Working on a 1031 Exchange Property
Thanks in advance for your responses to this.
I'm working on my first exchange -- a construction exchange. I have two corporations. Corp 1 exchanged condo properties for undeveloped land property. Corp 2 will be the General Contractor and Development corporation for the land. What are the restrictions? Can Corp 2 bill the exchangor for the improvements until it meets the exchange value?
Thanks
David
maximize,
I am not quite sure how to answer your question. You say that you are working on an exchange, but in the next sentence say that an exchange of condo properties for undeveloped land has already been accomplished. Where are you in the process, who holds title to the replacement property, and was a qualified intermediary used?
While I am waiting for you to answer these questions, let me give you some general guidelines and limitations concerning construction exchanges.
The tax code does permit the taxpayer to participate in an exchange even if the replacement property is not in existence, or is being produced, at the time the property is identified. The tricky part is that the replacement property must still be properly identified (within 45 days) and received within 180 days.
Identification must be as accurate as possible. For buildings to be constructed, use the legal description of the land and as much detail concerning the proposed improvements as practical.
The constructed property must be sustantially the same as identified. If substantial changes are made after identification, the replacement property will not be considered substantially the same as identified and the exchange will be deemed a taxable sale and subsequent purchase. Variations due to usual or typical production changes are not taken into account.
There is no extension of time (for the 180-day rule) and if the real property is in the construction phase -- but not completed at time of receipt-- the end product must be substantially the same as originally identified. The good part of this limitation is that the real property does not have to be completed within the exchange period.
Of course, you still have all the usual exchange restrictions on constructive receipt of the proceeds of the sale of the relinquished property.
Now for the (possibly) bad news. The exchange rules prohibit a transfer of property for construction services. Building on land that you already own (you said the exchange is completed) will be considered receiving building services and materials -- not qualifying property. To make the exchange work, you need to build on land you do not presently own.
A qualified intermediary is essential to facilitate a construction exchange. Generally, in a construction exchange, the intermediary purchases the land, receives the deed, then contracts for the building construction. At the end of the construction phase (or the exchange window) the intermediary transfers title to the exchangor to complete the exchange.
Since the intermediary will be on title, and will have some liability during the construction phase, your exchange fees may be very expensive. Strongly suggest you discuss this strategy with a tax professional to preserve the integrity of the exchange. Also, discuss how related party rules may come into play if your construction company produces the replacement property.[ Edited by DaveT on Date 01/20/2003 ]
Sorry, I wasn't clear. It was late. The Exchange for property was done with an intermediary. The undeveloped property and the proposed construction site was identified appropriately. My question is that around my construction company doing the work and getting paid and reimbursed as the general contractor for the construction. I have two corporations. The first owns the investment property. The second does construction and development. Hope this is clearer. Thanks again.
You say that the exchange was done (past tense). Sounds like you (through your corporation) have already taken title to the replacement property, and the intermediary has already settled the exchange escrow. If this is the case, then any development you want to do now is not covered by the exchange umbrella.
If this is not the case, it still is not clear to me that you have a viable construction exchange still alive. Even though you say the undeveloped property and the proposed construction site was identified appropriately, if your identification did not describe the proposed improvement, you have a problem.
At this point, it would be best to take all the facts and circumstances of your exchange to a tax attorney familiar with exchanges. Together you can sort out where you stand and what is still possible within the exchange umbrella.
Just as an aside, I wonder if you aren't undoing some of benefit of your exchange by converting tax deferred capital gains to ordinary income. It appears that some of the gain on the sale of your relinquished property is being paid to your construction company. Since your construction company will have to declare taxable income from this construction project, how much tax benefit do you really derive from doing the exchange? I ask this as a rhetorical question, but one that you should also take up with your tax attorney.
The construction exchange is valid. We did describe the improvements to this property. My question is about who can do the work. Do you or others have experience similar to what I've described? I'm sorry I didn't make this clear earlier.
OK, I have thought about this a little more. You asked who can do the work, and, can your construction company bill the exchangor for the work. I would say YES, your construction company can do the work, and YES your construction company can bill Corporation 1 (the exchangor) for the work.
Can the funds Corporation 1 uses to pay Corporation 2 for the work come from your exchange escrow? YES.
Since Corporation 1 (the exchangor) and Corporation 2 (the construction company) are related parties, will the exchangor be considered having constructive receipt for that money paid from the proceeds of the sale of the relinquished property for the construction work (and therefore taxable boot)? I don't know.
While I have done a construction exchange, there were no related parties involved. I am not an attorney, and I am uncomfortable taking this discussion any further.
At this point, I can only reiterate my previous suggestion. It would be best to take all the facts and circumstances of your exchange to a tax attorney familiar with exchanges. Together you can sort out where you stand and what is still possible within the exchange umbrella. [ Edited by DaveT on Date 01/22/2003 ]
Thanks. That's exactly was what I was asking. Thanks a bunch.
dp