Has your company outgrown its space? Have you considered moving your company to another location? If so, you may want to take advantage of one of the more valuable tax saving strategies available under Internal Revenue Code Section 1031: the “build-to-suit exchange” – also called a “construction” or “improvement exchange.”

Many companies in the New England area currently reside in older spaces which may have substantially appreciated in value with the recent real estate boom. However, recognizing this value, through a taxable sale, can be a costly endeavor. Therefore, if a current space is not the highest and best use for the real estate from a return on investment perspective, a tax-free build-to-suit exchange can help unlock this value by allowing a transfer of the appreciated value into a better business facility.

Build-to-suit exchanges allow the acquisition of land and the creation of newly constructed property or improvements, repairs or capital improvements, to an existing property prior to acquisition. These types of exchanges are an excellent opportunity to customize a property or locate a suitable property because the owner can build to their specifications while avoiding gain recognition and preserving wealth.

In the most common type of build-to-suit exchange, the exchanger first sells the relinquished property and then orders the sale proceeds transferred to a qualified intermediary. A qualified intermediary is a person or company satisfying several requirements under the income tax rules, but is most often a subsidiary of a bank or affiliated with a title company.

For example, Company X owns a manufacturing plant that has outgrown its current building and the company wants to acquire raw land to construct a replacement property. To control the construction of the new plant, Company X hires an “accommodation titleholder” to acquire title to the raw land. Company X then directs the construction of the manufacturing plant and finances the construction of the plant using the exchange proceeds held by the qualified intermediary. When the construction is completed, the plant is transferred to Company X, completing the exchange.

Another build-to-suit scenario involves a prospective buyer who approaches a company to purchase its facility because of the facility’s desirable location – often the result of rezoning or new construction in the area. To take advantage of a build-to-suit exchange, the company owner could instruct the buyer to find a new facility and make any necessary improvements according to the owner’s specifications. The exchange of property occurs following completion of the improvements.

While the tax savings are significant, in order to take advantage of a “safe harbor” build-to-suit exchange, there are a number of factors to keep in mind:

• The exchanger must identify a replacement property within 45 days of the sale of relinquished property. The tax code allows for 45 days to provide written identification of the replacement property and any improvements to be completed on the property following the sale of the relinquished property; this typically involves a legal description of the property along with floor plans and specifications for new construction or a complete description of the renovation.

• For purposes of the identification rule, the exchanger is allowed to identify up to three properties without regard to fair market value or multiple properties, so long as the aggregate amount of the fair market value of the multiple properties does not exceed 200 percent of the aggregate fair market value of the relinquished property. In the built-to-suit situation the 200 percent value should be the estimated fair market value at the time the property is fully constructed.

• The party constructing the improvements may not act as the exchanger’s agent.

• The exchanger cannot pre-pay for construction services to be completed after the replacement property is acquired. Construction materials that are just delivered to the site and not constructed are also considered pre-paid services and not “like-kind” to real property.

• Improvements completed after the exchanger has acquired the property do not qualify as replacement property.

• Perhaps most importantly, the exchanger must obtain title to the replacement property within 180 days of the sale of the relinquished property. The tax code provides the exchanger with only 180 days from closing on the relinquished property to acquire and complete construction on the replacement property; however, the qualified intermediary can pay invoices and bills received after the 180-day period for work performed during the 180-day exchange period.

Open Ocean

But what if the exchanger can’t meet the 180-day transfer requirement due to the time involved in obtaining permits and approvals, construction and financing contracts, inclement weather or other normal construction delays? The exchanger can embark on a “non-safe harbor” transaction, which is riskier due to the fact that the Internal Revenue Service has not blessed the tax treatment of non-safe harbor exchanges and because the IRS reserves the right to challenge these transactions as it sees fit. While riskier than the safe harbor transactions, non-safe harbor transactions are still a viable option for taxpayers who cannot meet the safe harbor requirements. However, consultation with a tax advisor is essential.

Any company that owns property should consider whether it is getting the highest and best use of the value of a property. A build-to-suit exchange may be the best way to unlock this value and allow a company to renovate or construct a new business site with significant tax savings.