1031 exchange rules for next property?

Question

Is it possible to take a 1031 from a property I have for sale and use it to build an investment property on a lot I currently own? This will be my first 1031 one and don't know if this is possible or not.  Thank You

Nathaniel Nooner · Answer

@Dave Foster nothing special. I bought a house to flip and it has 3 extra lots. I was think about keeping one and building a new house on it. For no more money I'll be paying taxes on it may not be worth the trouble.

Bill Exeter · Answer

Hi @Nathaniel Nooner,

Yes, you can, but it will involve risks.  We call this an Advanced Improvement 1031 Exchange™ where you sell one or more properties (“relinquished property”) and subsequently build or make improvements on land that you already own (“replacement property”).

The general idea is that you must acquire an interest in real estate that you do not already own, and since you already own the land we have to structure an Advanced Improvement 1031 Exchange™ so that you can acquire an interest in real estate that you do not already own (in fact, it does not exist yet).

Essentially, your new replacement property will consist of (1) a thirty plus (30+) year ground lease on your land, and (2) the new improvements made on the land that you already own.   The ground lease and improvements represent the interest in real estate that you do not already own (and that is being created through this structure).  There will be risks involved in the transaction, some of which will be discussed below.  You and your accountant and/or attorney should review in greater detail to ensure that you understand the risks involved.

The transaction involves the sale of your relinquished property through a Qualified Intermediary.   An Exchange Accommodation Titleholder (“EAT”) would sign a 30 plus year ground lease for your land.  This 30 plus year ground lease begins to create an interest in real estate that did not exist before.  The EAT would then begin to complete the improvements on the land that you already own in the name of and on behalf of the EAT.  The 30 plus year ground lease plus the improvements made to/on the land creates/represents the new real estate interest that you will be identifying and acquiring as your replacement property in your 1031 Exchange.

Dave Foster · Answer

@Nathaniel Nooner, Yep.  That kind of little infill opportunity is awesome.  We've seen tons of this right here in St. Pete where land is really scarce.  One house on 2 or 3 lots and you replat and either fix the house and rent/sell or you tear it down if it interferes   with the lot lines.  In your case I'd go forward with your subdivide.  But hang on to that house and hold while you're deciding how to proceed with the other lots and planning.  If you hold over a year.  Put a renter in and generate some income but don't disturb the rest of the land other than getting entitlements, you'll at least be able to sell that as a capital gain rather than ordinary income.

Then you can embark on your new career of infill builder extraordinaire!!  There's probably any number of lenders who would lend for a new build on one of the lots with a loan secured by the existing house.

Bill Exeter · Answer

Hi @Nathaniel Nooner,

Actually, the IRS has issued three (3) Private Letter Rulings specifically allowing this transaction structure (one as recent as 2014), and we understand from our outside tax counsel that there is a fourth PLR on the way but we have not seen it yet.

Here are the references to the three (3) PLRs for your own tax advisors review:

PLR 201408019PLR 200329021PLR 200251008

Dave Foster · Answer

@Nathaniel Nooner, The exchange that would accommodate that would accommodate what you're talking about is not new.  But in recent years it has fallen under scrutiny and the disapproving eye of the IRS and subsequently there are new hurdles.  It is no longer enough for you to lease the property on a 30+ year lease to the EAT of the QI.  You cannot have owned the property for a 180 day period prior to the QI taking title by virtue of the lease.  So in essence, you must sell that property to an entity what will own the property for 180 days.  And if you're using a related party then you must also beware of related party issues.

As said above there are risks.  The few we do are with heavily attornied up clients willing to take the risk.

If it's your first 1031 I dunno - there might be a simpler way.  Is there something special about that lot?  Or is it just a lot you want to build an investment property on.  The tried and true way to get where you want to go would be to sell the lot and the property you are already selling and buy a house on a lot that equals the aggregate totals of the two sales.  Or sell both and do a more traditional reverse construction exchange under rev proc 2000-37.  Where you pick out a lot and the QI takes title in the EAT and holds while construction is completed. Still a complicated process but one with a solid road map from the IRS.  And one where your biggest challenge will be getting enough construction done within the 180 day period.

1031 exchange rules for next property?

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