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Recent IRS “private-letter” rulings have cleared the way for more investors to construct their own 1031 exchange replacement properties, literally creating new opportunities for entrepreneurs who were facing a shortage of reinvestment properties.

Issued last summer and late 2002, the rulings technically apply only to the taxpayers who requested them. But financial advisors and investors unfailingly adopt such rulings as guideposts, say 1031 experts. Though a fast-food restaurant or other quickly built structure may fit more neatly into the 180-day replacement timeframe in a 1031 exchange, these so-called improvement exchanges now offer enough flexibility to allow a broader spectrum of construction possibilities.

Here's how it works: A real estate investment trust (REIT) wanted to develop a $200 million shopping center on the East Coast as a 1031 replacement property for several older centers that it wanted to sell, says Louis Weller, a principal at Deloitte & Touche's national real estate tax services group in San Francisco. Because construction would take a couple years to complete, the REIT would miss the 180-day deadline.

But by using an intermediary, also known as an Exchange Accommodator Titleholder (EAT), to buy the land and own it during construction, the REIT could sell the old centers before it bought the new center in an arrangement that satisfied both the IRS and the REIT, Weller says.

Many investors used the improvement exchanges, also called construction exchanges, before the ruling, but did so with trepidation until the issuance of the private-letter ruling. The rulings also addressed the potential for conflicts of interest, and in effect gave the green light to investors who wanted to build replacement properties on land already owned by a close affiliate.

Improvement exchanges can be done on unimproved lots, or include additions to existing buildings, provided that they create enough value to constitute an exchange. A taxpayer can't construct improvements after taking title to property, however.

There are other caveats. Due to the potential for construction delay, a standard improvement exchange can leave investors shortchanged, says Steve Regenstreif, vice president and senior director of the national retail group for Marcus & Millichap. “If it's only 80% to 90% ready (when 180 days elapse), the IRS will ultimately give you credit toward only portion of the project completed.”

Thus far, developers and investors have been relatively slow to take advantage of the ruling, he says.

The two rulings have followed a litany of other investor-friendly 1031 clarifications in recent years by the IRS. In 2002, the IRS said investors could buy just a portion of a property for their replacement buys, creating a new universe for buyers who had been handcuffed by the scarcity of compatible “like-kind” properties available.

Two years prior, the IRS ruled investors could buy replacement properties even before selling their exchange properties. The flexible “reverse exchange” was officially born, removing some of the selling urgency from 1031 deals. Today, reverse exchanges are common.
— Steve McLinden