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A key fact about the 1031 process is that you CANNOT use your 1031 proceeds to fund improvements on land you own. This is a frequent stumbling block of unwary property owners. In order to qualify for a capital gains tax deferral, the replacement property must be of like kind with the relinquished property. In this case, the property you acquire as a result of the 1031 exchange must be real estate with a value greater than or equal to that of the property sold. A renovation that is not finished is thought of as a 'contract for service,' comprising personal property but not real estate. Because a replacement property has to be of like kind and equivalent value with the relinquished property upon closing, it is, at times, difficult to locate one that fulfills these legal requirements and also fulfills his or her specifications.

So, how can you get the property you want out of a exchange? There are two main ways you can acquire a build-to-suit property that measures up to your wants and needs as well as complying with the accounting requirements necessary for a like-kind exchange under section 1031

Your first choice is to conduct what is known as a poor man's build to suit in which you ask the seller to construct particular improvements on a property to increase its value prior to closing on the sale. To illustrate: if you were to relinquish a property worth $100,000, and you were considering a replacement property valued at ten thousand dollars, the seller of the property could construct $90,000 of improvements in order to raise the value of the property. These finished improvements would constitute real estate, and you could then buy the piece of property for $100,000, complying with the requirement of equivalent value. the majority of sellers, however, will not be very enthusiastic to perform the renovations you requested so that you may conduct an exchange.

In the other, likelier scenario a qualified intermediary who holds your money purchases the replacement property from the seller and take title to it in a limited liability company owned by the intermediary. Then, the intermediary would use the remaining money to make the necessary renovations on the piece of property. Upon completion, the intermediary returns the replacement property to you, allowing you to complete the exchange process.

Back to the previously mentioned ten thousand dollar replacement property: the intermediary would purchase it at the asking price and would construct the desired modifications with the remainder of the money, transferring the replacement property to you when the value of the property suffices to constitute a like kind exchange.

Although a build to suit exchange can help you acquire the replacement property that you really want, it is essential to be attentive to the span of time required for the construction of necessary improvements. You only have 180 days in which to bring a exchange to completion, so you must be conscious of what work can actually be finished in this time span. Keep in mind that an improvement is only considered to be real estate when it is completed, so a work in the process of construction doesn't increase the value of the property. Although you might not be able to build improvements as extensive as you might want, 180 days is ample time to complete considerable renovation, and to bring your replacement property much closer to your ideal.