A 1031 tax-deferment can be used on many types of investment property exchanges. However, can an investor use a 1031 Exchange for a new construction project?
The simple answer is yes, but the process can be complex.
In general, the IRS prevents using funds from a 1031 exchange for new construction projects; however, they do have guidelines under which it can be done.
In a basic 1031 exchange, the funds from the sale of an investment property are used to buy a similar new investment. In the right circumstance, under IRS guidelines, the taxpayer can defer capital gains taxes from that sale.
Eligibility for a 1031 exchange with new construction is multifaceted, and there are many variables to consider.
How It Works
First, and most important, is that the title for the new construction property is in the name of someone other than the taxpayer/exchanger.
To do this, the exchanger names an independent third party representative. The representative can be an Exchange Accommodation Titleholder (EAT) or Qualified Intermediary (QI). The assigned representative’s name will be the name on the Purchase Agreement and who will receive the title.
Sometimes, the exchanger might have their contractor acquire the land where the new construction will take place.
While the title will go to the EAT or QI at closing, all associated funds will be in an escrow account set up by the investor. The construction is under the taxpayer’s guidance, and the titleholder pays the bills out of the escrow account.
The assigned representative holds the title until the construction is complete or for the 180-day exchange period, which is the time allocated by the IRS to complete the acquisition of a new property after the sale of a relinquished property.
As with other 1031 exchange transactions, there is a 45-day time limit after the sale of the original investment to identify the replacement investment, which in this case would be the new construction property.
If a replacement property is new construction, there are stringent requirements, and the description must detail items like specific building plans.
When construction is complete, the representative will transfer the title to the investor and complete a regular 1031 exchange for the new property.
Things to Consider
There are several things to keep in mind about using a 1031 exchange for new construction, including:
- The new construction project must be equal to or greater than in value than the original investment property at the end of the construction and before the representative deeds it back to the original investor.
This means that the investor can buy land or property that is worth less than the relinquished property as long as the value is equivalent by the end of construction.
- The representative cannot transfer the title back to the investor until construction is complete, and it must be within the 180-day exchange period.
- All of the the equity from the relinquished property must be used on construction costs or a down payment within the 180-day exchange period.
A 1031 exchange can be difficult on a new construction property. There are many variables, so it is highly advisable to work with a knowledgeable partner to navigate the process.