Using 1031 Funds to Build on Property You Already Own

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One of the long standing beliefs of a 1031 exchange is that you can not use exchange proceeds from the sale of your Old Property to build a building on land that you already own.

However, the IRS has just issued Private Letter Ruling 200251008 which blows that belief out of the water. Better than that is the rumor, as I write this article, that there is another ruling that will soon be issued that amplifies this ruling and its conclusion.

Using this Ruling as guidance, here is how you can now structure a transaction so you can do exactly what you want: use exchange proceeds from the sale of another property to build on land you already own.

The first thing you need to do is set up an entity that will lease your land from you. In the ruling this entity was an LLC, and I would recommend you use an LLC as well. This LLC can be owned by you, could even be a single member LLC, and must lease the property from you for at least 30 years. (To be treated as real estate, a lease, with extensions, must have at least 30 years of remaining life). Since there must be at least 30 years left on the lease when the construction is finished, I suggest something longer, maybe 40 or 50 years, or even 99 years.

It is important that the LLC lease the land from you at fair market value. The IRS makes note of this fact several times in the ruling. Don’t play games here, and don’t guess – make sure that you know what fair market value is, and make sure that the LLC makes timely lease payments to you.

At this point you own title to the land which is leased to your LLC for 50 years. The next step is that your Qualified Intermediary’s exchange entity (called an Exchange Accommodation Titleholder, or “EAT”) will lease the property from your LLC for more than 30 years. It is important that this lease have at least 30 years left on it when you finish construction to ensure that it is treated as real estate.

Then the property is transferred from the Intermediary (i.e. the EAT) to you to complete the exchange; this happens by transferring the ownership of the EAT.

This is important: When the EAT is transferred to you, only one shareholder can take title to the EAT. This shareholder needs to be the same shareholder as the one that sold the Old Property. If you have more than one owner of the Old Property, call your Intermediary and they’ll help you solve this problem.

One additional issue that was mentioned several times in the ruling is the fact that this transaction needs to be completed within 180 days of when the EAT signs the lease. This is one of the safe harbor requirements of the reverse exchange rules from Revenue Procedure 2000-37. You could actually sign the lease and start construction before you close the sale of the Old Property, but once you start you only have 180 days to equalize your exchange.

When you get into these types of transactions, it is critical that you use a very knowledgeable Qualified Intermediary. Use someone that has the technical background and experience to guide you through this difficult technique.

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