1031 Exchange - Existing Duplex to New Construction 4plex

[Account Closed]

I have an aging duplex purchased in 2012 with substantial gains and I'm considering cashing out to build a 4plex. 

Would this be considered a "like kind" exchange in the eyes of Almighty IRS b/c it's a new construction project? 

If so, any specific requirements I should look out for? Like violating time constraints or special paperwork b/c new construction? 

[Robert Hetsler]

@Dave Foster is correct.  I would also add, and correct me anyone if you disagree because I am aware that some investors, attorneys, CPA's and other professionals differ in this area, you can take title initially via your QI, as Dave suggested and get the construction moving forward as quickly as possible and as long as you have constructed the value (meaning using all the proceeds you need to qualify for the full tax deferment) prior to the 180 days, you are fine even if the construction itself is not entirely complete.  This assumes you take title from the QI prior to the 180 days of course and not wait till the end of the construction period.  So this would only apply in a situation where you are clearly going up in value which it sounds like might be the case if you are moving to a 4plex from a 2plex.  However, even if you did not spend all that is required because of construction delays, which we all know are inevitable and provided title has been transferred from the QI to you within the 180 days, you would still receive a partial exchange to the extent you have spent more than your depreciated basis.

Additionally, be cautious on how much you assign to the land value when working through the numbers because you will need to be consistent with that value going forward when you are depreciating the capital improvements.  As you know, land is not depreciable so your tax benefits going forward should be considered with respect to the allocation of the price because it will effect your bottom line with respect to taxable income.

Additionally, ensure that you have the property you are buying titled the same way as the property you are selling because the taxpayer is the one who receives the benefit of the exchange so the selling taxpayer (individual, LLC, Corp) and buying taxpayer need to be the same. That is a core requirement and most investors know that; however, you do want to consider it a little more if you have the QI buy the property initially. The reason is that when the QI sets up the new entity to buy the property the transfer back over to you can be a transfer of units of the LLC as opposed to a deed transfer and second real estate closing on the same property. Thus avoiding doc stamps, transfer tax (each state has their own type of fees) and a new title policy along with any other fees associated with a second closing. As an aside, my opinion is that when a QI takes title to a clients future property, they should set up a new specific entity for that purpose because a QI could have a liability in the past or one arise during your exchange that puts your assets at risk so setting a new entity to facilitate the exchange is not negotiable as the benefits and peace of mind far outweigh the cost of setting up an LLC.

The reasoning is that a disregarded entity is the individual for tax purposes but still affords you asset protection.  Again, this only works if this property is owned individually or in an existing disregarded entity, if you are going to have the QI close on the property, and then construction begins. 

Further, another caution is that you want to ensure that if you are about to engage in this process in the next few weeks or months, to file and extension on your Federal & State, if applicable, 2016 tax returns and not your full federal tax return as that can cut you off at the "knees" if you make that mistake. 

Two final cautions.  If you are using any lender financing, especially a traditional lender, you need to tell them in advance of your intentions.  The reason is that they will likely not close the deal out until all the construction is complete, unless warned and agreed to in advance, which could kill the deal if you are buying up a bit and need to take title before construction is complete because you the 180 days is expiring.  So make sure to speak with your lender in advance if that is an issue.

The second caution is that you do not want to try and sneak in a bunch of pre-paid construction just to qualify those fees as you can only pay forward to the extent it is reasonable given the circumstances and the "normal" way things are done.  So if you are building a steel building and you have evidence the price of steel is about to skyrocket, an aggressive play might be to pay, and include, those costs as capital expenses paid within the 180 days.  You cannot pay for the mailbox though if you have not even formed the foundation and include it though.  I hope that makes sense as it is a bit of an extreme example I recognize.

Again, this is intended to be a positive response because everything is easy to us that do this everyday but if you do not have an experienced QI, you could find yourself in a bad situation quickly.  @Dave Foster and @Bill Exeter are both very qualified and I believe I can include myself in that group as well.  Best of Luck as I wish you high profits!