1031 when the selling exchanger builds to suit

[Mike Miller]

I own a lot currently worth about $850,000. I want to sell it for $1,75 mil with a contingency that I would design and build a house on the property to suit the purchaser. I would ask a down payment of $300,000 followed by subsequent payments appropriate to the degree of completion of the house. When completed, I would turn over to the 1031 intermediary $1,25 mil (= total paid to me by the purchaser less $500,000 spent on the construction of the house), and purchase a replacement rental property for $1.25 mil or more. Could this arrangement comply with 1031 requirements?

[Bill Exeter]

Originally posted by @Mike Miller:

I own a lot currently worth about $850,000. I want to sell it for $1,75 mil with a contingency that I would design and build a house on the property to suit the purchaser. I would ask a down payment of $300,000 followed by subsequent payments appropriate to the degree of completion of the house. When completed, I would turn over to the 1031 intermediary $1,25 mil (= total paid to me by the purchaser less $500,000 spent on the construction of the house), and purchase a replacement rental property for $1.25 mil or more. Could this arrangement comply with 1031 requirements?

Hi Mike,

There are a lot of moving parts here.  The critical issue is your intent to hold for rental, investment or business use.  What was your intent when you inherited the property?  Can you prove that your intent was to hold for investment purposes?  It would have to be a very strong argument because the IRS would very likely argue that you intent has changed to held for sale (development).  You would have to show that you intended to hold for investment and that your intent has not changed but that you are trying to maximize the value in order to sell the investment property.  It would not be a slam dunk argument and would involve some risk if you were to get audited.

The question of when was the house sold would also be an issue.  Was it sold upfront with an installment sale as part of the deal or are the payments earnest money deposits/progress payments as you progress through the construction project?  The question really relates to when the "sale" occurred and when the 1031 Exchange deadlines commence. 

The $500,000 in construction costs would not be able to be recovered.  The full $1.75 million would have to be reinvested.  If you pull $500,000 out at the sale, it would be applied first toward your taxable gain.  There is no way to pull out cost basis, construction costs, etc., through a 1031 Exchange without incurring taxable gain.

I've just quickly hit on the major issue that I see right off the bat.