An investor may choose to improve a replacement property by building a structure or making improvements to an existing structure on the property. As with any exchange, the exchange account must be opened prior to the close of escrow on the relinquished property. Despite the complicated and time-consuming nature of this type of exchange, it can be properly executed by adhering to the following structure.
- Identification of the Improvements – After selling the relinquished property, the investor must identify the property to be improved as well as the improvements to be made during the 45-day identification period. The description of what the improvements will look like must be as detailed and precise as is practicable at the time of identification. Completed improvements must look substantially like the detailed identification.
- Build-to-Suit Titleholder (“BTS Titleholder”) Acquires Title to Replacement Property – At the closing of the replacement property, title must be conveyed to the BTS Titleholder so that the improvements may be made. Any contracts and invoices for improvements must be in the name of BTS Titleholder, and not the investor. Funding for the improvements may come from exchange funds or financing may be obtained. If financing is obtained for the improvements, invoices in the name of BTS Titleholder may be submitted to the lender for payment. It is strongly recommended that the lender have close communication with BTS Titleholder as specific verbiage is required in the loan documents. The investor is prohibited from having control over the funds in either scenario.
- End of Exchange Period – Before the end of the exchange period, all improvements must be permanently affixed to the replacement property. Any exchange funds remaining in the account are taxable and may not be utilized for the prepayment of future improvements or the purchase of materials.It is essential to realize that additional costs are associated with this type of exchange, all of which are to be borne by the investor. For example, the investor is required to obtain a hazard and liability insurance policy with BTS Titleholder as an additionally insured party. The investor is also responsible for city and county transfer taxes, if any. Additionally, if a title insurance policy in the investor’s name is desired when the property is subsequently deeded to the investor, it is recommended a binder policy be ordered at the closing of the replacement property. These costs may be paid out of exchange funds.
- Conveyance of Replacement Property to Investor – Finally, the improved replacement property must be conveyed to the investor prior to the expiration of the exchange period. It is not required that all improvements be completed by this date. However, the value of the replacement property at the time title is transferred to the investor, including the contract price and the amount paid for the improvements, is the value the IRS will use in evaluating the deferral of capital gains for the exchange.
Issues to Consider
The most common difficulty encountered with this type of exchange is finding a lender who will lend to an investor for improvements to a property to which the investor does not origi- nally hold title. Another difficulty is the rigid time constraint for a general contractor to complete a sufficient amount of work within the exchange period to make the exchange beneficial. Other problems that exist beyond the investor’s control include delays for acquiring permits from governmental entities and adverse weather conditions. Unfortunately, there are no extensions to the exchange period. An investor should carefully consider these issues together with their tax consultants and ERI before deciding to engage in a build-to-suit exchange.