A construction exchange allows you to sell your old property and use that money to buy a piece of bare land and build a building on it. This situation arises when the seller is a land or lot owner, or perhaps a builder or developer who requires you to buy, or take title to, your land first before you or they start construction. If this is your situation, then the construction exchange would fit your bill. However, if the developer holds title to the land during construction, such as a developer like WCI Communities, Lennar or DR Horton, etc., then your challenge would be if you can get in title to the new property by day 180. See our separate discussion regarding buying replacement property from a developer following this discussion.
There are a few critical things that you need to know about a “Construction Exchange”:
- You Must Equalize Your Exchange
The first critical rule is that you only have 180 days from the closing of your old property to equalize your exchange. The construction of the new building does not need to be completed by this time, but you need to equalize your exchange.
For example, you sell your old property for $250,000 and you are thinking of buying a piece of land for $100,000, and constructing a building for $500,000 on it. The total project will run you about $600,000. By the 180th day, you need to have at least $250,000 invested in the new project (both land and construction) to equalize your exchange. This means you just need another $150,000 of installed construction costs on top of your $100,000 land cost to “equalize” your exchange to the $250,000 target amount. An advantage here is you do not need a Certificate of Occupancy (C.O.) by the 180th day in order to be within the IRS guidelines for a 1031 exchange.
- The Costs Must Be “Installed Costs” to Count
For costs to be included in your construction totals and count towards your 1031 exchange, they must be “installed”. This means that you cannot buy lumber, for example, and have it trucked to the site to count – it won’t count until you nail it together and into the dirt.
- What Happens if You Don’t Meet Your Equalization Target?
If you don't meet your equalization target ($250,000 in our example), you pay tax on the amount that you fall short. Using our example, if you only incur $200,000 of construction and land costs by the end of your 180 days, you would pay tax on the difference of $50,000. As is true with 1031 exchanges in general, the gain comes first, which means that the entire $50,000 is taxable - you cannot prorate your investment equity in the old property across the gain.
- Once You Take Title to the Property, Your Exchange is Over
When you take title to the property, your exchange is over, at least on that property. For this reason, you need someone, other than yourself, to take title to the land and do the construction. One easy way to accomplish this is to have your builder buy the land. He will hold title to the property until you reach your equalization target, or until you run out of time on your 180 day limit. One problem that many of our clients have with their builder taking title to the property is security. What happens if the builder goes bankrupt? What happens to the property? What if the builder is not performing? Can you get rid of the builder and still get your property back? What if there is a dispute over how much you owe the builder? Is there a way you can force him to transfer the property without him holding it hostage?
For these reasons, most of our clients choose to have us take title to the property. The title will be in the name of a limited liability company (an “LLC”) that we will set up for just this purpose. The money for the purchase of the land and for payment of construction costs can come from your exchange account that we are holding. Of course, you still pick the architect, you pick the contractors, you pick the colors, you pick the carpet, etc. we just pay the bills. The LLC will continue to hold the land until you reach your equalization target, or until you run out of time on your 180 day limit.
- How Do You Identify the Construction on Your 45 Day Letter?
Since you will be taking title to the land and the partially completed building to complete your exchange, you need to identify this as such on your 45 Day Identification Form. In most cases your identification will read something like this: “Purchase of the bare lot at 123 Main Street, Fort Myers, FL, and the construction of a 10 unit apartment building, complete with landscaping and parking lot, thereon.”
- How Is The Construction Contract Handled?
If we are taking title to the property, the contract you negotiate with the builder should be in the name of the LLC that we set up to take title to the property. You should add a clause to this contract that allows you to assume the contract. In this way, the contract will stay in force even after the LLC transfers ownership of the property to you.
- How Do The Construction Bills Get Paid?
As construction progresses, there will be a need for periodic payments. In most construction projects there is a general contractor. The general contractor typically gets paid once a month. He then pays the sub-contractors. The general contractor’s bill will detail how much of his bill is attributable to each sub-contractor. The general contractor needs to submit his bill to you for your approval. After you approve it in writing, please fax it to our office for immediate payment. Funds for the payment of the bill will be withdrawn from your exchange account and forwarded to the general contractor. These payments will include a “lien waiver” statement. We do not pay any bills until they have been approved by you first.
- Can You Do Some of the Construction Work Your Self?
Yes, you may - but there is a problem with paying you for that work. One of the requirements for a proper exchange is that you may not touch the money in between the sale of your old property and the purchase of your new. Therefore, if you, Fred Jones, do the work, we cannot write a check from the exchange account to Fred Jones for construction. On the other hand, if you own Jones Construction Company, we can write a check to the construction company for work it does.
- What Happens if There Is a Construction Loan?
First of all, construction lenders rarely have a problem with construction exchanges, so it would be unusual for the lender to have a problem with us holding title to the land for the first few months of construction. Typically, you and the general contractor will prepare a “draw request” for the lender. This draw request usually shows the current state of construction and the costs incurred to date. Costs incurred through the last billing are also noted with the difference being the amount of the current draw request. The draw request is approved by you, and then sent to us (as long as we are still the owner of the property) for our approval. If you have already approved the draw request, we will sign it and immediately return it to the lender. Usually the lender will pay the general contractor directly as soon as they get the signed draw request from us, and the lender will be responsible for attaching the appropriate lien waiver. In unusual cases the lender will forward the draw funds to us for disbursement.
- Why Choose 1031 Exchange Connection for your Construction Exchange?
What many QI’s don't want you to know is that their industry is largely unregulated. Without standards, they can offer you little assurance of their training and qualifications. In fact, they will do little more in an exchange than fill in the blanks on generic forms. At 1031 Exchange Connection, all of our exchanges are handled by a team of CPAs and real estate professionals. Choosing our licensed professionals ensures that the education, knowledge and ethical standards of our team have passed rigorous testing. You can trust our experience as well. We’ve completed thousands of qualified 1031 exchanges.
- What Can I Expect with 1031 Exchange Connection?
When you choose 1031 Exchange Connection, you’ll have reliable service before, during and even after your exchange. Our expert consultants are available seven days a week, virtually around the clock, to answer your questions as they arise.
- Here’s How All of Our Exchanges Work:
- Our experts consult with you on how to best structure your exchange – always considering your particular situation.
- We meticulously document your exchange to meet all IRS requirements.
- We coordinate with your realtor, attorney, CPA and closing agent to properly complete the exchange.
- We keep everyone informed at critical points throughout the process
All it takes is a phone call or e-mail, and 1031 Exchange Connection will go to work for you. We are ready to provide further information and answer any of your questions.
- Can I buy new construction from a developer in a 1031 exchange?
If you are considering buying new construction from a builder or developer, such as a WCI Communities, Lennar, DR Horton, and they require you to enter into a contract to start on construction with them, remember that you only have 180 days from the date you sold your old property to get in title to the new one. Also note that this is not a “construction exchange” explained earlier because you do not need to take title to the land with this type of developer. In essence, you are just entering into a contract to buy replacement property, with the caveat that what you are buying needs to be built first before you can take title to it. At the same time, you need to keep in mind that developers make no guarantees they will finish construction within the 180 day time frame of a 1031 exchange, but they will promise you the world to get you to contract with them. In these cases, we recommend you place at least two (2) more properties on your 45 day ID form in addition to the one being constructed just in case the new one will not be ready in time. In this manner you may have a better chance of completing your exchange if the construction is not completed by day 180. However if you have your heart set on a property in a new development, try to get firm assurances written into the contract that the developer will commit to that will guarantee you get in title by day 180.
Another way to work with a developer and new construction is to buy one of their models, and then lease it back to them. We like this strategy because you should be able to buy right away and get in title by day 180, and then earn cash flow from them while they show their models to prospective buyers. In this manner you satisfy the “held for investment” requirement in a 1031 exchange as well. In addition, developers typically keep their models impeccably clean during the model period, assuring you will get your property in great shape by the time they turn it over to you. Also, many developers build on “spec”. Try to buy one of their spec homes as those have a much better chance of being completed by day 180. Otherwise, if day 180 comes and construction is not finished, your exchange has a good chance of becoming toast.