We recently had a client looking to complete their 1031 Exchange with a brand new “Build-to-suit” Replacement Property. Their rationale for going down this “still under construction” property road was that the owner/developer of the property was willing to offer a slightly more attractive Cap Rate as well as other lease terms to entice a Buyer to purchase his yet to be completed property.
In all honesty, the higher Cap Rate was offset by the Buyer incurring greater risk. In a 1031 Exchange whereby the Exchanger is looking to exchange into property that is still being constructed, the single most important element of the 1031 trade is timing.
As we’ve mentioned previously, 1031 Real Estate Exchanges are defined by their unbending rules and regulations. One such cast-in-stone rule that was established through the Tax Reform Act of 1986 is the 180-day exchange period under IRC Section 1031. Simply stated, the 180-Day Rule says that in order to successfully fulfill the requirements of 1031, the Replacement Property must be Closed by the Exchanger no later than 180 days from the date that the Relinquished Property was SOLD.
This 180 Day Rule coupled with the potential construction delays inherent in any new Build-to-Suit property make this a Replacement Property Strategy not for the faint of heart.
So what happens if construction is Not complete on Day 180? If on Day 180 the Exchanger does a “partial closing” on the yet to be fully completed Replacement Property, the stringent 1031 Rules on new construction kick in. Any improvements made to the property after it is received by the taxpayer are not considered “like-kind” to real estate.
In other words, let’s say that our Exchanger is buying a $3 mill Build-to-Suit as his 1031 Replacement Property. And let’s also say that on Day 180 he closes on the new property with $1 mill in improvements still yet to be completed on his new Replacement Property. 1031 Rules say that he is able to claim only $2 mill toward his 1031 Exchange as the unfinished $1 mill in new construction is not considered to be “like-kind” real estate for the purposes of his Exchange.
Moral of the Story: When it comes to Build-to-Suit 1031 Replacement Properties, you need to pursue this route with both eyes wide open. Permitting, weather, construction delays and cost overruns can easily throw your 1031 Replacement Property into Exchange Jeopardy. There are some exchange strategies specifically designed to reduce the risk of 1031 Build-to-Suits, but the easiest might just be planning your 3 Property Identification cautiously. It might not be the best of ideas to identify all three of your properties as being under construction.
Still the potential for higher returns that Build-to-Suit Replacement Properties can offer make this an enticing strategy.
Just be careful.