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Recent Developments in Build-to-Suit Exchanges: Can I Build on Land I Already Own?

By: Mary Kay Kennedy, Esq., Senior Vice President and National Operations Manager, First American Exchange Company, LLC


In a specialized 1031 exchange called a build-to-suit or improvement exchange, an investor can acquire replacement property and make improvements to it using exchange funds. This is useful for several reasons.  First, it gives the investor more flexibility to acquire property that is lower in value than the relinquished property. The transaction would typically be partially taxable if the investor did that, but he can increase the value of the replacement property by building on it before he takes title.

Another benefit of doing a build-to-suit exchange is that the investor can use exchange funds to make the improvements rather than using his own money or borrowing money.

The improvements can either be new construction or renovations, but to be within the IRS safe harbor, they must be done within 180 days of the date that the relinquished property closed. The 180-day time limit is one of the biggest limitations on an investor’s ability to benefit from a build-to-suit exchange.



A build-to-suit exchange is accomplished by having a holding entity (called an “exchange accommodation titleholder” or “EAT”) temporarily hold title to the replacement property while the improvements are being made. The EAT is typically a limited liability company owned by a qualified intermediary. Most build-to-suit exchanges are structured under the safe harbor that was created by the IRS in Revenue Procedure 2000-37. Provided the guidance is followed, the EAT can be considered the owner of the property for tax purposes, but the investor can control the construction and use exchange funds to build the improvements.

It is necessary to have the EAT hold title to the property while the improvements are being made because only the improvements that are made before the investor takes title will increase the value of the property for exchange purposes. Improvements that happen after the taxpayer takes title to the replacement property are not like kind to real estate. (See IRC Regulation 1.1031(k)-1(e)(4).)

There are special identification rules that apply when the replacement property will be improved between the date of the identification and the date the investor takes title. The investor must identify not only the legal description or address of the property, but also what will be built on it, with as much specificity as is practical. (See IRC Regulation 1.1031(k)-1(e)(2).)



Some investors have tried to trade into replacement property by building improvements on land they already own. This does not work, however, because an exchange must include trading one property for another like kind property, and in this case the investor is disposing of real estate and receiving in return materials and construction services. (See Bloomington Coca-Cola Bottling Co. v. C.I.R., 189 F. 2d 14 (7th Cir. 1951).) There are also rulings that say receiving improvements as replacement property without acquiring an underlying interest in real estate is not an exchange of like kind property. In other words, the improvements must be attached to a new real estate interest in order to be like kind to real estate.

Another strategy investors use to build on land they already own is to transfer the property to a cooperating third party, such as a contractor. The contractor builds the improvements and eventually transfers the property back to the investor as replacement property; however, the parties need to build in sufficient benefits and burdens of ownership or the property will be considered to be owned by the investor the entire time and the exchange will be disqualified. (See DeCleene v. C.I.R., 115 T.C. 457 (2000).)



After Revenue Procedure 2000-37 created a safe harbor for reverse and build-to-suit exchanges, some investors transferred their properties to an EAT and the EAT made the improvements to the property. The advantage of this arrangement was that the EAT is considered the owner for tax purposes under a safe harbor arrangement even if the EAT does not have the benefits and burdens of ownership. In 2004, the safe harbor was amended, however, to provide that it is not available if the replacement property was owned by the taxpayer within the 180-day period before the date the EAT takes title. (See Revenue Procedure 2004-51.)


A more successful strategy than trading into property you own is to trade into property that is owned by a related party, but only when a certain set of circumstances exists. This method may be most useful to taxpayers who own multiple pieces of real estate, each in an entity that is considered separate for tax purposes.

In most cases, buying replacement property from a related party (through an intermediary) doesn’t work in an exchange because of the related party rules in Internal Revenue Code Section 1031(f), which exist to prevent basis shifting. Nevertheless, a recent private letter ruling provides an example of when an investor may be able to acquire property from a related party using a ground lease.

In early 2014, the IRS published Private Letter Ruling 201408019. In this PLR, a party related to the taxpayer owned the property and leased it to another related party entity for a term in excess of 30 years. The ground lessee subleased the property to an EAT and a build-to-suit exchange was set up under the Revenue Procedure 2000-37 safe harbor. The sublease had a term in excess of 30 years (which was represented to be longer than the useful life of the improvements) and provided for fair market rent for the land. The existing building was demolished and the EAT constructed improvements on the property. Within the 180-day time frame, the EAT transferred the leasehold interest and the improvements to the taxpayer as replacement property.

This build-to-suit exchange qualified for tax deferral for several reasons. First, the real estate that was held by the EAT and transferred to the taxpayer was not owned by the taxpayer but by a separate, related entity, so the taxpayer was not trying to build improvements on land it already owned.

Second, the IRS said that Revenue Procedure 2004-51 did not apply to this transaction because the replacement property was never owned by the taxpayer. Because of that, the parties could take advantage of the safe harbor rules and the EAT was considered the owner of the property for tax purposes.

Third, although many exchanges have been disqualified when a taxpayer acquires replacement property from a related party, here the related party created a ground lease and both the taxpayer and the ground lessee agreed that they would hold their interests for a minimum of two years after the exchange, which is required by the related party rules in Section 1031(f). The IRS said that Section 1031(f)(4) did not apply to this transaction to disqualify it because the parties agreed to keep their interests intact for at least two years.

Finally, the underlying lease upon which the improvements were built had a remaining term of at least 30 years at the time of the exchange. This is necessary for the leasehold interest to be like kind to a fee interest in an exchange. (See Reg. Section 1.1031(a)-1(c)(2).)



Build-to-suit exchanges provide the investor with more flexibility and give an investor the ability to use exchange funds to make improvements on the replacement property. The biggest challenge is usually that the whole transaction must be completed within 180 days. The recent private letter ruling provides an example of an exchange where a related party ground leased the property to an EAT, which allowed the taxpayer to trade into the ground lease and improvements that were built during the exchange period with exchange funds.

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