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Advanced Improvement 1031 Exchange Strategies: Improvements On Property Owned by a Related Party

In an advanced build-to-suit 1031 exchange transaction, also referred to as an improvement or construction 1031 exchange, a Taxpayer elects to use part of the equity to construct merged improvements to land previously purchased and owned by a related party, generally a related entity such as a partnership.

Structure has been derived predominantly from Private Letter Rulings, and taxpayers must be aware there is an inherent reliance issue. The only individual that may rely on any structure endorsed by Private Letter Ruling is the taxpayer that sought the ruling, so other taxpayers should be aware that there is an element of uncertainty (and accordingly, risk) that will not be eliminated until these transactions are established by authority on which everyone can rely.  

Concerns in Build-to-Suit 1031 Exchange Strategies

There are inherent concerns with the advanced planning build to suit transaction, and both are related to the structure utilized to effectuate the exchange. The first concern is whether or not the Accommodating party has structured the exchange so that the benefits and burdens of ownership are deemed to be held by the accommodating party as required under Section 1031 and Rev. Proc. 2000-37, and if they are present, whether or not ownership of a leasehold interest is sufficient to satisfy the benefits/burdens of ownership requirement. The other concern is whether or not the transaction is structured sufficiently to avoid recharacterization of the accommodation relationship as an agency relationship, which is difficult given the Taxpayer’s degree of control and participation in the acquisition and development of the replacement property.

Typical Form of Build to Suit Transaction

  • Taxpayer enters into a like-kind exchange agreement with Qualified Intermediary
  • Taxpayer enters into QEAA and Construction Management Agreement with Exchange Accommodation Titleholder
  • Taxpayer advances funds and/or guarantees a loan to the EAT to purchase Replacement Property and construct improvements
  • EAT acquires title to Replacement Property pursuant to Rev. Proc. 2000-37 in a single member LLC
  • EAT then appoints Taxpayer General Contractor, who then constructs improvements to the Replacement Property
  • After 180 days, Qualified Intermediary will direct that EAT transfer RP directly to Taxpayer, and EAT will effectuate the transfer by either assigning the ownership interest in EAT directly to Taxpayer or conveying title to the RP by direct deeding; QI purchases RP from EAT using all the proceeds from the sale of the relinquished property; the EAT uses all of the proceeds from the purchase of RP by Qualified Intermediary to pay Construction Manager for construction and services and pay the loan from Taxpayer in full

Typical Form of Advanced Build to Suit Transaction

  • Taxpayer enters into like-kind exchange agreement with Qualified Intermediary
  • Taxpayer enters into QEAA and Construction Management Agreement with Exchange Accommodation Titleholder
  • Taxpayer advances funds and/or guarantees a loan to the EAT to purchase Replacement Property and construct improvements
  • EAT acquires title to Replacement Property and parks pursuant to Rev. Proc. 2000-37 in a single member LLC
  • EAT then executes a lease with another single member LLC, LLC2 for a 30 year or greater term, under the terms of which any merged improvements to the leasehold interest constitute property of the single member LLC
  • EAT exercises power under Construction Management Agreement to appoint Taxpayer General Contractor, and then acts as Fund Control to make disbursements as construction commences
  • After 180 days, Qualified Intermediary will direct that EAT transfer RP directly to Taxpayer, and EAT will effectuate the transfer by assigning the ownership interest in LLC2 directly to Taxpayer; QI purchases RP from EAT using all the proceeds from the sale of the relinquished property; the EAT uses all of the proceeds from assignment of LLC2 to pay Construction Manager for construction and services and pay the loan from Taxpayer in full

How the Advanced Build to Suit Transaction Differs from the Standard Transaction

The advanced build to suit transaction differs from a typical tax deferred exchange with build to suit component only in the type of property designated as replacement property. In a typical build to suit tax deferred exchange, the Taxpayer seeks to acquire replacement property owned by a third party and the EAT acquires title to the replacement property and holds title while the merged improvements are constructed on the property. In the advanced build to suit transaction however, the implicit restriction imposed by Rev. Proc. 2004-51 on identifying replacement property owned by the Taxpayer within 6 months of the exchange means that the Taxpayer can not accept either assignment of the LLC or direct deeding of the Replacement Property after the improvements have been made directly. To accommodate this structure, a distinct property interest – one NOT owned by the Taxpayer in 6 months prior to conveyance of the Replacement Property – must be created. This is accomplished by the EAT, who creates a new real property interest in the form of a 30 year or greater ground lease on the Replacement Property, and executes that lease with a second single member LLC. The second single member LLC then constructs the merged improvements on the land pursuant to the provision in the lease that designates that the improvements are deemed to be the property of the LLC. In the end of the transaction, the EAT direct deeds the replacement property back to the Taxpayer, who then designates the newly created leasehold interest and the merged improvements as the Replacement Property for the purposes of the 1031 exchange and acquires the title by assignment of one hundred percent of the membership interest in LLC2.

Presented in this light, it becomes clear that the premise underlying the advanced build to suit transaction is that the EAT, in acquiring the newly created leasehold interest from the taxpayer and constructing merged improvements to the property, is creating a real property interest distinct from the interest owned by the Taxpayer prior to the exchange which the Taxpayer subsequently acquires as the replacement property in his tax deferred exchange. While this seems to be a transaction that would run great risk of attack under the agency or step transaction doctrines, all current law surrounding transactions of this nature indicates that the form of the transaction will be respected by the IRS so long as the structure adheres to the requirements of Rev. Proc. 2000-37, as amended by Rev. Proc. 2004-51. 

Requirements for a Valid Parking Arrangement under Rev. Proc. 2000-37

Revenue Procedure 2000-37: This procedure provides a safe harbor under which the Service will not challenge (a) the qualification of property as either “replacement property” or “relinquished property” for purposes of section 1031 of the Code or (b) the treatment of the ““exchange accommodation titleholder” as the beneficial owner of such property for federal income tax purposes, if the property is held in a “qualified exchange accommodation arrangement” (QEAA).

Under Rev. Proc. 2000-37, the Service will deem a property to be held pursuant to a QEAA if all of the following requirements are met:

(1) Qualified indicia of ownership of the property is held by a person, the “Exchange Accommodation Titleholder”, who is not the taxpayer or a disqualified person and either such person is subject to federal income tax or, if such person is treated as a partnership or S corporation for federal income tax purposes, more than 90 percent of its interests or stock are owned by partners or shareholders who are subject to federal income tax. Such qualified indicia of ownership must be held by the exchange accommodation titleholder at all times from the date of acquisition by the exchange accommodation titleholder until the property is transferred as described in section 4.02(5) of this revenue procedure.

For this purpose, “qualified indicia of ownership” means legal title to the property, other indicia of ownership of the property that are treated as beneficial ownership of the property under applicable principles of commercial law ( e.g., a contract for deed), or interests in an entity that is disregarded as an entity separate from its owner for federal income tax purposes ( e.g., a single member limited liability company) and that holds either legal title to the property or such other indicia of ownership;

(2) At the time the qualified indicia of ownership of the property is transferred to the EAT, it is the taxpayer's bona fide intent that the property held by the exchange accommodation titleholder represent either replacement property or relinquished property in an exchange that is intended to qualify for nonrecognition under Section 1031;

(3) No later than five business days after the transfer of qualified indicia of ownership of the property to the exchange accommodation titleholder, the taxpayer and the EAT enter into a written agreement (the “Qualified Exchange Accommodation Agreement”) that provides that the EAT is holding the property for the benefit of the taxpayer in order to facilitate an exchange under § 1031 and this revenue procedure and that the taxpayer and the EAT agree to report the acquisition, holding, and disposition of the property as provided in this revenue procedure.

The agreement must specify that the EAT will be treated as the beneficial owner of the property for all federal income tax purposes and both parties must report the federal income tax attributes of the property on their federal income tax returns in a manner consistent with this agreement;

(4) No later than 45 days after the transfer of qualified indicia of ownership of the replacement property to the EAT, the relinquished property is properly identified in a manner consistent with the principles described in § 1.1031(k)-1(c). For purposes of this section, the taxpayer may properly identify alternative and multiple properties, as described in § 1.1031(k)-1(c)(4);

(5) No later than 180 days after the transfer of qualified indicia of ownership of the property to the EAT, the property is transferred (either directly or indirectly through a qualified intermediary to the Taxpayer as the Replacement Property or the property is transferred to a person who is not the taxpayer or a disqualified person as relinquished property; and

(6) The combined time period that the relinquished property and the replacement property are held in a QEAA does not exceed 180 days.

Under Rev. Proc. 2000-37, the Service will not treat the Property as failing to be held in a QEAA as a result of any one or more of the following legal or contractual arrangements, regardless of whether such arrangements contain terms that typically would result from arm's length bargaining between unrelated parties with respect to such arrangements:

(1) An EAT that satisfies the requirements of the qualified intermediary safe harbor set forth in §1.1031(k)-1(g)(4) may enter into a tax deferred exchange agreement with the taxpayer to serve as the qualified intermediary in a simultaneous or deferred exchange of the property under § 1031;

(2) The taxpayer or a disqualified person guarantees some or all of the obligations of the EAT, including secured or unsecured debt incurred to acquire the property, or indemnifies the exchange accommodation titleholder against costs and expenses;

(3) The taxpayer or a disqualified person loans or advances funds to the EAT or guarantees a loan or advance to the EAT;

(4) The property is leased by the EAT to the taxpayer or a disqualified person;

(5) The taxpayer or a disqualified person manages the property, supervises improvement of the property, acts as a contractor, or otherwise provides services to the EAT with respect to the property;

(6) The taxpayer and the EAT enter into agreements or arrangements relating to the purchase or sale of the property, including puts and calls at fixed or formula prices, effective for a period not in excess of 185 days from the date the property is acquired by the EAT; and

(7) The taxpayer and the EAT enter into agreements or arrangements providing that any variation in the value of a relinquished property from the estimated value on the date of the exchange accommodation titleholder's receipt of the property be taken into account upon the exchange accommodation titleholder's disposition of the relinquished property through the taxpayer's advance of funds to, or receipt of funds from, the exchange accommodation titleholder.

Benefits and Burdens of Ownership

In order to have a valid exchange under Section 1031 and the parking arrangement established by Rev. Proc. 2000-37, the accommodating party must hold the “qualified indicia of ownership” Treas. Reg. 1.1031(j)-1. This requirement has been interpreted by the courts to mean the legal title to the property or other indicia of ownership of the property under applicable principles of commercial law or interests in an entity that is disregarded as an entity separate from its owner for federal income tax purposes and that holds either legal title to the property or other indicia of ownership. It is important to note that benefits and burdens of ownership for the purposes of Revenue Procedure 2000-37 is determined by state law legal title, and not the title of the property for tax purposes; this means that the accommodating party is not required to have tax ownership of the property for normal income tax purposes, and that there is some inherent structural flexibility for advisors to manipulate the titling of the replacement property in an exchange utilizing the parking arrangement under Rev. Proc. 2000-37. 

Rev. Proc. 2000-37 provides that the Internal Revenue Service will not challenge the qualification of property held in a QEAA “as either ‘replacement property’ or ‘relinquished property’ (as defined in § 1.1031(k)-1(a)) for purposes of § 1031 and the regulations thereunder, or the treatment of the exchange accommodation titleholder as the beneficial owner of such property….”, so that the Taxpayer will not have to establish that the exchange accommodation titleholder bears the economic benefits and burdens of ownership and is the “owner” of the property. However, it became evident that some advisors were stretching the interpretation of this requirement and structuring exchange transactions where the Taxpayer would transfer already owned property to an exchange accommodation titleholder and designate and receives the same property (with or without improvements) as the replacement property in a purported exchange.

The most frequently cited example of this abusive sort of structure is reported in DeCleene v. Commissioner, 115 T.C. 457 (2000), in which the Taxpayer attempted to exchange real estate owned by a taxpayer for improvements on land owned by the same taxpayer does not meet the requirements of § 1031. See DeCleene v. Commissioner, 115 T.C. 457 (2000);

In DeCleene, the Taxpayers petitioned for redetermination of deficiencies arising from disregarded like-kind exchange. The Tax Court held that: (1) in matter of first impression, transaction arranged directly with second party to exchange, without participation of third-party exchange facilitator, was a sale since taxpayer never divested himself of beneficial ownership of the replacement property, but (2) accuracy-related penalty was not warranted. The key question in DeCleene was whether the subject transactions was a taxable sale to Buyer of the McDonald Street property, as the IRS maintained, or rather was a taxable sale of the unimproved Lawrence Drive property to Buyer, followed 3 months later by DeCleene’s transfer of the McDonald Street property to Buyer in a like-kind exchange for Buyer’s reconveyance to DeCleene of the Lawrence Drive property subject to substantial improvements.

The tax significance of the answer to the question stems from the disparity in the adjusted bases of the McDonald Street and Lawrence Drive properties in DeCleene's hands. McDonald Street, which petitioner purchased in 1976-77, had an adjusted basis in his hands substantially lower than his cost of Lawrence Drive, which he purchased in 1992. Petitioner therefore reported as the taxable sale not his permanent relinquishment to Buyer of the low-basis McDonald Street property, but rather the reported as the taxable sale the conveyance of the high-basis Lawrence drive property, despite his intent to later have that property reconveyed back as the replacement property in his tax deferred exchange.

In issuing their ruling, the Tax Court characterized Taxpayer’s actions as not just locating and identifying the Lawrence Drive property in anticipation of acquiring it as replacement property in exchange for the McDonald Street property that was intended to be relinquished; rather Taxpayer purchased the Lawrence Drive property without the participation of an Qualified Intermediary a year or more before he was ready to relinquish the McDonald Street property and acquire the improved the Lawrence Drive property in anticipation of his tax deferred exchange, and then transferred title to the Lawrence Drive property subject to a reacquisition agreement with Buyer, the party to which he simultaneously obligated himself to relinquish the McDonald Street property. Determination of ownership of the Replacement Property is crucial to the analysis, as a determination that DeCleene had remained the true owner of the Lawrence Drive property during this period would prohibit the property from serving as the Replacement Property in the subsequent like-kind exchange of the McDonald Street property for the Lawrence Drive property; as the Court stated: “a taxpayer cannot engage in an exchange with himself; an exchange ordinarily requires a ‘reciprocal transfer of property, as distinguished from a transfer of property for a money consideration’ Treas. Reg. Sec. 1.1002-1(d)." Under the arrangement in DeCleene, the Buyer (acting in essence as the Accommodating Party) did not acquire any of the benefits and burdens of ownership of the Lawrence Drive property during the 3-month period it held title to that property: the arrangement gave the Buyer no equity interest in the Lawrence Drive property, the Buyer acquired the property with no economic outlay and was not at risk to any extent because the obligation and security interest executed on acquisition were completely non-recourse. In essence, under the terms of the agreements the Buyer simply incurred an obligation to reconvey the Lawrence Drive property back to the Seller prior to the end of the year and after the building on it that had been built to DeCleene’s specification and at their cost. 

The Court held that the reality of the transactions, given the degree of coordination between DeCleene and Buyer, was in essence a taxable sale of the McDonald Street property to the buyer, rather than a taxable sale of the Lawrence Property with the subsequent exchange of the McDonald property; sale of the Lawrence property amounted to nothing more than a parking transaction orchestrated by DeCleene and in which the Buyer contractually bound itself to acquire the McDonald Street property in exchange for building the facility on the Lawrence property and reconveying the property to DeCleene as soon as the facility to be built thereon to his specifications was substantially completed.Despite being termed as an exchange, the Court characterized the reconveyance of the

Despite being termed as an exchange, the Court characterized the reconveyance of the

Lawrence Drive property to DeCleene as simply reattributing the legal title to the property back to the holder of the beneficial ownership of the property, and accordingly disallowed DeCleene’s tax deferred exchange.

 

Revenue Procedure 2004-51

Regulators attempted to curb the perceived abuses of the parking arrangement, like that presented in DeCleene, under Rev. Proc. 2000-37by enacting Rev. Proc. 2004-51, which modified it to restrict application in certain cases. Rev. Proc. 2004-51 provides that the parking arrangement under Rev. Proc. 2000-37 is not available for replacement property held pursuant to a QEAA if the subject property has been owned by the taxpayer within the 180-day period ending on the date of transfer of qualified indicia of ownership of the property to an exchange accommodation titleholder.


Agency

Practically all deferred exchanges could be subject to an agency attack; ownership by the agent (Qualified Intermediary) is typically ignored and treated as ownership by the principal. Taxpayer is treated as owning the improvements at all times during the construction, and the taxpayer should be treated as exchanging for construction services if the EAT is treated as the taxpayer’s agent; with that characterization, the replacement property is actually the constructions services, which is not like-kind property and thus the exchange would be fully taxable to the Taxpayer. 

In Commissioner v. Bollinger, 485 U.S. 340 (1988), the Supreme Court reaffirmed its agency analysis set forth in National Carbide Corp. v. Commissioner, 336 U.S. 422 (1949). The Supreme Court's agency analysis has four factors and two requirements, "the sum of which has become known ... as the "six National Carbide factors.” Bollinger, 485 U.S. at 346. The Supreme Court's National Carbide factors are as follows (National Carbide Corp., 336 U.S. at 437):


(1) Whether the party in question operates in the name and for the account of the principal;
(2) binds the principal by its actions;
(3) transmits money received to the principal; and
(4) whether receipt of income is attributable to the services of employees of the principal and to assets belonging to the principal.
(5) The agency-principal relationship cannot be founded solely on the fact that the principal owns the agent. For example, a corporation will in most cases be treated as a taxable entity separate from its sole stockholder.
(6) The business purpose of the party in question must be the carrying on of the normal duties of an agent.

The foregoing authorities present three general requirements for an exchange to be recognized as a like-kind exchange under § 1031 and not recharacterized as a (disqualifying) agency relationship between the Qualified Intermediary and Taxpayer:

(1) the taxpayer must demonstrate its intent to achieve an exchange and the properties to be exchanged must be of like kind and for a qualified use;
(2) the steps in the various transfers must be part of an integrated plan to exchange the relinquished property for the replacement property; and
(3) the party holding the replacement property must not be the taxpayer's agent.

Basic principles for exchanges in which a third party acquires the replacement property to effect the exchange are established under Mercantile Trust Company of Baltimore v. Commissioner and Alderson v. Commissioner. This line of cases establishes that the third party acquiring the property to accommodate an exchange should not be treated as the agent of the taxpayer. The precedent established in these cases is that the third party must be respected as a substantive party whose role in the exchange is respected for tax purposes, and confirmed by the Ninth Circuit Court in Starker v. United States.

The Court in Mercentile Trust  approved non-recognition treatment on an exchange; Court held that party accommodating the exchange need not assume the benefits and burdens of ownership of the replacement property before exchanging it, but may acquire title solely for the purpose of exchange, and supports the idea that if the Taxpayer intends to participate in a tax deferred exchange and structures the transaction consistent with that intent, then the form of the transaction will be respected for federal income tax purposes and not subject to attack under the step transaction or agency doctrines. In Mercentile Trust, the form of the transaction was respected despite the fact that the Qualified Intermediary did not bear the benefits and burdens of ownership; the fact that the taxpayer intended an exchange and that the taxpayer intended to undertake an exchange was dispositive of the form being respected and the Qualified Intermediary being treated as a bona fide participant in the transaction.

In Alderson v. Commissioner, the Court held that a typical delayed tax deferred exchange qualified for non-recognition treatment, emphasizing the important of the taxpayer’s intent in undertaking the transaction. The Court in Alderson further held that there is no requirement for the accommodation party to bear the benefits and burdens of ownership of the replacement property in order for the exchange to be valid, and respected the form of the transaction by holding that it did not warrant recharacterization under the agency or step transaction doctrines.

 

Increased Agency Concerns in the Build to Suit Context

Tax deferred exchanges where there is a build to suit component are at an increased risk for recharacterization as a sale under the agency doctrine, given the increased scope of participation by the Qualified Intermediary in the acquisition and subsequent development of the replacement property. Despite this increased participation however, the Court has consistently held that so long as the Taxpayer intended to complete a tax deferred exchange and has respected the form of the transaction, the accommodating party will not be recharacterized as the taxpayers agent and/or the transaction recharacterized as a sale and/or an agency relationship with the provision of construction services.  

In Rutland v. Commissioner, the Court rejected the IRS agency argument on the facts surrounding a typical tax deferred exchange with a build to suit component. In Rutland, the IRS argued that the transaction should be viewed as the sale of the Taxpayer’s land and an immediate reinvestment of the sale proceeds into the replacement property; the IRS argued that the taxpayer was the actual purchaser of the replacement property and the accommodation party was acting as the Taxpayer’s agent. The IRS supported this argument by the fact that under the terms of the agreement: (1) all negotiations with respect to the acquisition of the replacement property were conducted by the Taxpayer; (2) the Taxpayer paid for all of the closing costs and undertook a title search for the replacement property; (3) the accommodating party never negotiated for the acquisition of the building, but assumed the title in a completely passive role; and (4) the accommodating party did not assume any of the benefits and burdens of ownership with respect to the replacement property.

Checklist for Structuring the Exchange to Avoid “Agency” Characterization

Does the Qualified Intermediary and/or Exchange Acommodation Titleholder operate/will operate in its own name and for its own account? Has the Qualified Intermediary and/or Exchange Accommodation Titleholder entered into all pertinent Agreements (Purchase and Sale Agreement, the Lease, the Loan ect.) in its own name and each for its own account?

Does the Qualified Intermediary and/or Exchange Accommodation Titleholder have the ability to bind Taxpayer by their actions?

Do the Agreements executed with Qualified Intermediary/Exchange Accommodation Titleholder give the Taxpayer any right to the funds held by Qualified Intermediary? Is Taxpayer specifically precluded from having any funds held returned until the tax deferred exchange transaction has failed?

Does Qualified Intermediary and/or Exchange Accommodation Titleholder have the right to the rental income under the Lease is pursuant to the Lessor-Lessee relationship established with Taxpayer and the EAT’s ownership of the Property?  Is Taxpayer's rental income from the subtenants under the subleases is pursuant to Exchange Accommodation Titleholder's assignment of such subleases to Taxpayer under an Assignment and Assumption Agreement?

Are Exchange Accommodation Titleholder and Taxpayer separate legal entities?

Is Exchange Accommodation Titleholder's normal business to offer and carry on the normal duties of an agent, as stated in the operational documents and evidenced by their actions?

Authority on Advanced Build to Suit Transactions

Private Letter Ruling 9243038 (July 27, 1992): contemplates an exchange involving merged improvements to the replacement property, although not in the context of a true build to suit component. Under the facts of the PLR, the lessee of the subject property constructed improvements to the leasehold interest, which was subsequently acquired by the taxpayer as part of a tax deferred exchange whereby the taxpayer sold a portion of his fee simple interest in the property and acquired the lessee’s interest in the lease, plus merged improvements. The private letter ruling determined that the exchange qualified for non-recognition treatment under Section 1031.

Private Letter Ruling 9110007 (November 26, 1990): contemplates an exchange in which the taxpayer sold a fee simple interest in property for a leasehold interest in real property plus merged improvements, and held that the exchange was eligible for non-recognition treatment under Section 1031.

Private Letter Ruling 200329021 (Jul 18, 2003): contemplates an exchange where Taxpayer entered into both a tax deferred exchange agreement with Qualified Intermediary (“QI”) and a qualified exchange accommodation arrangement (QEAA), under which the Exchange Accommodation Titleholder (EAT) will accept an assignment from Parent Company of a Leasehold Interest in Site Y (the "Leasehold Interest"). The Leasehold Interest was acquired by Parent from an unrelated Landlord, and was never the property of Taxpayer, and under the laws of the state in which the Leasehold interest is located, the interest is deemed to be a real property interest in its own right. When acquired by the EAT, site Y will be unimproved except for demolition of the existing building on the site, and rough grading (all to be performed by Landlord) and pursuant to the terms of the ground lease, Parent acquired the right to occupy and use Site Y for a period of twenty (20) years with four (4) five-year renewal options and to construct on Site Y certain types of real property improvements, which would be owned by Parent or its assignee. To execute the Advanced Build to Suit component, EAT agrees to construct and own a single story building pursuant to plans and designs provided by Parent (the "Improvements"), the completion of which is anticipated to occur on a date within 180 days after the earlier of the transfer of the Relinquished Property to QI or the date EAT acquires title to the Leasehold Interest.


Under the Exchange Agreement, Taxpayer will assign to QI the right to sell Relinquished Property to an unrelated buyer, pursuant to the terms and conditions of a purchase (sale) agreement, and QI will subsequently direct the conveyance of title to Relinquished Property to buyer. The proceeds from the sale will be held by QI and placed in an tax deferred exchange account which, under the Exchange Agreement, the Taxpayer has no right to receive, pledge, borrow or otherwise control. The Taxpayer will then identify as the Replacement Property the Leasehold interest owned by the EAT and will subsequently make a written assignment to QI of its right to acquire the Leasehold Interest and Improvements under the QEAA Agreement, and QI will make monthly disbursements to EAT from the qualified funds to permit EAT to make payments to the general contractor constructing the Improvements. None of the qualified funds disbursed by QI to EAT to pay construction costs will be paid to Taxpayer or to Parent, except for the planning costs to be paid to Parent.


Site Y, the intended site for the construction of Improvements, was originally ground leased to Parent by an unrelated person on arm's length commercial terms and the remaining term of the ground lease will exceed thirty (30) years (including renewal options) when EAT, at the direction of QI, transfers title to the Leasehold Interest and the Improvements to Taxpayer on or before 180 days from acquisition by EAT to complete the exchange.


Under the QEAA Agreement, the EAT is entitled to report the attributes of its ownership interest in the Leasehold Interest and the Improvements, as they are constructed during the 180-day safe harbor period, for federal and state income tax purposes. During the period that EAT holds title to the Leasehold Interest, EAT will pay any rent and other leasehold charges that come due and EAT also will pay the real estate taxes that accrue during such period.


Under the Exchange Agreement, the Taxpayer will identify within the 45-day period set forth in § 1031(a)(3) in a written instrument delivered to QI the legal description for the Leasehold Interest and a general description of the Improvements to be constructed on the Leasehold Interest, while it is owned by EAT.


Under the QEAA Agreement, the Taxpayer will identify, within the 45-day period beginning on Date 1, the Relinquished Property disposed of under the Exchange Agreement as the real property being exchanged for the RP held under the QEAA Agreement. The QI will not take title to either the Relinquished or the Replacement Properties; at both the closing of the Relinquished Property and the subsequent closing of the acquisition of the Leasehold Interest, Taxpayer will give written notice, respectively, to the buyer of the Relinquished Property and to EAT (as the seller of the Leasehold Interest) of Taxpayer's assignments of its contract rights to QI, as permitted by § 1.1031(k)-1(g)(4)(v).


Within one hundred eighty (180) days after the earlier of (i) the conveyance of the Relinquished Property and (ii) EAT’s acquisition of the Replacement Property in the form of the Leasehold Interest and Improvements, the Taxpayer will acquire under the Exchange Agreement and the QEAA Agreement the Leasehold Interest and the Improvements to complete the Exchange.


Under the QEAA Agreement, the purchase price to be paid by Taxpayer for the acquisition of RP will be equal to the costs incurred by EAT in constructing the Improvements and acquiring the Leasehold Interest, including capitalized costs such as accrued real estate taxes, rent and the planning costs. The final purchase price to be paid by Taxpayer will be determined immediately before acquisition of the Replacement Property. To the extent the actual purchase price exceeds the qualified funds held by QI, the excess purchase price will be paid in cash by Taxpayer or will be paid by Taxpayer by assuming the outstanding indebtedness of EAT for the construction period expenses.

To the extent the estimated cost of the Improvements is less than the qualified funds held by QI, if Taxpayer does not timely identify and acquire an additional like-kind replacement property, then Taxpayer will receive the remaining qualified funds as boot.

The proposed transaction involves Parent, whom is a related party to Taxpayer and who provides by transfer to QI part of the property that is to become RP, so the related party rules of Section 1031(f) are implicated. However, since both Taxpayer and Parent continue to be invested in exchange properties, both will remain so invested for a period of not less than two years following the exchange, and neither is otherwise cashing out its interests, gain recognition is not triggered under § 1031(f)(4).


In addition, the qualified exchange accommodation arrangement safe harbor (the QEAA) provided by Rev. Proc. 2000-37 applies to the proposed transaction. Taxpayer will also use the qualified intermediary safe harbor as set forth in the deferred exchange regulations under § 1.1031(k)-1(g)(4).

In the present case, the qualified indicia of ownership of the Replacement Property will be held by the EAT in compliance with all requirements stated in section 4.02(1) of Rev. Proc. 2000-37. Taxpayer represents as its bona fide intent, now and at the time the qualified indicia of ownership of RP is transferred to LLC, that the property held by LLC will constitute replacement property in an exchange qualifying for nonrecognition of gain (in whole or in part) or loss under § 1031, consistent with section 4.02(2) of Rev. Proc. 2000-37.


Within five days after the transfer of RP to EAT, Taxpayer will enter into a QEAA Agreement with an EAT providing that EAT will serve as EAT by acquiring Replacement Property as required by section 4.02(3) of Rev. Proc. 2000-37. Taxpayer represents that EAT (and LLC) will not be a disqualified person as defined by § 1.1031(k)-1(k). In addition, Taxpayer will enter into an exchange agreement with QI to facilitate transfer of Relinquished Property to an unrelated third party in the tax deferred exchange transaction as permitted by § 1.1031(k)-1(g)(4), providing that the QI will not be deemed to be the agent of the taxpayer for purposes of § 1031(a). Accordingly, Taxpayer's transfer of relinquished property through a qualified intermediary and the subsequent receipt or deemed receipt of like-kind replacement property through a qualified intermediary will be treated as an exchange, rather than a sale.

Further, all timing requirements necessary for property to be held in the QEAA, relating to notice and transfer of qualified indicia of ownership of the property to EAT will be satisfied. Within 45 days after the transfer of Replacement Property to EAT, Taxpayer will identify Relinquished Property as required by section 4.02(4) of Rev. Proc. 2000-37. Also, as required by section 4.02(5) of Rev. Proc. 2000-37, no later than 180 days after the transfer of qualified indicia of ownership of Replacement Property to EAT, Replacement Property will be transferred to Taxpayer. Consistent with section 4.02(6) of Rev. Proc. 2000-37, Relinquished Property will not be held by LLC or EAT in a QEAA and the total time that LLC will hold Replacement Property will not exceed 180 days. Replacement Property will be received by Taxpayer at or about the same time as the transfer of Relinquished Property to the unrelated third party buyer through QI. Therefore, Taxpayer will receive Replacement Property before the earlier of: (1) 180 days after the date on which the taxpayer transfers Relinquished Property in the exchange, or (2) 180 days after the date on which Replacement Property is transferred to EAT pursuant to the QEAA agreement.

As permitted by section 4.02(1) of Rev. Proc. 2000-37, the qualified indicia of ownership of Replacement Property will be held by EAT through LLC, a disregarded entity it wholly owns. EAT is and will be subject to federal income tax and is not Taxpayer or a disqualified person. Parent will transfer Leasehold Interest to LLC. One or more contractors hired and supervised by LLC will construct improvements on such property. Leasehold Interest, together with such improvements constructed by and for LLC, will constitute Replacement Property. Once construction is completed, Replacement Property will be transferred to Taxpayer to complete the exchange.

Section 1.1031(k)-1(e)(1) provides that a transfer of relinquished property in a deferred exchange will not fail to qualify for nonrecognition of gain or loss under § 1031 merely because the Replacement Property is not in existence or is being produced at the time the property is identified as replacement property. Section 1.1031(k)-1(e)(2)(i) requires a taxpayer to identify Replacement Property by providing a legal description of the underlying land that is subject to sublease and as much detail as is practicable regarding the construction of the improvements at the site.


Under the transaction as contemplated the Taxpayer will receive no money or other property directly, indirectly or constructively prior to or during the exchange and will receive no economic benefit of money or property other than that derived from the exchange. One possible exception will be if other property is transferred to Taxpayer incident to the failure of the contractors to timely complete the proposed improvements to the Replacement Property prior to its transfer to Taxpayer, in which case the Taxpayer will have taxable boot in addition to any like-kind replacement property received in the exchange. To the extent the estimated cost of the Improvements is less than the qualified funds held by QI, if Taxpayer does not timely identify and acquire additional like-kind replacement property, then the Taxpayer will receive the remaining qualified funds as boot.

Accordingly, the Court head that based on the documents presented, including the exchange agreement with QI, the QEAA Agreement with EAT setting up the QEAA, and all other representations made, Taxpayer's transaction will conform with the requirements of the qualified intermediary and the QEAA safe harbor rules, so that QI and EAT will not be agents of Taxpayer and Taxpayer will not be in actual or constructive receipt of money or other property before receiving the Replacement Property. Further, Taxpayer will not recognize any gain or loss upon the conveyance of Relinquished Property to a third party and the receipt of the Replacement Property. However, if planned improvements are not completed within the exchange period, gain will be recognized to the extent of any boot received in the exchange, and to the extent the estimated cost of the Improvements is less than the qualified funds held by QI, if Taxpayer does not make a timely identification and acquire additional like-kind replacement property, Taxpayer will receive the remaining funds as boot so that gain will be recognized to the extent of such boot.

Private Letter Ruling 200251008: contemplates a situation where Taxpayer is an S corporation which operates Business on a calendar year basis, using the accrual method of accounting, who owns a fee interest in the Relinquished Property with all improvements thereon. Lessor, an S corporation, currently leases Acreage situated on the Unimproved Real Property located in City and County under a Lease and Development Agreement ("Lease"), as amended, with City. The lease's term is 45 years from the commencement date (which was on or about September 2, 1997) and one 15-year renewal option. LLC-W agrees to sublease the Acreage from Lessor and all rights, title, interest and obligations under the original Lease for the entire term of Lease. LLC-W plans to utilize the Acreage, in part, as the new location for Business that presently exists on the Relinquished Property. LLC-W is currently developing and constructing the infrastructure required so that Business can be moved to the Acreage.


Taxpayer and Lessor are related parties, each owned half and half by Husband's Trust and Wife's trust, respectively. LLC-W is also related to Taxpayer, owned 45%, 45% and 10%, respectively, by Husband's Trust, Wife's Trust and Minority Member.
Village and Taxpayer entered into an Option Agreement for Sale and Purchase (Sale Agreement) of Relinquished Property on December 12, 2001, and December 13, 2001, respectively. Under the Sale Agreement, Taxpayers agreed to sell the Relinquished Property to Village for Sales Price. However, Taxpayer is arranging to have the transfer of the Relinquished Property to Village structured as a component of a like-kind exchange under § 1031 of the Code. Taxpayer will structure the exchange utilizing the qualified exchange accommodation arrangement (the QEAA) safe harbor provided in Rev. Proc. 2000-37, with an exchange accommodation titleholder (EAT) and its wholly owned subsidiary, Titleholder. Taxpayer will also use the qualified intermediary safe harbor rules of the deferred exchange regulations under § 1.1031(k)-1(g)(4) and enter into a tax deferred exchange agreement with a Qualified Intermediary (QI). Initially, the QEAA will be between Taxpayer and EAT, then later the Taxpayer's rights under the QEAA will be assigned to QI to facilitate transfer of Replacement Property from EAT to Taxpayer. The additional entity mentioned above, Titleholder, will be established for this exchange transaction, specifically to take title to Replacement Property, and will take the form of a limited liability company with the EAT serving as its sole member, so as to be disregarded for federal income tax purposes.

The advanced build to suit tax deferred exchange will be structured as follows: the single member LLC will sublease C-Acreage (which is part of Acreage) at a market rental rate for a fixed term of 32 years to Titleholder as part of the QEAA. EAT will cause Titleholder to construct Replacement Property improvements on C-Acreage. Taxpayer will identify Relinquished Property within 45 days of Titleholder entering into the sublease as provided in Rev. Proc. 2000-37 consistent with the requirements of § 1.1031(k)-1(c).

Under the QEAA, the Titleholder will enter into a contract with LLC-W, the Sublessor, who will act as Construction Manager and contract on behalf of Titleholder with independent subcontractors to construct Replacement Property improvements based on Taxpayer's plans and specifications. In addition, Titleholder will utilize the Bank Construction Loan to finance the construction of the Replacement Property improvements by executing a note payable to Taxpayer, thereby obligating the Titleholder to pay Taxpayer for draw requests paid to Construction Manager.

Subsequent to the commencement of the construction, Taxpayer will assign its rights under Sale Agreement of the Relinquished Property to QI and give notice of such assignment to all parties to such agreement in writing; Taxpayer will then transfer the Relinquished Property to Village as provided in the exchange agreement with QI. Under the terms of the agreement, the Taxpayer will retain liability on the underlying full recourse mortgage on the Relinquished Property by agreement with Bank, so that the Property will be transferred by QI to Village free and clear. Village will pay the purchase price for the Relinquished Property to QI and QI will receive and hold in escrow the proceeds from the sale.  


To complete the exchange, Taxpayer will assign its rights to receive Replacement Property under the QEAA to QI, and thereupon QI will direct that EAT transfer the Replacement Property directly to Taxpayer by transferring all of its ownership interest in Titleholder directly to Taxpayer.

Through this series of transactions, QI will purchase the Replacement Property from EAT using all the proceeds from the sale of the Relinquished Property, and the EAT (through its membership interest in Titleholder) will use all of the proceeds from the sale of the Relinquished Property to pay Construction Manager for construction and services and pay the loan from Taxpayer in full. The Taxpayer will then use the repayment proceeds to fully pay Bank Construction Loan before EAT transfers Titleholder to Taxpayer. Since Titleholder is a disregarded entity for federal tax purposes, the EAT will be deemed to enter into any contract Titleholder enters into and to perform any activity Titleholder performs. Furthermore, a transfer of all the interest in Titleholder will be treated as a transfer of the assets of Titleholder. Therefore, any reference herein to the transfer of the Replacement Property properly refers to the transfer of all the interests of EAT in Titleholder to Taxpayer.


None of the accommodators to be used to implement the proposed exchange (QI, EAT, Titleholder) are disqualified persons as defined in § 1.1031(k)- 1(k). Services to be performed for Taxpayer by EAT, Titleholder and QI, with respect to exchanges of property are intended to facilitate exchanges that qualify for nonrecognition of gain or loss under § 1031.


No later than five business days after the transfer of a qualified indicia of ownership of exchange property of the Replacement Property to EAT, Taxpayer and EAT will enter into a written agreement (setting up the QEAA) providing that EAT is holding the Replacement Property in order to facilitate an exchange under § 1031 and Rev Proc. 2000-37, and that Taxpayer and EAT agree to report the acquisition, holding and disposition of the property as provided in that revenue procedure. The QEAA will specify that EAT will be treated as the beneficial owner of the property for all federal income tax purposes and that Taxpayer and EAT will report the federal income tax attributes of the property on their federal income tax returns in a manner consistent with the terms of the QEAA.


Pursuant to the QEAA, Taxpayer will exchange the Relinquished Property for a 32-year sublease of C-Acreage and specifically identified buildings and improvements on C-Acreage to be utilized as part of the relocated Business (the “Replacement Property”). The QEAA will also provide that Titleholder will enter into a fixed term 32-year sublease with LLC-W and pay rent to LLC-W at a market rate of rent for C-Acreage of land, which is a portion of Acreage.

No later than 180 days after the transfer of the qualified indicia of ownership of Replacement Property to Titleholder, one hundred percent of the membership interest in Titleholder will be transferred directly to Taxpayer by assignment. If the production of the identified Replacement Property is not completed by Titleholder on or before the 180-day period has expired, the EAT will be required by the agreement to transfer all of its interest in Titleholder prior to the completion to Taxpayer in order to comply with the requirements of Rev. Proc. 2000-37. The agreement between Taxpayer and EAT will expressly limit Taxpayer's rights to receive, pledge, borrow or otherwise obtain the benefits of money or other property held by EAT or Titleholder in a manner consistent with the requirements of Section 1.1031(k)-1(g)(4)(ii) and (g)(6). EAT will hold qualified indicia of ownership of Replacement Property as defined in Rev. Proc. 2000-37, (through Titleholder) and such qualified indicia of ownership will be held by EAT at all times from the date of acquisition by EAT until the property is transferred to Taxpayer. At the time the qualified indicia of ownership of the property is transferred to EAT, it is Taxpayer's bona fide intent that the property held by EAT represent RP in an exchange that is intended to qualify for nonrecognition of gain (in whole or part) or loss under § 1031.


In addition to entering into the QEAA, Taxpayer will simultaneously enter into a written tax deferred exchange agreement with QI, which will require the QI to acquire the Relinquished Property from Taxpayer and direct deed the relinquished property to the third party purchaser, and to acquire the Replacement Property and transfer it to the Taxpayer. Also pursuant to the exchange agreement, Taxpayer will assign its rights under Sale Agreement for the Relinquished Property and assign its rights under the QEAA to receive the Replacement Property to the QI, and give proper and timely notice of these assignments to all parties of Sale Agreement and to all parties of the QEAA.

Pursuant to these agreements, assignments and notices, the Relinquished Property will be transferred (through QI) to Village, and the Taxpayer will receive complete ownership of the Replacement Property by assignment of all the ownership interest in Titleholder. Furthermore, since Taxpayer will transfer Relinquished Property and receive the Replacement Property simultaneously, the transaction will effectively satisfy the time requirements in Section 1031(a)(3), and the Replacement Property will not remain in QEAA for a period exceeding 180 days.


The entire proposed transaction at issue can be summarized in the following steps:

(1) Taxpayer will enter into the QEAA with EAT, and will enter into an exchange agreement with QI as described.

(2) LLC-W (Sublessor) will sublease Replacement Property at a fair market rental, for 32 years, to Titleholder, a disregarded entity wholly owned by EAT, as part of a QEAA as defined in Rev. Proc. 2000-37.

(3) Taxpayer will lend to Titleholder the funds to construct improvements necessary on leased property for relocation of Business.

(4) Taxpayer will assign its rights under Sale Agreement of the Relinquished Property to the QI and will give required notices of such assignment to all interested parties.

(5) Taxpayer will transfer Relinquished Property free and clear through QI to Village, the third party Buyer and QI will receive sales proceeds.

(6) Taxpayer will assign its position in the QEAA to QI and give required notices of such assignment to all interested parties.

(7) QI will use sales proceeds from the Relinquished Property to pay the EAT for all of its interest in Titleholder (which holds all of the Replacement Property, consisting of leased property and newly constructed improvements to suit Taxpayer's business requirements).

(8) EAT will use the proceeds received from QI, the consideration for the transfer of Replacement Property, to pay Construction Manager and to pay back the funds advanced/ loan from Taxpayer in full

(9) Taxpayer will use funds from the EAT to pay the Construction Loans in part or in full.

(10) QI will direct EAT to transfer its interest in Titleholder (holding the Replacment Property) directly to Taxpayer.

In the transaction as structured above, the qualified indicia of ownership of Replacement Property will be held by EAT in compliance with all requirements stated in section 4.02(1) of Rev. Proc. 2000-37, and it is and will be Taxpayer's bona fide intent that the property held by EAT represent replacement property in an exchange qualifying for nonrecognition under Section 1031, consistent with section 4.02(2) of Rev. Proc. 2000-37.

In addition, Taxpayer simultaneously entered into a tax deferred exchange agreement with QI to facilitate transfer of the Relinquished Property to the third party buyer in the exchange transaction as permitted by § 1.1031(k)-1(g)(4) of the regulations, so that the party facilitating the exchange may not be deemed to have an agency relationship with Taxpayer.  Accordingly, Taxpayer's transfer of relinquished property through a qualified intermediary and the subsequent receipt or deemed receipt of like-kind replacement property through a qualified intermediary is treated as an exchange, rather than a sale and reinvestment of proceeds.


As permitted by section 4.02(1) of Rev. Proc. 2000-37, the qualified indicia of ownership of the Replacement Property will be held by EAT through Titleholder, another disregarded, single member LLC which it wholly owns. The EAT is and will be subject to federal income tax and is not Taxpayer or a disqualified person. LLC-W is subleasing C-acres of the Unimproved Real Property to Titleholder, and EAT and Titleholder will construct improvements on such property by one or more contractors hired and supervised by LLC-W. C-Acreage, the subleased premises, together with the improvements constructed by and for Titleholder, will constitute the Replacement Property for purposes of the tax deferred exchange transaction. Once EAT and Titleholder complete the construction of improvements and the exchange of Replacement Property for the Relinquished Property is considered completed, the Taxpayer will take ownership of Titleholder (the disregarded entity holding title to Replacement Property).


Section 1.1031-1(e)(1) of the regulations provides that a transfer of relinquished property in a deferred exchange will not fail to qualify for nonrecognition of gain or loss under Section 1031 merely because the Replacement Property is not in existence or is being produced at the time the property is identified as replacement property.

Based on the documents presented, including the exchange agreement with QI, the qualified exchange accommodation agreement with EAT setting up the QEAA, and all other representations made, Taxpayer's transaction will conform with the requirements of the QI and the QEAA safe harbor rules, so that QI and EAT will not be agents of Taxpayer and Taxpayer will not be in actual or constructive receipt of money or other property before receiving Replacement Property. Further, Taxpayer will not recognize any gain or loss upon the conveyance of the Relinquished Property to third party buyer and the receipt of the Replacement Property.

How the two applicable PLRs Differ


The 2003 ruling differs from the 2002 ruling in two respects: the case presented in 2002 involves an assignment of the replacement property to the EAT rather than a sublease and the funding for the leasehold improvements was obtain in the form of a loan by the taxpayer to the EAT, while the 2003 case involved use of funds from the sale of the relinquished property to fund the construction by the Qualified Intermediary. While Revenue Procedure 2000-37 explicitly approved the use of funds loaned by the Taxpayer, the 2003 ruling goes a step further by allowing the use of funds held by the qualified intermediary, which is likely to be a funding method preferred by taxpayers.


While these rulings are complicated by “related party” restrictions, the underlying concepts as they pertain to advanced build to suit transactions are applicable to any like-kind tax deferred exchange where improvements are constructed by an EAT. In these transactions, the major practical limitation is the EAT's ownership (and therefore the construction period) may not exceed 180 days. If the construction is not completed by the end of the 180-day period, the property must nevertheless be conveyed by the EAT to the taxpayer on that date, and accordingly, only the value of the improvements completed by that date will qualify as like-kind exchange replacement property.

Does an Advanced Planning Build to Suit Transaction Make Sense for my Client?

While private letter rulings are not precedential authority and hence may not be relied on to structure advanced build to suit transactions, these rulings do indicate a favorable disposition by the IRS for transactions drafted with the inherent flexibility to incorporate like-kind exchanges and construction. When taken in conjunction with the overall legislative and common law approach that “notwithstanding the familiar and longstanding rule that exemptions are to be narrowly or strictly construed, * * * Section 1031 has been given a liberal interpretation.” Estate of Bowers v. Commissioner, 94 T.C. 582, 590, 1990 WL 43069 (1990) (citing Biggs v. Commissioner, 69 T.C. 905, 913-914, 1978 WL 3295 (1978), affd. 632 F.2d 1171 (5th Cir.1980))  and the lenient attitude toward deferred like-kind exchange cases evidenced by the Courts (see, e.g., Starker v. United States, 602 F.2d 1341 (9th Cir.1979)), it is a fair characterization to say that the advanced build to suit transaction is one that may be appropriately structured under current law and that key to the success of the transaction is adherence to a structure delineated in the applicable private letter rulings. Of paramount importance is an early determination that a separate leasehold interest is deemed to be a real property interest distinct from the fee simple ownership of the property in the state in which the contemplated Replacement Property sits, and further that the structure proposed for the advanced build to suit tax deferred exchange takes into account and appropriately addresses the issue of beneficial ownership and the risk of having the relationships characterized as agency. In the advanced build to suit transaction, like tax deferred exchanges generally, the key element to success is establishing a working relationship with an advisor early on, so that the advisor may present and guide the Taxpayer through the risks inherent in the advanced build to suit tax deferred exchange transaction so as to accomplish the Taxpayers objectives in the safest and most expedient means possible.

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