Build-to-suit exchanges.

Sec. 1031 allows for non-recognition of gain when property held for investment or trade or business use is exchanged for like-kind property. A common problem is how to handle an exchange in which all or a portion of the replacement property is to be constructed. This "build-to-suit" exchange is permitted by the deferred exchange regulations, but must be carefully structured to ensure that a taxpayer is treated as receiving the replacement property from a party to the exchange, not building the improvements as a principal.

Sec. 1031(a)(3) allows an exchange to qualify for non-recognition treatment if replacement property is both identified within 45 days of transfer of the relinquished property and received within 180 days of such transfer. (The latter may need to be assured by extending the due date of the taxpayer's return.) Regs. Sec. 1.1031(k)-1(e) describes how to identify property to be produced and, in the case of a real property exchange, allows construction-in-progress to qualify as replacement property if it constitutes real property under local law. However, Regs. Sec. 1.1031(k)-1(e)(4) does not permit an exchange of real property for construction services, including any services to be performed following the expiration of the statutory replacement period. Thus, a practical problem with many build-to-suit exchanges is the inability to complete the improvements within the allowed replacement period.

A tax adviser may be asked whether improvements may be constructed on land the taxpayer already owns. Because the taxpayer must exchange property with another party, such a plan is very difficult to fit under Sec. 1031. Simply contracting for improvements on land already owned would involve an exchange for construction services that would be taxable; see Bloomington Coca-Cola Bottling Co., 189 F2d 14 (7th Cir. 1951). The taxpayer would need to first transfer ownership of the land to another party, who would then build the improvements and transfer the land and improvements back to the taxpayer. Structuring such an arrangement without creating an agency relationship between the taxpayer and the other party (which would defeat nonrecognition treatment) may not be possible.

The IRS has approved certain build-to-suit structures. For example, in Rev. Rul. 75-291, a corporation (X) agreed to exchange its land and factory for land to be purchased by another corporation (Y) and improvements to be constructed thereon. The ruling stated that Y could terminate the arrangement if its costs exceeded a specified amount and that Y "built the factory solely on its own behalf" and "not as an agent of the taxpayer." X was allowed nonrecognition treatment, although the ruling did not detail the financing arrangements, who approved plans and specifications and selected the architect and other build-to-suit details that may arguably create an agency relationship between the taxpayer and the exchanging party.

J.H. Baird Publishing Company, 39 TC 608 (1962), acq., 1963-2 CB 4, illustrated some control elements that the taxpayer may have over the construction process without creating a prohibited agency relationship. The taxpayer conveyed land and a building to a realty firm that functioned as an intermediary. The intermediary sold the taxpayer's property and purchased land identified by the taxpayer. The intermediary had agreed to convey to the taxpayer a building that was suitable for his needs. The taxpayer had the right to approve (1) selection of the contractor, (2) all building plans and specifications, (3) all invoices and (4) all construction changes. The Tax Court determined that a principal-agent relationship had not been established. Several reasons were cited in support of this determination, including certain costs and risk of loss borne by the intermediary during the construction period.

In Letter Ruling 9149018, a corporation owned an office building that another party wanted to purchase. The corporation indicated that it would exchange its property for land and construction of a new building. The other party agreed to acquire land and to construct a building that would meet the taxpayer's needs. The corporation incurred due diligence costs in evaluating the acquisition of a long-term leasehold on the land and paid the project architect and project developer fees for services performed before the exchange documents and the construction loan documents were executed. The corporation also (1) provided much of the construction financing through a nonrecourse loan; (2) approved selection of the contractor and all subcontractors; (3) approved all plans and specifications and could require changes to such plans; (4) approved the contract with the architect; and (5) approved all construction costs. The ruling concluded that the corporation met the requirements of Sec. 1031. The other party incurred certain risks of ownership during construction that suggested it was more than the taxpayer's agent, including certain out-of-pocket costs apart from the taxpayer's loan, and exposed itself to liability under the construction contract, the exchange agreement, the construction process and the leasehold on the land.

The Tax Court and the Service will allow for some flexibility in a build-to-suit exchange. However, a tax adviser who participates in such an exchange should carefully examine the relationship between the taxpayer and the party who will acquire the land, construct the improvements and consummate the exchange. The use of "friendly" parties for this purpose need not be fatal, but a friendly party must bear some risks of ownership to avoid an agency relationship (which would result in an exchange for construction services). It is also important to carefully review the procedures for identification of property to be produced and to advise the taxpayer of the time constraints imposed by the statutory replacement period.

FROM JAMES R. HAMILL, PH.D., CPA, PROFESSOR, UNIVERSITY OF NEW MEXICO, ALBUQUERQUE, NM