How a Build to Suit 1031 Exchange Works

A build-to-suit exchange is a specialized tax-deferral strategy under Section 1031 of the Internal Revenue Code. It allows an investor to sell an existing property and use the sale proceeds to fund the construction of a new, custom-built replacement property. The purpose of this transaction is to defer the payment of capital gains taxes that would otherwise be due from the sale. This method allows for reinvesting capital into a property specifically tailored to the taxpayer’s needs, such as a company outgrowing its current facility.

This approach allows for the tax-deferred use of equity to build a new asset or make significant improvements to an existing structure. By channeling funds from the old property into the new construction project, the taxpayer can align their real estate holdings with their objectives without an immediate tax consequence. The structure is more complex than a standard exchange and involves specific rules and timelines that must be carefully managed.

Core Requirements for a Build-to-Suit Exchange

A rule for any 1031 exchange is the like-kind property requirement, meaning the property sold and the property acquired must both be held for productive use in a trade or business or for investment. For real estate, the definition of “like-kind” is broad, as an office building can be exchanged for raw land. In a build-to-suit exchange, both the land being acquired and the improvements constructed upon it are considered like-kind to the real property being sold.

To achieve full tax deferral, the transaction must satisfy specific value and equity rules. The total value of the replacement property, including the cost of the land plus the value of the new construction, must be equal to or greater than the fair market value of the property sold. All net cash proceeds from the sale must be used to acquire and improve the new property. If the taxpayer receives cash or the new property is of lesser value, that portion is considered “boot” and may be subject to capital gains tax.

The entire exchange is governed by a 180-day timeline. From the day the original property is sold, the taxpayer has 180 calendar days to complete the acquisition of the replacement property. Only the value of the property actually received by the taxpayer within this 180-day window qualifies for the exchange. This includes the value of the land and any improvements that are physically completed; materials paid for but not yet installed do not count.

Within this 180-day period, there is an initial 45-day identification window that begins when the relinquished property is sold. The taxpayer must formally identify the replacement property in writing. For a property not yet built, this identification requires a legal description of the land and detailed information about the planned improvements, such as architectural plans or blueprints.

Structuring the Exchange with an Accommodation Titleholder

A build-to-suit exchange cannot be accomplished by the taxpayer directly using exchange funds to improve property they already own. To navigate this, the transaction is structured using an independent third party known as an Exchange Accommodation Titleholder (EAT). The EAT is a special-purpose entity that temporarily acquires and holds, or “parks,” the title to the replacement property while construction is underway. This structure is necessary because improvements made to land already owned by the taxpayer with exchange funds would not qualify as like-kind property.

This parking arrangement is sanctioned under a safe harbor provided by IRS Revenue Procedure 2000-37. The EAT is an independent entity that facilitates the exchange by holding the property on the taxpayer’s behalf. The relationship between the taxpayer and the EAT is formally defined by a Qualified Exchange Accommodation Agreement (QEAA). This agreement is entered into before the EAT takes title to the replacement property and outlines the terms of the parking arrangement.

The EAT is typically established by a firm that also provides Qualified Intermediary (QI) services, although they must be separate legal entities. The QI’s role is to hold the proceeds from the sale of the relinquished property. The EAT’s role is to use those funds, as directed, to purchase the land and pay for the construction.

The Build-to-Suit Exchange Process Step-by-Step

The process begins with the sale of the taxpayer’s original investment or business property, known as the relinquished property. At the closing, the sale proceeds are not given to the taxpayer but are instead transferred directly to a Qualified Intermediary (QI). The taxpayer’s receipt of the funds would invalidate the tax-deferred nature of the exchange.

With the exchange funds held by the QI, the taxpayer engages an Exchange Accommodation Titleholder (EAT) and enters into a Qualified Exchange Accommodation Agreement (QEAA). This agreement contractually obligates the EAT to acquire, hold, and improve the replacement property on the taxpayer’s behalf.

Within the 45-day identification period, the taxpayer must deliver a signed, written notice to the QI that identifies the replacement property. This includes the legal description of the land and detailed plans for the construction to be completed.

Following identification, the taxpayer assigns their rights in the purchase contract for the new land to the EAT. The QI then forwards the necessary exchange funds to the EAT, which uses the money to formally purchase and take legal title to the replacement property land. At this point, the EAT is the legal owner of the property where the new construction will occur.

During the construction phase, the taxpayer acts as the project manager, overseeing development and approving work. As construction milestones are met, contractors submit invoices for payment. The taxpayer reviews and approves these invoices, which are then sent to the EAT for payment using the exchange funds held by the QI, who disburses funds to the EAT to pay the vendors.

On or before the 180th day following the sale of the relinquished property, the exchange must be completed. The EAT transfers the legal title of the replacement property, with all improvements constructed to date, to the taxpayer. This transfer can be done via a deed or by assigning the membership interests of the LLC that served as the EAT.

Handling Unfinished Construction and Post-Exchange Matters

In a build-to-suit exchange, the value of the replacement property for tax deferral purposes is its fair market value when it is transferred from the Exchange Accommodation Titleholder (EAT) to the taxpayer. This value is composed of the land’s purchase price plus the value of all capital improvements physically part of the real estate by the 180th day. A certificate of occupancy is not required for the exchange to be valid; what matters is the value of the work that is in place.

If construction is not finished by the 180-day deadline, the taxpayer may have to recognize a taxable gain. This taxable amount, known as “boot,” is created if the value of the property received from the EAT is less than the value of the relinquished property sold. For example, if a taxpayer sells a property for $2 million and the replacement property is only valued at $1.8 million on the 180th day, the $200,000 shortfall in value is generally taxable.

The calculation of recognized gain depends on the amount of boot received. If the taxpayer in the previous example had an $800,000 gain from the $2 million sale, the $200,000 of boot would be taxed as a capital gain. Partial tax deferral is still achieved on the portion of the gain successfully reinvested.

Once the taxpayer takes title to the property from the EAT, the 1031 exchange is officially complete. The taxpayer is then free to finish the construction project using their own personal or borrowed funds. These post-exchange expenditures do not affect the concluded exchange, as they are made on property the taxpayer now owns.