What is a construction 1031 exchange and how does it work?

What is a Construction 1031 Exchange?

A construction 1031 exchange, also known as a build-to-suit or improvement exchange, is a type of 1031 exchange that allows real estate investors to defer capital gains taxes on the sale of a property by reinvesting the proceeds into a new property and using part of those proceeds to make improvements or construct new buildings on the replacement property. This exchange is based on Section 1031 of the U.S. Internal Revenue Code, which permits the deferral of capital gains taxes under specific conditions.

Here's how it works:

1. Sale of Relinquished Property: The investor sells a property (relinquished property) and plans to reinvest the proceeds into a new property (replacement property). To qualify for tax deferral, the transaction must be structured as a 1031 exchange from the outset, and the proceeds must be transferred to a qualified intermediary (QI) rather than the seller.
2. Identification and Purchase of Replacement Property: Within 45 days of the sale of the relinquished property, the investor must identify potential replacement properties. The investor then has a total of 180 days from the sale of the relinquished property to complete the purchase of the replacement property. The replacement property must be of equal or greater value to fully defer the capital gains taxes.
3. Construction or Improvements: The unique aspect of a construction 1031 exchange is that the investor can use part of the exchange proceeds to fund improvements on the replacement property before taking title to it. The improvements must be completed within the 180-day period, which can be challenging due to the tight timeframe for completing construction projects. The final value of the replacement property, after improvements, must meet or exceed the value of the relinquished property to fully defer capital gains taxes.
4. Completion: Once the improvements are completed and the property is officially acquired within the required time frames, the exchange is complete. The investor effectively defers paying capital gains taxes by reinvesting the sale proceeds into a like-kind property and improving it as part of the transaction.

This type of exchange is complex and requires careful planning and coordination with a qualified intermediary, as well as potentially other professionals such as tax advisors, attorneys, and contractors, to ensure compliance with IRS rules and to maximize the benefits of the exchange.