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Using Exchange Funds for Improvements on Your Replacement Property


Courtesy of Jim Ogan. Contact 503-740-3453 or jogan@firstam.com

Using Exchange Funds for Improvements on Your Replacement Property

A 1031 exchange is a great tool for investors who want to avoid paying tax on the gain from the sale of real estate; however, in order to completely defer the tax, an investor must 1) find one or more “like-kind” replacement properties with a total fair market value that equals or exceeds what is being sold, 2) invest all the cash from the existing property (“relinquished property”) in the new property; and 3) acquire debt on the replacement property equal to or greater than the debt on the relinquished property, unless cash is added to offset the debt.

Many experienced real estate investors who are familiar with 1031 exchanges don’t realize that a build-to-suit exchange can give them more flexibility in structuring their transactions to meet these requirements and more ability to take advantage of opportunities in today’s market. Successful investors may also read articles like this Roofstock review to help improve their strategies. Real estate investment is a risky business so you must be prepared for all eventualities.

The build-to-suit exchange allows an owner to use the proceeds from the sale of the relinquished property not only to acquire replacement property, but also to make improvements to the property. For example, in a typical forward exchange, if an investor sells relinquished property with a fair market value of $800,000, debt of $200,000 and equity of $600,000, he must acquire a property equal to at least $800,000 and must invest at least $600,000 into that property. In a build-to-suit exchange, however, the investor could acquire property worth only $200,000 and have $600,000 in improvements made to the property by using the remaining $400,000 in exchange proceeds and by borrowing $200,000. This would use up the remaining cash and increase the fair market value of the replacement property to $800,000, resulting in a fully tax deferred exchange. A build-to-suit exchange can be a great tool in this market for investors looking to buy and improve distressed assets; however, investors should consult with their legal/tax advisors to ensure that they properly structure their transaction.

Structuring a Build-to-Suit Exchange

A build-to-suit exchange is accomplished by having a holding entity (called an “exchange accommodation titleholder” or “EAT”) temporarily hold title to the replacement property while the improvements such as electrical, plumbing, and HVAC repairs, along with chain link fence or entry gate installations are in progress. The EAT is typically a limited liability company owned by a qualified intermediary. The EAT is necessary because any work done to the property after the investor takes title to it is not considered like-kind property and therefore will not increase the value of the property for exchange purposes.

A build-to-suit exchange can be structured either as a deferred exchange where the existing property is sold before the new property is acquired, or a reverse build-to-suit, where the new property is acquired first. In either case, the entire transaction must be completed within 180 days. To learn about the benefits and drawbacks of a build-to-suit exchange, read on.

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