1031 - Use 3rd party to purchase property & extend 180-day window

[Brandon Priest]

Summary of transaction: I want to purchase a vacant piece of land and utilize a "Reverse/Construction 1031" in which I will be selling a rental home.  

My problem is that I won't be able to get permits required timely enough to get the construction costs into the 1031 transaction.  The seller of the vacant land cannot extend the sale.

Can I use a 3rd party to purchase and hold the vacant land and later sell it to me when I am ready to start construction?  This would delay the start of the 180-day window and I believe the only added costs would be excise tax on the transitional sale as well as escrow/title fees.

[Dave Foster]

@Brandon Priest, Potentially there's a possibility that maybe this could somehow be kind of sort of OK :).  But I would never recommend it. IN essence you're wanting to do a non-safe harbor reverse exchange using inexperienced agents as your QI.  The safe harbor found in Rev proc 2000-37 lays out the framework that the IRS has learned to love prefer and punish if you don't do it that way.  The clients we're going outside the safe harbor with are all extremely well represented legally and the bill for a reverse not meeting the safe harbor is pretty darn high.  This is very risky  For a bunch of reasons.

1. Step transaction likelihood.  You're taking a number of legal steps that while in and of themselves are not illegal, they are designed to afford you preferential tax treatment outside the letter of the code.  That's a step transaction and if the IRS sees that you were trying to do a reverse exchange without adhering to the letter of 2000-37 by manipulating some steps they will start looking into every crevice of that transaction.  And it's very easily seen as a step transaction apart from the reliance on the safe harbor.

2. No arms length 3rd party would ever buy a property and allow someone else to entitle and permit construction and then sell for no profit.  That doesn't hurt you but it leaves the 3rd party with a profit problem.  They have to make money or they're not really a 3rd party are they?!  How much profit is reasonable and what will they pay in tax and how will you make sure they're held harmless...  Lots of questions therer.

3. You're potentially relying on the same 3rd party outside the regs to not get divorced, file bankruptcy, lose a lawsuit, get addicted to meth (OK I'm reaching now but you get it) . You are exposed to every incident of life that could happen to that 3rd party  and affect the property.  And you can't run in once they've done something bad and say "just kidding.  He was only holding this property for me".  

3. Using a related party is not an idea I'd endorse either.  Related party rules around 1031 are even more strict.  I spose if the related party was going to simply buy and sell to you before your 1031 begins that might work.  But if you want to complete the reverse exchange it would have to be related party selling to the QI who starts the reverse for you.  See items 1 and 2.

It happens and you might be successful.  But the odds of success are really only because the optics of exposure are low.  And when you start relying on not getting audited in order to succeed that's a tough line to back up from.

The best way I seen around this is to extend the closing of the purchase and make it contingent on successful permitting and the seller cooperating with  you on that.  As long as the change is not something that jeopardizes the current entitlements the seller might not have any trouble doing this.  And then the project is shovel ready for when your QI takes title and you build like a busy little beaver (or a whole colony of little beavers if the project is that big)

The reason it's best done before you go through a lot of machinations (besides skirting the form of the law) is the risk of something ending up not working.  I'm probably sensitive to this after going to a commission meeting for the tiny little beach town I live in where client went ahead and bought the current house against advisement.  And then they applied for the "slam dunk" variance of 4 feet less back offset to the beach front.  After all it would only match the off sets of the house on the left and the mayor's house on the right - Variance Denied!!!  The dream of a beach front mansion - dead.  The client now has the option of a not so nice existing house or they'll have to cut the sq ft in half - profit gone.

Always best if you can get those thigs done before you have to purchase.  That also saves the reverse exchange fees which can get expensive.  But are well worth it rather than trying to DIY a reverse.