A key fact about 10310 exchanges is that you cannot use the proceeds to make improvements on land you already own. This is a common pitfall for unwary real estate investors. In order to qualify for tax deferment, the replacement property must be of like kind with the property it is replacing. If you give up real estate, the replacement property must also constitute real estate, valued at or above the value of the property sold.
An improvement that is unfinished is considered a “contract for service,†which constitutes personal property but is not real property. Because a replacement property has to be of like kind and of equivalent value with the property sold at the time of closing, it can be difficult for an investor to find a replacement property that both fulfills these requirements and meets his or her specifications.
So, how can you get the replacement property you want out of a 1031 exchange? There are two main ways you can go about acquiring a build-to-suit property that both fits your structural specifications and fulfills the accounting requirements necessary for a like-kind exchange.
Your first option is to perform what is known as a ‘poor man’s Build-to-Suit,’ in which you ask the seller to make certain improvements on a property to increase its value prior to closing. To illustrate: if you were to sell a property worth $100,000, and were looking at a replacement property valued at $10,000, the seller could make $90,000 worth of improvements to raise the property value. These completed improvements would constitute real estate, and you could then buy the property for $100,000, fulfilling the requirement of equivalent value. Most sellers, however, will not be very eager to perform these improvements so that you can make a 1031 exchange.
Tags: exchange, exchanges, deferred, captial gains taxes
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