Commercial Real Estate Blog by Madison

Parking Arrangements in Construction Exchanges and for Other Purposes

In the last few posts, we looked at how parking arrangements are handled in reverse exchanges. Construction exchanges are in some ways very similar to reverse exchanges. Both involve a parking arrangement. In a construction exchange, however, the purpose of the parking arrangement is different.

IRC § 1031 allows for the cost of construction on replacement property to be counted as part of the purchase price of that property, but only to the extent that the improvements have been made to the property before the taxpayer acquires it. Once the taxpayer owns the replacement property, it is too late. Moreover, payment for bricks and mortar sitting at the construction site does not count for exchange purposes until those bricks and mortar have been attached to the ground. The cost of services performed for construction counts, but not the cost of services that have not yet been performed. In a construction exchange, the parking arrangement allows these improvements to be made while the property is in the hands of a friendly party.

Generally, a traditional non-safe harbor construction exchange has all of the issues and dangers of a non-safe harbor reverse exchange. Therefore, Rev. Proc. 2000-37 safe harbor parking arrangements are just as useful for construction exchanges as they are for reverse exchanges. In the taxpayer’s identification notice, both the replacement property as well as the general nature of the improvements that will be made to that property should be described. When the property is acquired, it is parked with an EAT during the construction period. All construction that the taxpayer can claim credit for in the exchange must be completed by the end of the ordinary 180-day exchange period. Exchange proceeds held by the qualified intermediary can be used to make payments for construction as it progresses, but only to the extent of materials that have been attached to the real estate and work that has been completed.

The 180-day limit on construction is often a serious problem in a safe harbor construction exchange, but the expense and risk of a non-safe harbor construction exchange is still daunting. There is one type of non-safe harbor construction exchange that is worth a close examination whenever the 180-day time limit is too short. That is to get permission from the third-party seller to make improvements prior to closing of title. The third-party seller has, of course, “significant indicia of ownership.” So long as nothing in the sales agreement effectively transfers ownership of the property to the taxpayer during the construction period, and so long as the taxpayer does not pay an inordinate portion of the purchase price prior to closing title, permission by the seller to allow the buyer to improve the property should not raise any red flags. The seller can protect itself by charging reasonable rent, by requiring the taxpayer to provide construction insurance and indemnification, and by requiring payment of a significant deposit. The taxpayer/buyer can protect itself by researching title in advance of construction, by recording a memorandum of the agreement of sale, and by obtaining appropriate indemnification from the seller.

Despite the undeniable attractions of building while property is still owned by the seller, for a variety of reasons, most taxpayers find it impractical to reach a mutually acceptable agreement with the seller to do that. Furthermore, in order to take advantage of this strategy, it is necessary to delay sale of the relinquished property, which is often impossible. Therefore, safe harbor construction exchanges remain by far the more popular option although the time for construction is severely limited.

One final note about parking arrangements: They can sometimes be used for purposes that have nothing to do with reverse exchanges or construction exchanges. For example, let’s say that two taxpayers want to buy tenancy in common interests in a single replacement property to complete exchanges for each of them, but the purchase contract was drafted to provide that the property would be bought by XYZ LLC, a new single purpose entity. Some sellers, including certain government agencies, may resist amending the contract to provide for two buyers instead of one. At Madison Exchange, we have used a safe harbor parking arrangement to solve that problem. Ownership of XYZ LLC was transferred to our subsidiary company, Madison to Park, LLC. XYZ LLC then took title to the replacement property and issued deeds to each of the taxpayers.

Problem solved.

Tags: , , , , , , , , , , , , , , , , Comments Off

Comments are closed.

WordPress Appliance - Powered by TurnKey Linux