Building on Your Own Property in a 1031 Exchange

The Big Picture

Sometimes a taxpayer wants to sell a property and use the exchange proceeds to construct improvements on a property “they” already own as part of a §1031 exchange. The quotation marks around “they” are intentional—because in a 1031 exchange, the subject of “they” has significant implications.

If the relinquished property and the replacement property are owned by the same taxpayer, exchange proceeds generally may not be used to improve the replacement property. However, this restriction does not apply when the replacement property is owned by an affiliate or other related party. In that case, the exchange proceeds may be used for construction, provided the transaction is properly structured and complies with §1031 requirements.

Why it Matters

A taxpayer may find that the best opportunity for reinvestment is to add improvements to a property that one of its affiliates or related parties already owns, rather than purchase a property from someone else. In that case, we start with the fact that fee title is like-kind to a leasehold estate as long as the leasehold estate has 30 years or more remaining, including renewal options. IRC § 1.1031(a)-1(b). This allows for the following structure in accordance with IRS Private Letter Rulings 200251008 and 200329021:

• As with all exchanges, a taxpayer enters into an exchange agreement with a 1031 qualified intermediary (QI);
• The QI forms a special purpose limited liability company specific for this transaction as an “exchange accommodation titleholder” (EAT);
• The taxpayer enters into a qualified exchange accommodation agreement (QEAA) with the EAT;
• The taxpayer’s affiliate or related party leases the replacement property to the 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;
• The taxpayer (or a third-party bank where the taxpayer gives its personal guaranty) lends the EAT the funds needed to construct improvements on the leased property;
• The taxpayer assigns its rights to the sales contract of the relinquished property to the QI;
• The Taxpayer assigns its rights in the QEAA to the QI;
• The QI uses proceeds from the sale of the relinquished property to pay the EAT;
• The EAT uses the proceeds received from the QI to pay for improvements and/or to pay the construction loan in full; and
• The QI directs the EAT to transfer the replacement property directly to the taxpayer leasehold estate by the 180th day after the relinquished property closes.

This structure is known as the “leasehold improvement exchange.”

Strategy for Same-Taxpayer Situation

Can a taxpayer transfer property to a related entity and then effectuate a leasehold improvement exchange? Such question was addressed by the IRS for the first time in Private Letter Ruling 202520001. In that scenario, the taxpayer transferred land to a related party with the intent to initiate a leasehold improvement exchange after 180 days. Conditioned upon the detailed representations made by the taxpayer, the IRS ruled that the exchange would be allowed. Taxpayers and their advisors should review this PLR when both properties are owned by the same taxpayer.

The Takeaway

In a 1031 exchange, the issue is not whether improvements can be made; rather, the question to be addressed is who owns the land on which improvements are to be constructed. If the taxpayer owns both the relinquished and replacement properties, exchange proceeds generally cannot be used to make improvements. But when the replacement property is owned by an affiliate or a related party, perhaps even properties previously owned by the same taxpayer, improvement construction may be permissible. Proper planning with an experienced tax counsel—and sufficient lead time—is essential to ensure a leasehold improvement exchange is structured correctly.

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