify the Replacement Property in a Construction Exchange?

A transfer of relinquished property in a deferred exchange will not fail to qualify under section 1031 merely because the replacement property is not in existence or is being constructed at the time the property is identified as replacement property. In any tax deferred exchange, however, taxpayers must be very specific when identifying replacement property to be acquired. When identifying replacement property to be built, taxpayers must provide the legal description for the underlying land and as much detail regarding construction of the improvements as is practicable at the time the identification is made, including providing detailed plans and specifications for the structure to be built or repaired.

In determining whether the replacement property received by the taxpayer is substantially the same property as identified where the identified replacement property is property to be constructed, variations due to usual or typical construction 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, and the exchange will fail. A taxpayer should be able to avoid this possible trap by considering various alternative building designs prior to the exchange and identifying in the exchange the chosen alternative. The identification should contain as much detail as possible so that minor variations in the completed project can be classified as "usual and typical construction changes."

If the taxpayer decides to construct a substantially different structure prior to the expiration of the identification period (45 days), then the original identification can be revoked.


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3. Does the Construction have to be Completed within the 180 Day Exchange Period?

Receipt of Replacement Property in Construction Exchange

The fact that the construction of the replacement property may not be complete at the time of the exchange will not, in itself, cause the replacement property to be considered a substantial variation from the property identified, so long as the taxpayer would have received substantially the same property had the construction been completed. There is no requirement, for instance, that a certificate of occupancy be obtained before the exchange can be consummated. Once title is taken to the land by the taxpayer, however, the exchange is completed and any further disbursements of exchange proceeds are considered "boot" – taxable gain to the taxpayer.

If the construction on the replacement property is unable to be completed within the exchange period, the exchange may still go forward, but the exchange value of the replacement property will only include the land and construction work completed prior to its receipt. Accordingly, if the net proceeds of the sale of the relinquished property are completely expended on the construction prior to the end of the 180 day exchange period, then the exchange may be consummated even though the construction is incomplete, subject, of course, to the liability netting rules (any debt on the relinquished property should be matched by an equal amount of debt on the replacement property to avoid taxable boot). Improvements constructed after the taxpayer has acquired the replacement property do not qualify as like-kind replacement property.

The installed improvements should be documented by photographs and affidavits of completion both at the date of acquisition and the date of substantial completion. This will confirm that the exchange proceeds were expended on legitimate construction expenses. State law will govern exactly how much of the unfinished project will be considered replacement property (Treas. Reg., 1.1031(k)-1(e)(3)(iii)). Uninstalled fixtures such as cabinets, sinks, toilets and the like are unlikely to be considered real property under state law, and therefore will be considered as non-like-kind boot in the exchange. Similarly, construction labor occurring after the taxpayer receives the replacement property will not be considered like-kind property in the exchange, even if prepaid (Treas. Reg. 1.1031(k)-1(e)(4)). Prepayments to the taxpayer's general contractor for work to be performed after the 180 day period also are not allowed (plus, from a business standpoint, advance payments to a general contractor may not be a very good idea).


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4. Does the Qualified Intermediary act as General Contractor?

The taxpayer is not totally precluded from participating in the construction process. In various letter rulings by the IRS and relevant case law, the following actions have been permitted in connection with construction exchanges: (i) the taxpayer may supervise construction of the improvements, (ii) the taxpayer may review and approve payment of invoices/draw requests, (iii) the taxpayer may provide funds to finance the construction of the improvements; (iv) the taxpayer may agree to be responsible for cost overruns, and (v) a party related to the taxpayer may act as the contractor in building the improvements. The taxpayer can exert even greater control over the project, even acting as the general contractor (and receiving payments from the qualified intermediary) provided the taxpayer does not make a profit in that role, if the construction exchange is structured to comply with the safe harbor provisions of Revenue Procedure 2000-37.


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5. Can I Construct my Replacement Property before Selling my Relinquished Property?

If the replacement property is the taxpayer's future office or business location, the taxpayer may require that the construction of replacement property be completed before the disposition of the relinquished property. This scenario is known as a reverse construction exchange since the construction of the replacement property will occur prior to the sale of the taxpayer's existing facility. On October 2, 2000 the IRS issued Revenue Procedure 2000-37 providing long awaited guidance on structuring reverse exchanges and other "parking arrangements" to avoid IRS challenge. The Revenue Procedure describes a safe harbor for both forward and construction parking arrangements if certain requirements are met. (for more information concerning the safe harbor see article entitled "Reverse Exchanges - What a Difference a Year Makes" posted at www.allstates1031.com)

In order to accomplish a reverse construction exchange, under the Revenue Procedure or otherwise, taxpayers typically engage in so-called "parking" or "warehousing" transactions. Parking transactions typically are designed to "park" the desired replacement property with a qualified intermediary until such time as the taxpayer arranges for the transfer of the relinquished property to the ultimate buyer in a simultaneous or deferred exchange. In a typical reverse construction exchange, All States 1031 would take title (i.e. park) the replacement property through a single asset special purpose entity (typically an LLC), and enter into a construction agreement with the taxpayer's general contractor to construct the improvements. If necessary, due to difficulties financing the construction or otherwise, the relinquished property can be "parked" and the taxpayer can take title to the replacement property and construct the improvements.

Financing the acquisition of the replacement property and construction of the improvements may present difficulties if a commercial lender is involved. The financially independent taxpayer will loan the necessary funds to qualified intermediary securing the loan with a mortgage on the replacement property. An unsophisticated commercial lender, however, will typically be apprehensive of the parking arrangement, and will require personal guarantees from the taxpayer securing those guarantees with mortgages on the relinquished property or other property owned by the taxpayer. Such security arrangements will not disqualify a safe harbor exchange.

In many instances a reverse construction exchange cannot be completed by the end of the 180 day safe harbor period allowed in Rev. Proc. 2000-37. The Revenue Procedure only provides a safe harbor for reverse exchanges that meet its requirements, but also recognizes that parking transactions can be accomplished outside the safe harbor. Accordingly, a non safe harbor exchange can be successfully completed provided it is structured properly (i.e. so that the qualified intermediary has enough of the benefits and burdens relating to the property so that the qualified intermediary will be treated as the owner for federal income tax purposes).


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