A common stumbling block for inexperienced investors…
An essential truth regarding 1031 exchanges is that you CANNOT use the proceeds off the sale of your relinquished property to construct land you own already. This is a common stumbling block for inexperienced investors. To qualify for a capital gains tax deferral, your replacement property has to be of LIKE KIND with the relinquished property. Thusly, the property you purchase has to constitute real estate with a value at least as high, if not greater than that of the relinquished property. A renovation that is not completed is considered a contract for a service, which represents personal property but not real property. Due to the fact that a property acquired in a 1031 exchange has to be equivalent in type and value with the relinquished property upon closing, it is, at times, hard for an investor to locate a property that complies with these legal requirements but also meets his or her specifications.
So, how can you get what you really want out of a exchange? There are two main methods by which you can acquire a custom-built property that measures up to your wants and needs and fulfills the accounting requirements necessary for a like-kind exchange.
The first option is to perform what is known as a ‘poor man’s Build-to-Suit,’ in which you request that the seller make certain renovations on a piece of property to heighten its value prior to closing on the sale. For example, if you were to sell a a piece of property worth one hundred thousand dollars, and you were looking at a replacement property valued at $10,000, the seller of the property could construct ninety thousand dollars’ of improvements in order to raise the property value. These completed improvements would represent real estate, and you could then buy the piece of property for $100,000, fulfilling the requirement that the two properties be of equivalent value. the majority of sellers, however, will not be enthusiastic to perform these improvements so that you may successfully conduct an exchange.
In the second, likelier scenario an intermediary who holds the proceeds from the sale of the relinquished property buys the replacement property and take title to it in a limited liability company, intermediary-owned company. Then, the intermediary would make use of what remains of the proceeds to make the necessary improvements on the property. Upon completion, the intermediary returns the replacement property to you, allowing you to complete the exchange process.
Returning to the previously mentioned $10,000 replacement property: the intermediary who held your money would purchase the aforementioned piece of real estate for the asking price and would make the desired improvements with what is left of your proceeds, transferring the replacement property to you when the value of the property suffices to establish likeness with the relinquished property.
Though a build-to-suit exchange can help you acquire the replacement property that is right for you, it is key to take into consideration the time required for the construction of necessary improvements. You have only one hundred and eighty to bring a 1031 exchange to completion, so you need to be conscious of what can actually be completed in this period. Keep in mind that a renovation represents real estate when it is completed, so renovation in progress doesn’t increase the value of the property. Although you may not be able to modify your property as extensively as you might want, 180 days is enough time to accomplish considerable remodeling, and to bring your replacement property much closer to your ideal.
