In a typical improvement 1031 exchange, the Exchanger uses a Qualified Intermediary to sell its relinquished property. An affiliate of the Qualified Intermediary (QI), an Exchange Accommodation Titleholder (EAT), uses the proceeds from this sale to purchase a new replacement property from a third-party seller, improve the property, and transfer improved property to the Exchanger within 180 days after the day the relinquished property was transferred.
The use of the EAT and QI, in this manner, allows the Exchanger to control the property and improvements built thereon. Because the EAT is treated as owning the property for federal income tax purposes, however, the Exchanger is able to reinvest the proceeds from the sale of the relinquished property in the land and improvements tax-deferred. This creates greater tax deferral than the Exchanger would obtain if only the land had been replacement property.
It is well established that an Exchanger cannot include improvements to property already owned as replacement property. However, recently the IRS released Private Letter Rulings 200251008 and 200329021, which set forth structures where an EAT made improvements to a property owned by an affiliate or related party and then the Exchanger received the improved property as qualifying replacement property. Although these rulings do not have identical circumstances, they do share a similar approach:
1. Exchanger enters into a Qualified Exchange Accommodation Agreement (QEAA) with the EAT and enters into an exchange agreement with a QI;
2. Exchanger’s affiliate or related party leases the replacement property to EAT at fair market rent, for a term of not less than 30 years, as part of the QEAA as defined in Revenue Procedure 2000-37;
3. Exchanger (or third-party bank where the Exchanger gives its personal guaranty) lends EAT the funds needed to construct improvements on the leased property;
4. Exchanger assigns its rights to the sale contract of the relinquished property to the QI;
5. Exchanger transfers title to the relinquished property to the buyer.
6. Exchanger assigns its rights in the QEAA to the QI;
7. QI uses proceed from the sale of relinquished property to pay EAT;
8. EAT uses the proceeds received from the QI to pay for improvements and/or to pay the construction loan in full; and
9. QI directs EAT to transfer the improved replacement property directly to the Exchanger.
Note: API urges every taxpayer to consult with their own legal and/or tax advisors regarding their specific situation. A PLR applies to the facts and circumstances of a taxpayer’s specific situation. Most Private Letter Rulings have language as follows: “This ruling is directed only to the taxpayer who requested it. Section 6110(k)(3) of the Code provides that it may not be cited as precedent.”