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Can You Use 1031 Exchange For New Construction?

November 17, 2023

A traditional 1031 exchange involves exchanging your investment property for another while deferring capital gains tax. For real estate investors looking to invest in undeveloped properties, you may be wondering if you can exchange a property for another property for new construction or improvement.

Yes, the 1031 strategy can also be used for the exchange of a real property for a new construction under certain conditions

An investor can sell a property and use the proceeds to fund the construction of a new property provided that they comply with all relevant legal requirements. You can consult with a reputable qualified intermediary at Universal Pacific 1031 Exchange for expert guidance if you’re ready to start an exchange.

In this article, you’ll learn how a 1031 exchange for new construction works, the potential risks and challenges involved, and pro tips for choosing a suitable qualified intermediary for a successful tax-deferred exchange.

How Does a 1031 Exchange on a New Construction Work?

How Does a 1031 Exchange on a New Construction Work?

The key difference between a standard 1031 exchange and a 1031 exchange involving new construction is the added complexity of constructing or improving the replacement property instead of purchasing an existing one.

The process begins with the sale of the relinquished property. To legally defer capital gains taxes, you need to identify potential replacement properties within 45 days from the day of the sale of the relinquished property. This may include properties for new construction exchange. 

The identification must be done in writing and submitted to a qualified intermediary. A qualified intermediary is responsible for holding the sales proceeds and ensuring compliance with 1031 exchange rules.

Instead of acquiring an existing property, you can use the exchange funds to finance the construction or improvement of the replacement property. You should also make sure that the construction or improvement process adheres to the guidelines provided by the Internal Revenue Service (IRS).

You must complete the construction or improvement of the replacement property within 180 days of the sale of the relinquished property. This includes both the 45-day identification period and the overall 180-day exchange period.

To simplify the process and reduce the risk of the IRS challenging the exchange, investors may choose to follow the safe harbor guidelines outlined in Revenue Procedure 2000-37. This involves meeting certain criteria, including completing at least 95% of the replacement property’s costs and 50% of the improvements by the end of the exchange timeline.

Note that the new construction property title should be in the name of someone other than the taxpayer/exchanger. Hence, the exchanger has to name an independent third party representative who maybe an Exchange Accommodation Titleholder (EAT) or Qualified Intermediary (QI). Finally, you report the 1031 exchange on your tax return using IRS Form 8824 with details about the relinquished and replacement properties and the intermediary used.

Debunking the Value Equivalence Misunderstanding

Debunking the Value Equivalence Misunderstanding

One of the keys to a successful 1031 exchange with new construction is understanding the requirement for equal or greater value. You should carefully consider both the property value and the debt associated with the improved replacement property to ensure compliance with IRS regulations. Here is a breakdown of the actual value requirements.

According to the IRS, the value of the replacement property, including the new construction project, must be equal to or greater than the original investment property. The value in this context is not necessarily monetary value but the overall investment in the property. Also, the debt on the replacement property should be equal to or greater than the debt on the relinquished property.

1031 Exchange for New Construction: Real Case Scenario

George, a Los Angeles-based real estate investor sells his commercial property valued at $500,000 as part of a construction 1031 exchange. He later identifies and acquires an undeveloped piece of land for $800,000. Here, the total value of the replacement property is less than the relinquished property. So, George may need to invest an additional $300,000 at least into the piece of land to defer capital gains taxes.

Potential Risks Associated With 1031 Exchange For New Construction

Potential Risks Associated With 1031 Exchange For New Construction

Considering the limitations of a 1031 exchange, new construction projects naturally involve more variables and uncertainties compared to the purchase of an existing property. Factors that make up such complexities include:

1. Construction Delays 

Building a new property takes time, and unforeseen delays can occur due to permitting issues, unfavorable weather, labor disputes, financing, or other unforeseen circumstances. These delays in construction can jeopardize the exchange, as the IRS mandates completing the construction or improvement exchange within the safe harbor period.

2. IRS Rules and Requirements

You need to properly understand and strictly comply with IRS rules to maximize the benefits of a 1031 exchange for new construction. Such rules include the like-kind requirement, property value-related rules such as the 200% rule, and strict timelines. Violating any of the rules may disqualify the exchange and make the transactions liable to capital gains tax.

3. Financing Issues

You may incur taxable boot and immediate tax liability if the money from the sales of the relinquished property exceeds the safe harbor amount. On the other hand, your project may suffer delays if the funds are not enough to cover construction costs.

4. Cost Management

Managing construction costs can be challenging depending on the type of new construction. Investors must not only consider the purchase price but also the expenses related to the entire construction or improvement process.

5. Identification of Replacement Property

It may be complicated to identify a suitable replacement property for a 1031 exchange especially when dealing with a property that doesn’t yet exist. You may need to rely on architectural plans, permits, and contracts and these flexible materials can change in the course of construction.

6. Changing Plans

Plans for new construction can change over time, which may create discrepancies between the identified replacement property and the final product. This should be managed carefully to maintain compliance.

7. Market Volatility and Its Implications

Market volatility can cause uncertainties that may pose challenges in the 1031 exchange process, especially when it involves new construction. Some of the factors that contribute to these uncertainties include:

  • Changing Property Values: Regular fluctuations in property values can impact the perceived value of both the relinquished and replacement properties. For instance, a piece of land valued at $10,000 at the time of identification may rise up to $13,000 when you’re ready to purchase and start the new construction.
  • Construction Cost Variability: Market volatility may affect construction costs, leading to unexpected increases during the build-out phase of new construction.
  • Financing Challenges: Volatile market conditions can impact financing options, interest rates, and lending practices, potentially affecting an investor’s ability to secure funding for new construction.

Strategies to Meet the 180-Day IRS Timeline

Strategies to Meet the 180-Day IRS Timeline

The 180-day timeline is the maximum time stipulated by the IRS for completing a 1031 exchange process. It includes the 45-day identification period within which the investor must identify potential replacement properties. Within the remaining 135 days, the IRS expects the investor to wrap up every transaction within the exchange.

Note that the 180 days include weekends and holidays. If an investor fails to identify and purchase a suitable replacement property within the 180-day period, they risk the disqualification of the 1031 exchange. This would result in the immediate recognition of capital gains, potentially leading to a significant tax liability.

Proper Preparation and Planning

Before initiating an exchange, it’s important to have a clear plan including how to identify the replacement properties, the criteria to look out for, and the financing options.

Identifying Replacement Properties Early

Identify potential replacement properties as soon as possible, preferably before you sell the relinquished property. Also, it’s recommended to identify alternative replacement properties to avoid delays in case the primary replacement property becomes unavailable or encounters delays

Flexibility in Property Selection

To reduce the risk of construction delays and improve the likelihood of meeting the 180-day deadline, consider properties that are readily available, under construction, or in the final stages of completion.

Use of Qualified Intermediary

A qualified intermediary helps facilitate the exchange process efficiently, handle the funds, and provide guidance on meeting IRS requirements. You can book a free consultation with our experts at Universal Pacific 1031 Exchange to discuss your transactions and start an exchange.

Tips on Choosing a Suitable Qualified Intermediary For 1031 Exchanges

Tips on Choosing a Suitable Qualified Intermediary For 1031 Exchanges

1. Experience in Handling 1031 Exchanges

Choose a QI with experience in handling exchanges involving new construction. The expertise helps ensure that experience ensures that they are familiar with the unique challenges and timelines associated with construction or improvements.

2. Financial Stability

Especially if your exchange involves large sums, you need to be sure that your potential QI is financially stable Select a QI with financial stability. A financially stable QI can instill confidence in the investor that funds will be handled responsibly.

3. References and Reviews

Reviews and testimonials provide valuable insights into the reputation and reliability of QIs. Research and seek references from other investors who have hired the services of your potential QI for a real-world assessment of their services. 

4. Clear Fee Structure

Understanding the QI fees upfront can help you budget appropriately for the exchange and avoid surprises. Visit the QI’s website for insights into their fees or contact them directly for enquiries.

5. Communication and Accessibility

Choose a QI that communicates effectively and is accessible throughout the exchange process. Clear communication is essential for a smooth and successful transaction.

Conclusion

A 1031 exchange for new construction involves some complexities that may pose serious challenges if you do not pat attention to them. If you must maximize the benefits of tax-deferred exchange with new construction, it’s crucial to have a proper understanding of these factors and develop a suitable strategy to address them. At Universal Pacific 1031 Exchange, our team of experts possess the required expertise and experience to facilitate and guide you through a successful exchange process. Book a free consultation with us today to start an exchange.

About The Author

Michael Bergman, CPA
Michael Bergman is a California licensed CPA and Real Estate Broker with over 32 years of experience in commercial real estate. Specializing in 1031 tax-deferred exchanges and financial oversight, his expertise is invaluable for complex real estate transactions. Michael’s unique blend of financial acumen and real estate knowledge positions him as a trusted advisor in the industry, offering sound advice and strategic insights for successful property management and investment.

Don’t let taxes hinder your property investment decisions. Connect with us today for a free, no-obligation 1031 exchange consultation. Let us help you navigate the process with ease.