Constructing Improvements On Replacement Property
Using exchange funds from the sale of relinquished property to purchase real estate and construct improvements can be complicated. Funds received from the sale of relinquished property cannot be released to the exchanger to pay for construction without the funds becoming taxable. Consequently, the intermediary, or an entity it forms, must purchase the property to be improved and construct improvements before the property is transferred to the exchanger.
A typical construction exchange is structured as follows:
- The exchanger sells relinquished property and diverts funds to the intermediary.
- The exchanger contracts to purchase replacement real estate and assigns the contract to the intermediary.
- The intermediary purchases the replacement property and holds title in a special purpose entity (SPE) formed and owned by the intermediary.
- The exchanger loans or arranges for a loan to SPE to finance construction of improvements.
- The intermediary enters into a construction management agreement with the exchanger delegating responsibility for construction over sight to exchanger.
- When construction is complete, the property is transferred to the exchanger.
The exchanger gives up the relinquished property, receives a completely constructed replacement property, does not receive cash, and is able to defer taxable gain.
If construction cannot be completed within 180 days, which is the maximum amount of time permitted for a delayed exchange, a reverse exchange with construction must be used.
A construction exchange is substantially more complex than an exchange which does not involve construction:
- The SPE will hold title creating potential title insurance issues.
- The SPE will need funds to construct improvements requiring a loan to the SPE. If the loan is made by a third party lender, the exchanger may be required to guarantee payment of the loan.
- The exchanger, intermediary, builder, and third party lender will have to coordinate arranging progress payments to the builder as construction progresses.
- Title to the completed project will have to be transferred to the exchanger when construction is complete. This may be accomplished by transferring ownership of the SPE from the intermediary to the exchanger.
- If construction is not complete on the 180th day, title to the property will have to be transferred to the exchanger to preserve deferral of taxable gain. The cooperation of a third party lender will be required to permit the transfer.